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In re Modular Structures

filed: June 23, 1994.


On Appeal From the United States District Court For the District of New Jersey. (D.C. Civil Action No. 92-02024).

Before: Becker, Alito and Roth, Circuit Judges.

Author: Roth


ROTH, Circuit Judge :

This appeal arises from the Chapter 7 bankruptcy proceedings of Modular Structures, Inc. ("Modular"). Prior to filing for bankruptcy on March 8, 1991, Modular had contracted to construct a new corporate headquarters in Newark, New Jersey, for the Salvation Army. First Indemnity of America Insurance Company ("First Indemnity") issued a bond to the Salvation Army to secure Modular's performance and payment obligations under the contract. Eleven months after the institution of the bankruptcy proceedings, First Fidelity Bank ("the Bank"), as a secured creditor of Modular, filed a Notice of Motion for Turnover of Funds to obtain the unearned contract proceeds and retainage held by the Salvation Army. First Indemnity filed a cross-motion to place the contract proceeds and retainage in escrow in order to assure that the funds remained available to secure Modular's obligations to pay subcontractors. On March 2, 1992, the bankruptcy court denied First Indemnity's cross-motion and entered an Order Allowing Turnover in favor of the Bank. First Indemnity appealed this decision to the district court which affirmed the bankruptcy court.

Because we conclude that the district court and the bankruptcy court incorrectly determined that the contract proceeds and retainage, which the Salvation Army was holding, were part of the estate in bankruptcy, we will reverse the order directing turnover to the Bank. We also conclude that the bankruptcy court made an insufficient examination of whether Modular had any legal or equitable interest in the funds held by the Salvation Army. We will therefore remand this issue to the bankruptcy court for further proceedings in this regard.


On February 27, 1989, Modular entered into a contract with the Salvation Army for the design and construction of a new corporate headquarters in Newark, New Jersey. In accordance with the terms of the contract, First Indemnity, as surety, issued its Labor and Material Payment Bond and its Performance Bond to the Salvation Army, as obligee, to secure Modular's performance of the contract. The bonds bound Modular and First Indemnity to pay Modular's laborers and materialmen in connection with the contract, which was incorporated by reference into the bonds.*fn1

In March 1989, the Bank loaned Modular the principal sum of $1.5 Million to enable Modular to undertake construction contracts such as the one with the Salvation Army. The Bank entered into a General Security Agreement whereby it took a security interest in all of Modular's accounts receivable, contracts and proceeds thereof. Modular also executed a Uniform Commercial Code Financing Statement which was filed on April 20, 1989, thereby perfecting the Bank's lien.

Modular commenced work on the Salvation Army project but was unable to complete all of its obligations under the contract. On March 8, 1991, Modular filed for protection under Chapter 7 of the United States Bankruptcy Code, and a Trustee was appointed. Modular stated in its bankruptcy schedules that the Bank maintained a first, perfected security interest in Modular's accounts receivable and contracts and proceeds thereof. On August 5, 1991, the Bank obtained a consent order from the Trustee granting it a "Superpriority Lien" in Modular's account receivables. Following the consent order, the Bank pursued collection of Modular's accounts receivable.

First Indemnity contends that the unpaid contract proceeds and retainage held by the Salvation Army were not properly characterized as accounts receivable owing to Modular so that the Bank's superpriority lien would apply to them. Pursuant to Article 6 of the contract between Modular and the Salvation Army, the Salvation Army was not obligated to make final payment to Modular until: "(1) the Contract has been fully performed by the contractor except for the Contractor's responsibility to correct nonconforming work as provided in Subparagraph 12.2.2 of the General Conditions and to satisfy other requirements, if any, which necessarily survive final payment; and (2) a final Certificate for Payment has been issued by the architect . . .." App. at 79a. Article 9, section 1.2, of the Contract defined the "General Conditions" as the General Conditions of the contract for Construction, AIA Document A201, 1987 Edition. Those General Conditions included Article 3, section 4.1, which stated that the Contractor shall provide and pay for the labor, materials and equipment necessary for the proper completion of the work, as well as Article 9, section 3.1.2, which provided that a Contractor's application for payment "may not include requests for payments of amounts the Contractor does not intend to pay to a Subcontractor or material supplier because of a dispute or other reason." App. at 96a, 104a. Article 9, section 5.1.3, permitted the Architect to withhold his certification for payment to the extent necessary to protect the Owner from loss as the result of the failure of the Contractor to make payments properly to Subcontractors or for labor, materials or equipment. See app. at 105a.

Additionally, Article 9, section 10.2, provided that:

Neither final payment nor any remaining retained percentage shall become due until the Contractor submits to the Architect (1) an affidavit that payrolls, bills for materials and equipment, and other indebtedness connected with the Work for which the Owner or the Owner's property might be responsible or encumbered (less amounts withheld by Owner) have been paid or otherwise satisfied, . . . (4) consent of surety, if any, to final payment and (5) if required by the Owner, other data establishing payment or satisfactions of obligations, such as receipts, releases and waivers of liens, claims, security interests or encumbrances arising out of the Contract to the extent and in such form as may be designated by the Owner . . ..

App. at 106a. Finally, Article 14, section 2.1.2, provided that the owner might terminate the contract if the contractor "fails to make payment to Subcontractors for materials or labor in accordance with the respective agreements between the Contractor and the Subcontractors." Article 14, section 2.2, further provided that upon such a termination, "the Contractor shall not be entitled to receive further payment until the Work is finished." See app. at 111a-112a. ...

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