Web prepared, posted and Copyright © April 15, 2000, by the American Bankruptcy Institute.

Public Works Construction Remedies: Bonding, Not Bondage

By: Douglas G. Fox, CCE
Mannesman Rexroth Corp.

Construction projects are often awarded to the lowest bidder. However, that process can increase the risk of default because the successful bidder is often the one with the lowest overhead—and few, if any, unencumbered assets.

The Miller Act of 1935 (40 U.S.C. §270(a)-(f))requires performance and payment bonds for federal public works projects. The different types of bonds are as follows:

(a) The bid bond is often the first type of bond required in connection with any public works project, and it must often be provided at the bidding stage. This demonstrates that the contractor is bondable and provides some protection to the government by providing a third-party guarantee that the contractor will start the project. A typical bid bond might be 20-40 percent of the contractor's bid, which is forfeited in the event the contractor fails to start work or to provide the required performance and payment bonds within the prescribed time limit.
(b) The performance bond insures the government for the successful completion of the project.
(c) The payment bond insures subcontractors so that they will be paid by the general contractor (GC).

The states have enacted similar statues, often referred to as "The Little Miller Acts." In the event that a job is bonded and the GC defaults, the surety essentially has four options:

1. Put out the uncompleted work for bid by other contractors.
2. Finance the original GC to complete the job.
3. Do the work itself (an impractical option).
4. Pay the bond penalty (usually 100 percent of the value of the contract) to the GC and walk away.

The bankruptcy filing of a GC may not always result in a default. Sometimes, the surety with the consent of the court is granted a super-priority lien in exchange for providing new DIP financing.

Many creditors make the mistake of thinking they are automatically protected whenever there is a payment bond. However, for federal public works projects (such as U.S. Army Corps of Engineers projects) where the amount of the contract exceeds $5 million, the statutory minimum for the bond is $2.5 million. That $2.5 million of insurance coverage is the amount provided for all claims combined. Thus, in extremely large contracts, the amounts owed or potentially owed to subcontractors (SCs) can grossly exceed the protection afforded by the payment bond.

In practice, how the surety divides the $2.5 million seems to be "less than fixed in granite." Underwriters say that in some cases, the surety has paid first come, first served, and those who came too late got nothing. However, that appears to be the exception rather than the rule. To be safe, creditors should notify the surety as soon as serious problems appear.

Often large jobs are bid by several GCs acting as a "joint venture" (J/V). What happens in the event of a default by one member of the J/Vs? Each member of the J/V is responsible for up to 100 percent for the financial obligations of the project. In the event that one partner cannot complete its obligations, the other(s) must do so—as supported by their own surety bond(s). In other projects, it is common for the bonds to be 100 percent of the contract value. Obviously, those bonds provide greater protection for SCs.

It is not unusual for a surety to have multiple obligations as a result of more than one project running simultaneously. However, bonds for each project are considered unique. Obligations on one project will not spill over to any other. From a bonding perspective, any deficit on one project cannot be applied against a surplus on another—and vice versa.

How (and when) should creditors determine whether the project is bonded? In order to avoid problems down the road, it is extremely important to request this information from your customer prior to order placement.

However, failing this, you may still be "in the ball game." Many statutes (including The Miller Act) require the GC to furnish a copy of their bond(s) upon request. However, be forewarned that there frequently are strict time limitations on the submission of claims, and even a day's delay may render your claim null and void.

The Surety Association of America (SAA—the trade group of the surety industry) has established, on behalf of participating members, a voluntary Bond Authenticity Program. The author has used this program and his inquiries have always been met with a timely response from the individual surety. To find out about the program, simply log onto the SAA home page at www.surety.org, then (in the left side bar) click on the word "surety."

On extremely large or complicated jobs, it may be in your best interest to assess the financial condition of the surety. The leading rating company is A M Best Co. Ratings on individual sureties may be obtained by (a) automated telephone/fax reply or (b) online via the A M Best Co.'s home page at www.ambest.com (go to the second column entitled 3rating information,2 and click on the first choice "ratings search.")

Also, many states have enacted legislation establishing a trust fund whereby the construction funds are deemed to be held in trust by the GC and are not considered property of the GC's estate. But that is a topic for another time.

The preceding is not intended to be nor should it be considered legal nor financial advice. Interested parties with questions should consult competent counsel. Douglas G. Fox is a member of ABI's Unsecured Trade Creditor Committee and is active with The National Association of Credit Management in the Philadelphia area.

1999 Winter Leadership Conference UTC Committee Meeting Minutes

The Unsecured Trade Creditor Committee (UTCC) met at the Winter Leadership Conference on Dec. 4, 1999 in La Quinta, Calif. The business portion of our meeting was abbreviated due to the excellent program by Lynnette R. Warman (Jenkens & Gilchrist, Dallas) and Mark V. Bossi (Thompson Coburn, St. Louis). They reviewed changes to Article 9 of the Uniform Commercial Code, which will impact secured and unsecured trade creditors, and used a hypothetical example to walk us through a typical transaction under the revised Code. It quickly became evident that we are all in for a confusing period of at least five years following the July 1, 2001, effective date for revised Article 9 as we cope with the transition between the two systems.

On the business side, Geoffrey Berman (Development Specialists Inc., Los Angeles) advised the group that the Manual on Assignments for the Benefit of Creditors should be published in the spring. Lynnette Warman was congratulated for her excellent work on News and Views, the UTCC newsletter. She is working to get as many NACM web sites as possible to include the newsletter on their sites. Committee Co-chair Sandra Schirmang (Kraft Foods Inc., Northfield, Ill.) announced that plans were underway for a presentation by the UTCC to be included in the agenda for the NACM Legislative Conference in Washington in March. Bruce Nathan (Davidoff & Malito LLP, New York), Lynnette Warman and Mark Bossi gave the presentation on revised Article 9 on March 12, 2000. Committee Co-chair Judy Thompson (Poyner & Spruill LLP, Charlotte, N.C.) updated the UTCC on the progress on the Preference Handbook project, which will explain preferences and defenses available to creditors, and will provide a summary of state preference laws as well. Finally, a call was made for topics for ABI's online newsletter, "Cracking the Code," on ABI World, and for News and Views. Anyone with ideas for a topic for an article for "Cracking the Code," which should be a practically oriented, 750-word piece, should contact Judy Thompson at jdthompson@poynerspruill.com. Those of you who would like to publish a short (1-2 page) article for the newsletter should contact Lynnette Warman at lwarman@jenkens.com.

The next meeting of the UTCC will be Saturday, April 29, 2000, from 9:30 to 11:00 a.m. at the J.W. Marriott in Washington. For more information, send an e-mail to Sandra at sschirmang@kraft.com or to Lynnette at lwarman@jenkens.com.

—Judy Thompson
Poyner & Spruill LLP

The "Nuts & Bolts Creditors' Forum" is a feature that contains questions relating to credit issues and their suggested solutions. Questions or comments to be included in future newsletters are welcome. Question: Will the proposed revised Article 9 affect consignments? Answer: Yes. Much to the surprise of creditors selling goods through "consignment," the revisions to Article 9 will affect their transactions. Careful attention to the changes, which are intended to take effect in most states on July 1, 2001, should be paid to make sure that consignments do not become unsecured creditor relationships. The sale of goods on a true consignment is often used as a vehicle to protect the supplier of goods (consignor) against the creditors of the buyer (consignee) of the goods. The advantage to the consignor is that, until the goods are sold, title to the goods is retained by the consignor. In the event of the consignee's bankruptcy, the consigned goods do not become property of the bankruptcy estate and are not subject to claims of either secured or unsecured creditors of the consignee. The consignor, having retained title throughout the relationship, maintains the right to recover the consigned property, subject to the application of the automatic stay imposed by §362 of the Bankruptcy Code. Consignments are currently regulated under Article 2 of the Uniform Commercial Code. The current Uniform Commercial Code states in §2-326 that a consignment will be recognized and enforced if one of the following occurs: (A) the buyer complies with an applicable law providing for a consignor's interest in the goods to be evidenced by a sign stating that the goods are being sold on consignment, (B) it is generally known that the seller is selling consigned goods, or (C) the consignor files a UCC-1 financing statement as required under Article 9 of the UCC. Under the current Uniform Commercial Code, the protection afforded to the consignor's interest in the goods is similar to that of a purchase-money security interest, including priority over a secured creditor holding an earlier interest in the consignee's property, so long as the consignor has complied with the requirements as set forth in §2-326 of the Uniform Commercial Code. Under current §2-326, this priority would be retained even without filing a UCC-1 statement, although it was always the best practice to do so. Article 9 of the UCC has been revised, as has §2-326 of Article 2, and it is expected that nearly every state will adopt these revisions on or before the effective date of July 1, 2001. The revisions impact consignments in several ways. Consignments will be governed only by Article 9. The beneficial aspects of §2-326 of Article 2, providing consignors with several means to prove their consignment interest and to defend against actions of a bankruptcy trustee attacking the validity of the consignor's interest in the goods, will no longer apply. The only available defenses will be those provided by the terms of revised Article 9. This means that only properly perfected consignments under Article 9 will be valid and protected against a trustee in bankruptcy, against any earlier perfected security interests and against the rights of unsecured creditors. To claim that proper signs evidenced the consignment, or that everyone knew the goods were consigned, will not be available as defenses to the trustee's actions, unless they are coupled with the proper filing of a financing statement. To make matters more difficult, the manner of filing UCC-l statements under revised Article 9 will change. Under revised Article 9, financing statements must be filed in the state of incorporation of the consignee. This is different from the current system, where filing takes place in the state where the consigned goods are physically located. Prior to entering into every consignment transaction, the consignor must verify the correct state of incorporation of the consignee and ensure that the proper rules of perfection are followed for that state. Some have argued that revised Article 9 effectively eliminates consignments by transforming the title retention transaction into a purchase-money security interest, thus transferring title to the consignee and creating a debtor/creditor relationship between consignee and consignor. This effect is not the result of revised Article 9, which does not change the nature of a "true consignment," being an agency relationship in which the consignee acts as "bailee" or holder of the goods. The comment to revised §9-103 states: Under former §9-114, the priority of the consignor's interest is similar to that of a purchase-money security interest. Subsection (d) achieves this result more directly by defining the interest of a "consignor," defined in §9-102, to be a purchase-money security interest in inventory for purposes of this article [9]. This drafting convention obviates any need to set forth special priority rules applicable to the interest of a consignor. Rather, the priority of the consignor's interest as against the rights of lien creditors of the consignee, competing secured parties and purchasers of the goods from the consignee can be determined by reference to the priority rules generally applicable to inventory, such as §§9-317, 9-320 and 9-324. For other purposes, including the rights and duties of the consignor and consignee as between themselves, the consignor would remain the owner of goods under a bailment arrangement with the consignee. [Emphasis added)]. Therefore, title is still retained by the consignor. However, enforcement of consignment rights will only be permitted when notice to the outside world is provided by filing a UCC-1 financing statement in the proper location. Once the UCC-1 is properly filed, the consignor will hold a priority security interest with the same priority as a purchase-money secured creditor.

UTC Committee Meeting Calendar

The UTC Committee will meet at the upcoming conference:

• April 27-30, 2000: ABI Annual Spring Meeting J.W. Marriott, Washington

The next issue of News & Views will be published in the summer. Call Lynnette Warman at (214) 855-4792 or e-mail lwarman@jenkens.com for more information.