American States Insurance Co. v. United States

In 2000 SSEM Corporation entered into a subcontract with Manhattan Construction Company (Manhattan) in relation to a construction project. Under the subcontract, Manhattan could hold 5 percent of the contract fee in retainage until the project was complete. American States Insurance Company (American) (plaintiff) agreed to act as surety for the subcontract. SSEM performed some work under the subcontract and then defaulted. At the time of the default, Manhattan held approximately $89,000 in retainage. As surety, American paid over $430,000 to complete SSEM’s work. In 2003 SSEM filed for bankruptcy. The Internal Revenue Service (IRS) (defendant) filed a claim in the bankruptcy proceedings for $500,000 in unpaid payroll taxes. The IRS filed a motion to collect its claim. The IRS argued that the retained funds were part of SSEM’s bankruptcy estate and that its claim had priority over other claims. American filed its own motion, arguing that it had equitable-subrogation rights to the funds held in retainage and that the retainage was not part of SSEM’s bankruptcy estate, because SSEM never earned the retained funds. To support its motion, American cited Pearlman v. Reliance Insurance Co., in which the United States Supreme Court held that a surety had equitable-subrogation rights to funds held in retainage if those funds were necessary to repay the surety. The bankruptcy court denied both the IRS’s and American’s motions. Because Pearlman was decided before the United States Bankruptcy Code was codified, the bankruptcy court disregarded its holding. American appealed.