By: Thomas S. Tripodianos Published: November 2013

Payment and Performance Bond Surety

Question. Does the fact that that a payment and performance bond surety has satisfied some suppliers' claims prevent a statutory trust from attaching to the owner withheld funds or otherwise give the surety priority?

Answer. No.
This case stems from the award of a contract for a public improvement. Owner awarded a contract to Prime Contractor. This contract contained a provision that permitted the Owner to "deduct from the amounts certified under this Contract to be due to the Contractor, the sum or sums due and owing from the Contractor to the subcontractors." Shortly thereafter, Surety provided the Owner with a payment bond and a performance bond on behalf of Prime Contractor. A year and a half later the Owner terminated the contract "for convenience" pursuant to the pertinent clause of the contract. Prime Contractor defaulted on payments due to various suppliers of labor and materials. As the surety on the payment bond, Surety paid $127,631. 29 to these suppliers from March 21, to December 1. It has also received additional claims of approximately $188,000.

On November 29, Owner agreed to pay to Surety $171,917.38 in funds that had been approved for payment to Prime Contractor, "upon the satisfaction, discharge, release or cancellation of all those valid liens, levies, restraints and encumbrances filed with the Liens and Disbursements Clerk in the office of the Owner which have a superior or greater legal or equitable right than Surety to said earned funds".

On June 26, the Owner paid the $171,917.38 into court and named as parties defendants, the Prime Contractor, Surety, and the United States of America by and through the United States Internal Revenue Service.

The IRS, claims that Surety was not entitled to priority over the funds and asserts that Prime Contractor failed to remit to the IRS Federal tax withholdings on behalf of employees who worked on the project. The IRS argument is that the funds constitute a Lien Law Article 3-A trust, to which Surety cannot have legal priority.

The IRS claims that the contract fund in this action qualifies as an Article 3-A trust fund to which the IRS should be granted statutory (Lien Law § 77[8]) priority over Surety.

Surety counters that an Article 3-A trust fund never arose in this matter because Prime Contractor, as contractor, never received or had the right to receive the contested funds. Surety states that by paying the outstanding claims of laborers and materialmen, it became equitably subrogated to the rights of the Owner. Because the Owner was entitled to withhold funds pursuant to the contract, Surety urges that it became entitled to similarly withhold funds in order to reimburse itself for its expenditures as a surety. As a result, Surety asserts that Prime Contractor never became entitled to receive the funds at issue, so a trust never attached to the funds.

By depositing the money with the Court, the Owner, in effect, seeks to pay out contract funds, and an Article 3-A trust protects those funds. The classification of the funds as a trust arises by operation of law pursuant to statute (see, Lien Law § 70[4]). This statutory framework governs the resolution of this issue, and guides the outcome of the entire case. A "trust" under Article 3-A can include assets of every conceivable type and form arising from the work. Even rights of action for payment "due or earned or to become due or earned" can constitute a trust (Lien Law § 70[1], [6])

This statutory trust springs to life at the time when any qualifying asset comes into existence, regardless of whether beneficiaries exist at that same time (Lien Law § 70[3] ). This kind of trust will continue until every trust claim arising at any time prior to the completion of the contract has been paid or discharged, or until all such assets have been applied for the purposes of the trust. A trust claim is deemed to be in existence from the time of the making of the contract or the occurrence of the transaction out of which the claim arose (Lien Law § 71[5]). The class of trust beneficiaries is the same as the class of persons who are given the right to file mechanics' liens, as well as the United States and State of New York for pertinent employment related claims.

Surety has acknowledged that unpaid claims related to the project still exist in the amount of approximately $188,000. Regardless of the fact that Surety previously paid $127,631.29 worth of claims related to the project, all of the subcontractors and statutory beneficiaries have not yet been paid, and mechanics' liens, as well as trust fund claims, apparently still remain outstanding. Because Surety has not paid all outstanding claims, any subrogation rights that may otherwise arise have not matured here. In this circumstance, Surety does not have a sufficient beneficial interest in the moneys, due or to become due from the owner under the contract, to give Surety a property right in them, except insofar as there is a balance remaining after all subcontractors and other statutory beneficiaries have been paid. Thus, contrary to Surety's assertions, it is not entitled to apply the $171,917.38 to its earlier payment of some claims.

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