CHARLES CONSTRUCTION COMPANY, INC. & another vs. LEISURE RESOURCES, INC. & others.

ARMSTRONG, J. This is a bill to reach and apply the proceeds of six insurance policies payable to Leisure Resources, Inc. (Leisure) to satisfy an alleged indebtedness of Leisure to Charles Construction Company, Inc. (Charles). The United States Trust Company (the Bank) was allowed to intervene as a party plaintiff in the proceeding, claiming

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an interest in the proceeds of two of those policies. [Note 1] Charles appeals from a final decree entered upon a master's report awarding $31,818.18 to the Bank and $2,784.09 to Charles.

The facts established by the master's report are scanty in many respects but are nevertheless somewhat complex. Charles performed construction service worth $34,845 on Leisure's Merrimack Valley Country Club. On October 20, 1970, the clubhouse was destroyed by fire. At that time it was insured against loss by fire for $220,000, $200,000 of which was underwritten by the Hartford Fire Insurance Company (Hartford) and the Aetna Casualty and Surety Company (Aetna). On March 25, 1971, Charles brought the present bill to reach and apply the insurance proceeds up to the amount of the alleged indebtedness and to enjoin the insurance companies from paying and Leisure from receiving or encumbering the proceeds to the extent of $40,000. A temporary restraining order and then a preliminary injunction were issued to that effect. Pursuant to a stipulation entered into by Charles, Leisure and the defendant insurance companies, an interlocutory decree was entered on April 12, 1971, dissolving the preliminary injunction upon the delivery of an insurance company draft or drafts totaling $35,000 into a joint escrow account, with the respective attorneys for Charles and Leisure to serve as escrow agents. The decree further provided for the discharge of the insurers upon issuance of the draft or drafts. This stipulation was executed prior to the filing of answers by the insurers and presumably prior to final settlement between Leisure and the insurers. There is nothing in the record to indicate any agreement between the parties as to the expected contributions of the various insurers towards the escrow account or as to whether Charles knew or had reason to know that some of the insurance proceeds might be otherwise encumbered.

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On October 21, 1970, the day following the fire, Leisure had executed an assignment of $70,000 in proceeds of the Hartford and Aetna insurance policies to the Bank as security for a $25,000 loan, as evidenced by a promissory note. Approximately three weeks later, Leisure executed a second promissory note of $45,000 to the Bank. [Note 2]

In April, 1971, some time after the April 12, stipulation, Leisure and the Bank executed an undated instrument denominated an "Authorization" by which the Bank released the insurance companies "from any obligations and/or responsibilities under any assignment of the insurance proceeds . . . predicated [sic] that they will include . . . [the Bank] as a payee on a settlement draft totalling Thirty-Six Thousand Five Hundred ($36,500) Dollars, and having a check in the sum of Thirty-Five Thousand ($35,000) Dollars payable to [the joint escrow agents] . . . with the understanding that . . . [the Bank] shall file a petition to intervene in such action." An addendum attached to the "Authorization" released all the insurance companies, including one not joined as a defendant, from all other outstanding claims in consideration of a settlement of $107,500, [Note 3] $97,727.27 of which was payable under the Hartford and Aetna policies. It is not clear from the master's report when the terms of this settlement were arrived at, but the brief for the Bank indicates that the settlement was agreed upon some time in March, 1971.

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Drafts from the various insurance companies dated April 26, 1971 (Hartford), April 27, 1971 (Aetna), and April 30, 1971 (two other insurance companies) totaling $34,602.27 [Note 4] were made payable to the order of Charles, Leisure and the joint escrow agents pursuant to the stipulation and interlocutory decree. This sum consisted of $31,818.18 in proceeds of the Hartford and Aetna policies and $2,784.09 paid by the other insurance companies. These funds were deposited in the escrow account some time after May 10, 1971. Insurance company drafts of the same dates totaling $36,085.23 [Note 5] were made jointly payable to Leisure, Leisure's attorney, the trustees of the Merrimack Valley Golf Club Trust, Hale & Dorr, and the Bank and duly negotiated to the Bank. These drafts were clearly issued as part of the consideration for the release contained in the "Authorization."

The master's report contained findings of Leisure's remaining indebtedness to the Bank in the amount of $33,915.37, [Note 6] the balance due under the $70,000 in promissory notes, plus $4,409.07 in interest, and of Leisure's indebtedness to Charles of $34,845. In awarding to the Bank the $31,818.18 contributed by Hartford and Aetna into the escrow account the trial judge impliedly ruled that these funds remained subject to the assignment to the Bank and that the Bank was entitled thereto as senior encumbrancer. Charles contends that it should obtain all the funds in the escrow account.

Charles argues that the "Authorization" executed by the Bank should be construed to effect a complete release of the Bank's security in the insurance proceeds. We are inclined, however, to agree with the Bank's construction of the

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document. While the "Authorization" did release the insurers from personal liability under the assignment, it made their release conditional upon a payment of $36,500 directly to the Bank and a payment of an additional $35,000 into an escrow account established in connection with this suit in which the Bank was about to intervene. From the Bank's point of view the latter condition would have served no purpose if its intention had been to release its claim in the sum deposited, and we believe any such interpretation of the "Authorization" would be unreasonable. See Hill v. Whidden, 158 Mass. 267, 274 (1893). Rather, we believe that the "Authorization" was intended to release the Bank's claims against Aetna and Hartford, but to retain the Bank's claim against the proceeds of the Aetna and Hartford policies which would be paid into the escrow account.

We do not agree, however, with the Bank's contention that the "Authorization," to which Charles was not a party, should be permitted to accomplish what the Bank intended to accomplish. We do not accept the proposition that because the Bank held senior rights in the security it was in effect at liberty to release a part of the security to the detriment of a creditor with a security interest junior to its own.

After the entry of the stipulation, and before the execution of the "Authorization," the total proceeds held by the insurance companies were sufficient to pay in full, or substantially in full (taking into account interest due to the Bank), the claims of both (and so far as the record shows, all) of the secured creditors. After the "Authorization" was consummated both secured creditors could look only to the escrow account for security for their respective claims. The "Authorization" had the effect of releasing approximately a third of the total insurance proceeds from the effect of any secured claims, and that third was in fact paid to persons not entitled to any preference. The Bank participated in the "Authorization," knowing that its effect would be to force two substantially fully secured creditors to satisfy

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their claims from a diminished fund, sufficient to cover the claim of but one, and to permit the remainder of the proceeds to be paid to unsecured persons.

Under the equitable doctrine of marshaling, a senior encumbrancer whose claim is secured by two funds, one of which is also claimed by a junior creditor, may be required to pursue his claim against the fund not subject to the encumbrance of another, provided he may do so without detriment to himself. See Carter v. Tanners Leather Co. 196 Mass. 163, 166 (1907); Broadway Natl. Bank v. Hayward, 285 Mass. 459, 462-464 (1934); James Stewart & Co. Inc. v. National Shawmut Bank, 291 Mass. 534, 556-557 (1935); Grise v. White, 355 Mass. 698, 705-706 (1969). Pomeroy, Equity Jurisprudence (5th ed.) Sections 396, 1413 and 1414. While that doctrine has generally been discussed and applied in cases involving two funds, as in the James Stewart case, the reasons underlying the doctrine have equal application here. If a stakeholder pays a junior encumbrancer with funds subject to the paramount encumbrance of another, the paramount encumbrancer may ordinarily pursue his claim either against the stakeholder or against the funds thus wrongfully paid (see Gilmore, Security Interests in Personal Property, Section 7.9); but here the paramount encumbrancer has authorized the stakeholder to make the payment into the escrow account, and has expressly released other security which in the hands of the stakeholder would have been available either to itself or to the junior encumbrancer. As a result the claim of the paramount encumbrancer in the security available in the escrow account must in equity be subordinated to the claim of the junior encumbrancer, to the extent of the security released. Pitman Bldg. & Loan Assn. v. Wright, 106 N. J. Eq. 47, 48 (1930). Beckman v. Alberts, 346 Ill. 74, 78-79 (1931). Fidelity & Cas. Co. v. Massachusetts Mut. Life Ins. Co. 74 F. 2d 881, 883 (4th Cir. 1935). See Kidder v. Page, 48 N. H. 380, 382-383 (1869); Sherman v. Foster, 158 N. Y. 587, 594-596 (1899); 55 C. J. S., Marshaling Assets and Securities, Section 11, and Anno. 110 A. L. R. 65. See also

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Parkman v. Welch, 19 Pick. 231, 238 (1837), and Clark v. Fontain, 135 Mass. 464, 466 (1883). Any other rule would be conducive to fraud.

If the insurance companies had funded the escrow account without the Bank's authorization, it must be assumed that Aetna and Hartford would have insisted on retaining enough of the proceeds to cover the assignment, as they would otherwise have been liable to the Bank for any deficiency. Buttrick Lumber Co. v. Collins, 202 Mass. 413, 420-421 (1909). And Charles could have insisted, under the two-funds principle, that the Bank first pursue its claim against the funds retained by Aetna and Hartford, rather than against the Aetna and Hartford funds in the escrow account. James Stewart & Co. Inc. v. National Shawmut Bank, 291 Mass. 534, 556-557 (1935). By its "Authorization" the Bank in effect told Aetna and Hartford that it would release its priority in the proceeds they retained (which in fact amounted to $32,727.27, nearly enough to fully cover Leisure's remaining indebtedness to the Bank), and would instead pursue its claim against the funds they would use to discharge their obligation to Charles. As the record does not disclose the reason for its so doing, we cannot say that the Bank acted fraudulently, but it is enough that the Bank acted with knowledge of Charles' interest. Cheesebrough v. Millard, 1 Johns. Ch. 409, 414 (N. Y. 1815). Sherman v. Foster, 158 N. Y. 587, 595-596 (1899). King v. Milford Natl. Bank, 168 Misc. 571, 573 (N. Y. Supr. Ct. 1938). As between the Bank which knew about and participated in the destruction of a part of the security and Charles which did not, we are of the opinion that the loss should be borne by the former, which acquiesced therein and without whose participation it would not have occurred.

As the insurance proceeds exceeded the total assignment to the Bank and the equitable attachment obtained by Charles (as modified by the stipulation) and as Leisure's indebtedness to Charles amounts to less than the total released from the proceeds to unsecured parties, but more

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than the amount in the escrow account, Charles has priority in all funds in that account.

The final decree is to be modified in part (c) to declare that Charles is entitled to receive all the funds in the escrow account, and in part (d) to direct the payment thereof accordingly. As so modified, the final decree is affirmed.

So ordered.