Recent Development from the SJC Regarding Secured Creditors under the U.C.C.

Published on: May 18, 2013

It happens like this: a subcontractor assigns its right to collect payment on its contract with the general contractor to a bank. The contractor then agrees to the assignment, and to make all payments directly to the bank. But, what if the contractor erroneously makes all payments directly to the subcontractor instead? What if those payments total $3.8 million? Is the contractor liable for the full $3.8 million, even if the bank’s actual damages are only $500,000? After a recent Supreme Judicial Court ruling, in Massachusetts, the answer is yes.

On March 13, 2013, the Supreme Judicial Court (“SJC”) issued an important decision concerning the rights of secured creditors in Massachusetts. In Reading Co-Operative Bank v. Suffolk Construction Company, Inc., the SJC considered whether the Uniform Commercial Code (“U.C.C.”) displaces common law on the question of the proper measure of a secured creditor’s damages. The U.C.C. seeks to “simplify, clarify and modernize the law governing commercial transactions” and has been adopted in a number of states, including Massachusetts. The terms of Article 9 of the U.C.C., which contains the language at issue in this case, address the rights of secured creditors, or creditors that have an interest in some collateral of the debtor.

In Reading, Suffolk Construction Company (“Contractor”) contracted with Benchmark Mechanical Systems (“Subcontractor”) for the installation of a HVAC system at one of the Contractor’s developments. The Subcontractor then obtained from Reading Co-Operative Bank (the “Bank”) a revolving line of credit. As security for the line of credit, the Subcontractor assigned to the Bank its rights to receive payment under its contract with the Contractor. The Bank was then a secured creditor of the Subcontractor. The Contractor received notice of the assignment and agreed, in an acknowledgment and assent to assignment, to make its payments under the contract to the Bank. The Contractor failed to alert certain employees of the assignment, and as a result, the Contractor made twelve payments directly to the Subcontractor. The payments totaled approximately $3.8 million. The Subcontractor then defaulted on the line of credit.

The Bank filed suit against the Contractor for breach of contract and violation of Article 9 of the U.C.C. seeking recovery of the full amount of the misdirected payments – $3.8 million. A jury later found that the Bank’s actual damages were just over $500,000.00. The Judge, basing his decision on Article 9 of the U.C.C., found that the Contractor was liable for the total amount of the misdirected payments.

In reviewing the lower Court’s decision, the SJC first considered whether the Bank was entitled to its actual damages under the common law, or the total amount of the misdirected payments under Article 9 of the U.C.C. The Court found that when an account debtor [the Contractor] has notice of an assignment, but pays the assignor [the Subcontractor] anyway, the account debtor remains obligated under the contract, and if the assignor defaults, the assignee [the Bank] can enforce the account debtor’s obligations in full. In other words, once an assignment of a debt has been made and the account debtor is notified, the contractual obligations of the account debtor can only be fulfilled by making payments to the assignee. The Bank, the SJC reasoned, was entitled to be put “in as good a position as if the other party had fully performed.” In this case, the Bank was entitled to be put in the position it would have been had the Contractor paid the monthly installments directly to the Bank.

Even though the Contractor is liable for the full $3.8 million, that does not mean the Bank can keep the full amount. Article 9 of the U.C.C. demands that any surplus funds collected by the assignee (here any amount over $500,000) be paid out: first to subordinate creditors of the assignor and then back to the assignor itself. The SJC suggests that in this case, because of the seemingly harsh result, the Contractor could sue the Subcontractor to put itself in line as a subordinate creditor, and attempt to regain the surplus.

In calculating the secured creditor’s damages, the SJC also considered (1) the application of the doctrine of mitigation of damages and (2) whether the Bank was estopped from collecting on two of the misdirected payments. The Contractor argued that the $3.8 million should be reduced by the amount of a personal guaranty signed by one of the Subcontractor’s owners. The Contractor argued that because the Bank had the right to collect on the personal guaranty, it had an obligation to do so in order to lessen its damage amount. The SJC disagreed. The Bank, the SJC found, could choose what remedies to pursue, and was thus under no obligation to collect on the personal guaranty. Moreover, the actual damages of the Bank are immaterial under the U.C.C.

The Contractor further argued that the Bank was not entitled to the last two misdirected payments because, at that point, the Bank was aware the Contractor was paying the Subcontractor directly and never objected. Thus, the Contractor argued, the Bank consented to the Contractor essentially ignoring the assignment. The SJC again disagreed and instead found that there was no evidence that any consent by the Bank, if it existed, was ever communicated to the Contractor, and consequently, the Contractor could not have relied on the supposed consent in making its last two payments to the Subcontractor directly.

The important take-away from this decision is that, if an assignment occurs, payments must be made according to the assignment agreement. If account debtors are not careful, they could end up on the hook for much more than they had bargained.