Money in the Bank? Surety Payments and the Danger of a Broad Release

11.02.2016

Imagine this hypothetical:  a subcontractor, ABC, Inc. (ABC), contracts with a sub-subcontractor, XYZ, LLC (XYZ) to perform work on a construction project.  As part of the project, ABC posts a payment bond.  ABC subsequently runs into financial trouble and files for Chapter 7 bankruptcy.  In order to get paid for its work, XYZ makes a claim against the payment bond.  The surety pays XYZ, and XYZ executes a release.  Money in the bank for XYZ?  Perhaps not according to the October 18, 2016 decision by the United States District Court for the District of Maryland in Kimball Construction Company, Inc. v. XL Specialty Insurance Company.  

Blumenthal Kahn Truland Electric, LLC (Truland) was a direct subcontractor for several construction projects and entered into sub-subcontracts with Kimball Construction Company, Inc. (Kimball) to perform electrical work.  Truland posted payment bonds for each project with XL Specialty Insurance Company (XL), with Truland as the principal, XL as surety, and the general contractor as obligee. 

On July 23, 2014, Truland filed for Chapter 7 bankruptcy.  After the bankruptcy filing, in December 2014, Kimball made claims against the payment bonds and received payments from XL.  As a condition of payment, Kimball executed a release.  In the release, Kimball agreed to “release, acquit, exonerate and discharge Surety from all acts, suits, claims, damages and liabilities whatsoever which [Kimball] may have against Surety and Contractor covering the following contracts.”

In a Chapter 7 bankruptcy, certain debts paid to a creditor within the 90 days prior to the bankruptcy filing may constitute an avoidable preference.  In other words, such payments could be essentially unwound in the bankruptcy and the creditor forced to repay those funds to the bankruptcy estate.  On October 16, 2015, the Chapter 7 Trustee filed a complaint against Kimball, seeking to do just that—to avoid $588,127.01 in preferential payments made by Truland to Kimball in May and June of 2014.  Kimball then sued XL, requesting XL be held liable under the payment bonds for any amounts that Kimball was compelled to pay the Trustee.

The district court found that XL had no liability under the payment bonds, because the express language of the releases released any and all claims Kimball might have against XL, including any arising from the preference action.  The court based its decision on three factors: (1) Kimball signed the releases with clear notice of the bankruptcy and could have contemplated the possibility of future preference actions; (2) even in the absence of express inclusion of preferential payments in the releases, the releases were sufficiently broad to cover any claim, including preference claims; and (3) the releases constituted an express contract categorically prohibiting Kimball’s recovery for an unjust enrichment claim. 

Takeaways

• In a similar factual situation, attempt to negotiate either a carve-out in the releases of any Chapter 7 claims or additional consideration for broad releases.
• You may be able to distinguish this decision on the grounds that the releases were executed after the bankruptcy was filed and after the Kimball knew about the bankruptcy filing.