Before CLARK, Chief Judge, and SWAN and LUMBARD, Circuit Judges.
This is an appeal in a bankruptcy proceeding in which the parties contest their relative priorities to some $41,000 now left in the bankrupt's estate. Involved are claims of the United States for unpaid withholding, social security, and unemployment taxes, claims of the State of New York for unpaid franchise, motor fuel, and unemployment insurance taxes, and two claims of Massachusetts Bonding and Insurance Company, a surety on two contracts performed in part by the bankrupt.
A petition for adjudication of bankruptcy was filed against Fago Construction Corporation on March 31, 1949, and it was adjudicated a bankrupt on the same day. Prior to bankruptcy, on May 15, 1947, the bankrupt had entered into a contract with the United States for the construction of a flood control project at Bath, New York, at a contract price of $417,860. In compliance with the Miller Act, 40 U.S.C. §§ 270a et seq., it furnished two bonds to the United States - one guaranteeing performance and the other securing the payment of laborers and materialmen. On both bonds Massachusetts Bonding and Insurance Company was the surety pursuant to the bankrupt's applications, in which, as consideration for the bond, it inter alia assigned to the surety, effective upon its default under the contract with the United States, all deferred payments or retained percentages, and any and all moneys and properties that might be due and payable at the time of claim or default, or that might become due and payable to the bankrupt in connection with the contract. And in August 1947, the bankrupt made a similar arrangement with the surety in connection with another contract with the United States for work on a Veterans Hospital in Buffalo, New York.
The record shows that in April 1948, the bankrupt informed the surety that it was in trouble financially and needed the surety's assistance to proceed with the Bath and Buffalo jobs. As a result of this, the surety presented a program to assure completion of the projects and the bankrupt gave the surety a collateral chattel mortgage on its equipment. In addition Dominick S. Fago, the bankrupt's principal shareholder and president, gave the surety a collateral mortgage on certain real property which he owned. Under the surety's program the bankrupt executed a letter of authority addressed to the United States Engineers directing that all checks due on the Bath project be sent to J. Herbert Crafts, the surety's attorney. In addition the bankrupt executed a Treasury form power of attorney authorizing Crafts to receive, endorse, and collect checks in its name drawn on the Treasurer of the United States. The surety and the bankrupt then opened a joint bank account in which the surety deposited substantial sums of its own money and certain checks of the United States for estimates on the Bath job. The bankrupt agreed that all such proceeds would be deposited in that account, which was used to pay labor and material bills on the two projects.
During the course of this arrangement the bankrupt, in breach of its agreement, sought to collect a check from the United States for some $41,000 due on the Bath job. The surety brought an action to attach the check and eventually was successful in collecting those proceeds. Massachusetts Bonding & Insurance Co. v. Fago Construction Corp., D.C.Md., 82 F.Supp. 619. On another estimate check on the Bath job, however, the surety was less successful, for Fago, after improperly revoking the bankrupt's instructions to the United States Engineers to mail checks due on the Bath job to Crafts, succeeded in securing $25,893 due on that job which he deposited in the bankrupt's own account. The record shows that immediately afterwards Fago withdrew $18,000 of these proceeds, which he put in his own personal account. Of this he used $9,500 to purchase a tract of land in the name of another of his corporations. This $9,500, plus interest, eventually was recovered by the trustee and is now part of the assets in the bankrupt's estate.
Well prior to the adjudication, the bankrupt became delinquent in the payment of federal withholding and social security taxes. Between January 1947 and September 1948, the Commissioner of Internal Revenue received assessment lists on these taxes which, with interest and penalties, aggregated $51,868.41. He duly filed notices of these deficiencies in December 1948 and January 1949. The United States then set this sum off against a progress payment otherwise due to the bankrupt on the Bath job, and a certificate releasing the lien was filed.
The relevant claims filed in this proceeding disclose the following: The United States claims $31,166.40 for social security, unemployment, and withholding taxes for the years 1947 and 1948. The State of New York claims $8,829.77 for franchise, motor fuel, and unemployment insurance taxes for the years 1947, 1948, and 1949. The surety claims for unrecompensed expenditures of over $136,000 on the two projects $51,868.41 as a subrogee to the tax liens of the United States which were satisfied by the setoff and $9,500 as the equitable owner of the proceeds recovered by the trustee which were used by Dominick S. Fago to purchase land for another of his corporations. The referee ruled that the surety became subrogated to the satisfied tax liens and awarded it all the assets of the bankrupt, less administration expenses and the New York franchise taxes. The district court affirmed the referee with regard to the administration expenses and franchise taxes, but accorded third priority to the tax claims of the United States and the remaining tax claims of the State of New York, and fourth priority to the surety's claims. From this judgment both the surety and the United States appeal. The surety argues in substance that the referee's decision was proper. The United States contends that New York was improperly afforded priority on its claim for franchise taxes and that the United States is entitled to priority over New York to the extent of $5,757.41. We proceed to the surety's appeal first.
The surety contends that it is entitled to be subrogated to the position of the United States in relation to the latter's liens for taxes with interest and penalties of $51,868.41, which were satisfied prior to bankruptcy by setoff against money earned by the bankrupt on the Bath job. Basic, of course, to this contention is that the surety paid the tax, or, in the context of this case, owned the funds against which the setoff was made. But the surety cannot establish this fact, for under the doctrine of United States v. Munsey Trust Co. of Washington, D.C., 332 U.S. 234, 67 S. Ct. 1599, 91 L. Ed. 2022, neither the bankrupt nor the surety ever became entitled to these funds, so that there was nothing for the surety to own. In short, the surety by way of subrogation might be entitled to progress payments and retained percentages due its principal if the surety completes the job after the principal's default. See, e. g., Henningsen v. U.S. Fidelity & Guaranty Co., 208 U.S. 404, 28 S. Ct. 389, 52 L. Ed. 547; Prairie State Nat. Bank of Chicago v. United States, 164 U.S. 227, 17 S. Ct. 142, 41 L. Ed. 412; American Surety Co. of N.Y. v. Sampsell, 327 U.S. 269, 69 S. Ct. 571, 90 L. Ed. 663. See also annotations at 45 A.L.R. 379, 134 A.L.R. 738, and 164 A.L.R. 613. But this right relates only to funds otherwise due to the principal. United States Fidelity & Guaranty Co. v. Triborough Bridge Authority, 297 N.Y. 31, 74 N.E.2d 226. Where, as here, the funds never became payable because of the creditor's right to a setoff for other debts, the surety never owned or became entitled to the funds and hence cannot be subrogated to the position of the creditor who made the setoff.
The surety also claims that $9,500 in the hands of the trustee belongs to it, and not to the bankrupt's estate. These funds were part of the progress payment of $25,893 made to the bankrupt after the surety commenced supervising the bankrupt's operations. Prior to the bankruptcy the surety instituted an action against Fago and the bankrupt to impress a lien on the real estate purchased with part of the payment and for conversion of the remainder, alleging that the payment belonged to it. The bankruptcy intervened and the action against the bankrupt (now represented by the trustee) was severed. The action against Fago came to trial and resulted in a judgment in favor of the surety for the full amount of the progress payment. This judgment remains unsatisfied. The trustee then instituted an action to impress a lien on the real property purchased with the $9,500. This was settled, and the trustee received a general mortgage on the property which has now been satisfied by payment of $9,500.
The surety's position below and here is that it was entitled to the payment in question which was converted by Fago and the bankrupt. It urges that the trustee recovered the proceeds of the real estate mortgage impressed with a trust in its favor and that the estate now contains at least $9,500 belonging to it. The referee declined to rule on the surety's claim because he found that the surety was otherwise entitled to the major portion of the assets in the estate as a subrogee to the satisfied tax liens of the United States. Therefore he never reached the question which the district court thought necessary to decide, viz., whether the bankrupt, in addition to Fago, converted the payment in question. Thus the district court refused to rule that the $9,500 belonged to the surety because of the failure of the referee to find that the bankrupt converted the payment.
We believe that a finding of conversion is unnecessary to entitle the surety to the $9,500 and that on familiar principles of subrogation the surety has a prior claim to this sum which the record clearly shows represents a traceable portion of a payment made by the United States to the bankrupt under the construction contract which was completed by the surety. It is settled law that a surety which undertakes to complete a construction contract after its principal has defaulted and pays laborers and materialmen becomes entitled to payments due the principal from the owner, here the United States, independent of any formal assignment.*fn1 Prairie State Nat. Bank of Chicago v. United States, supra, 164 U.S. 227, 17 S. Ct. 142, 41 L. Ed. 412; Henningsen v. U.S. Fidelity & Guaranty Co., supra, 208 U.S. 404, 28 S. Ct. 389, 52 L. Ed. 547. This right to "first" priority attaches not only to moneys due the principal at the time of default, but to so-called "unearned" moneys which arise from the surety's activities in completing the contract after the principal's default. Arrow Iron Works v. Greene, 260 N.Y. 330, 183 N.E. 515; Maryland Casualty Co. v. Board of Water Com'rs of City of Dunkirk, 2 Cir., 66 F.2d 730, certiorari denied 290 U.S. 702, 54 S. Ct. 346, 78 L. Ed. 603.Of course the surety's rights might be defeated if the payment is received by the principal, who then pays it to another of his creditors who is unaware of the surety's rights. See, e. g., California Bank v. U.S. Fidelity & Guaranty Co., 9 Cir., 129 F.2d 751.But if the payment is still in the hands of the principal, its trustee in bankruptcy, or a stakeholder, the surety's rights are ...