Context Impacts Application of Surety Equitable Subrogation Rights

Sureties have a variety of contractual and common law remedies to recoup losses incurred as a result of a bond principal’s default.

One legal doctrine, equitable subrogation, was recognized by the United States Supreme Court over 60 years ago in Pearlman v. Reliance Ins. Co., 371 U.S. 132, 136-137 (1962) (“Pearlman”). Pearlman, however, has not been universally followed over the years. This article discusses a recent Minnesota Supreme Court decision that did follow Pearlman, holding the equitable subrogation doctrine gives a performing surety priority to contract funds created by the surety’s performance of its bond obligations, over a secured creditor, United Prairie Bank v. Molnau Trucking, LLC., ___N.W.2d ___, 2025 WL 1943964 (July 16, 2025) (“United Prairie”).

The Equitable Subrogation Doctrine

The equitable subrogation doctrine holds that a party who pays another’s debt or obligation, steps into the shoes of the original creditor, acquiring the same rights and remedies of the original creditor. In the surety context, a surety who performs the obligations of its principal to pay laborers and suppliers is entitled to all the rights of the party the surety paid to enforce the party’s right to be reimbursed. Pearlman, 371 U.S. at 136-137. The surety seeking reimbursement must pay the debt before it can be substituted to the original creditor’s rights and must not act as a volunteer, but rather on compulsion to save itself from loss by reason of a claim on the part of the creditor. Prairie State Nat. Bank v. U.S., 164 U.S. 227 (1896) (“Prairie State”).[1] Equitable subrogation arises from operation of law to promote justice and avoid injustice. Ibid., at 144, United Prairie, at *6.[2]

The United Prairie Decision

The parties in the controversy were a surety and the principal’s creditor bank, each of whom claimed a priority interest in bonded contract funds held by the principal’s receiver. The surety, having issued payment bonds to the principal on public works projects was called upon to pay the principal’s laborers and suppliers for their work. The bank, having issued a loan to the principal, had a perfected security interest in the principal’s account receivables. The surety claimed that the doctrine of equitable subrogation entitled it to the contract funds over the bank. The bank claimed priority because it had perfected its security interest in the principal’s accounts receivable before the surety issued the bonds.

The Supreme Court of Minnesota held the timing of when the parties’ respective interests arose was not determinative of the priority issue because a surety’s right to equitable subrogation is not a security interest subject to Article 9 of Minnesota’s Uniform Commercial Code (UCC). United Prairie, at *6.[3] Rather, priority to contract funds on a bonded project is determined by the nature of the parties’ financial relationships. United Prairie, at *7. The Court reasoned that a lender has a relationship only with the principal debtor and its rights are limited to those of the principal. In contrast, a surety has a relationship not only with the principal but with the bond obligees, i.e., the awarding body and the principal’s laborers and suppliers. United Prairie, at *7, citing Pearlman, supra, at 141-142. By performing under compulsion of the bond, the surety becomes subrogated to the rights of the laborers and suppliers, and the right of awarding body to withhold payment from the principal to complete the work and pay the laborers and suppliers. Ibid. A narrow exception is recognized where a bank acts like a surety by paying costs a surety would otherwise be obligated to pay thereby relieving the surety of the obligation and the funds advanced by the bank are used solely in paying laborer and material supplier claims. United Prairie, at *7. However, in the absence of a superior equity, a performing surety’s right to equitable subrogation has priority over a secured creditor to bonded contract funds. United Prairie, at *8.[4]

United Prairie’s holding that a surety’s equitable subrogation right is not a security interest subject to the UCC was premised upon Pearlman’s holding that a surety is not limited to the rights of the defaulting principal but is subrogated to the rights of the parties that benefit from its performance, i.e., the laborers, suppliers, and awarding bodies. United Prairie, at *7. Pearlman involved a dispute between a bankruptcy trustee and a payment bond surety over who had superior rights to withheld contract funds. Recognizing a security interest in withheld funds to which a surety is subrogated, Pearlman noted that the proper inquiry is not priority, but rather the surety’s ownership interest in the withheld fund prior to the principal’s bankruptcy. Pearlman, at 136. The United States Supreme Court used the doctrine of equitable subrogation to find the surety obtained a right to property (the withheld funds) that did not come into the principal’s bankruptcy estate. Pearlman, at 135-136 (property interests in a fund not owned by a bankrupt at the time of filing are not part of the bankruptcy’s property and do not vest in the trustee).

United Prairie awarded the contract funds to the surety in reliance upon the principle stated in Pearlman, that a performing surety is subrogated to the rights which the government obligee has to withheld funds to pay laborers and supplier and to rights the principal would have had if it had completed the work, thereby giving the surety a priority claim to remaining contract funds over a secured creditor. United Prairie was decided in the context of receivership. Had the dispute over contract funds arisen in the bankruptcy context, equitable subrogation would not necessarily exclude the funds from property of the bankruptcy estate. See, e.g., In Re Glenbrook Group, Inc., 552 B.R. 735 (2016) (awarding contract funds to bankruptcy trustee, distinguishing federal contracts from municipal contracts and finding withheld contract funds were property of the bankruptcy estate) (“Glenbrook”). The differing result is due to amendments to bankruptcy law since Pearlman was decided which expanded the definition of property of the estate. Pearlman’s holding that withheld contract funds are not property of the bankruptcy estate, eliminated the need for a surety to obtain a finding in the bankruptcy proceeding that it has a greater equitable interest over the debtor. Glenbrook found property subject to equitable interests excluded from property of the estate in Pearlman, is recognized as property of the estate under the Bankruptcy Code enacted in 1978, which replaced the Bankruptcy Act. Notwithstanding, some jurisdictions continue to rely upon Pearlman to find a surety’s equitable subrogation rights take the contract funds out of property of the bankruptcy estate. See, e.g., Board of Trustees of University of Illinois v. U.S. Fidelity and Guar. Co., 191 WL 127589 (1991) (surety’s claim as subrogee of principal was not property of the bankruptcy estate).

Conclusion

In order to understand a surety’s rights to remaining contract funds, it is important to understand the context in which the right to equitable subrogation is being asserted because equitable subrogation is applied to sureties differently depending upon the context, the types of opposing party, and the jurisdiction.