Subrogation is an important right of the surety. It is the means by which a surety can minimize or ameliorate its losses by assuring its priority to contract funds remaining in the hands of the obligee. Consequently, the surety and its counsel will want to make certain that the surety has taken all possible steps to preserve and assert such rights. This article will serve to acquaint the newcomer with the doctrine of subrogation and sharpen the saw for those more seasoned practitioners.
In 2023, this publication provided a piece authored by Alexis Breedlove that covered the topic of equitable subrogation through a focused analysis of Federal Court of Claims cases. However, this article will analyze the published decisions of certain other federal circuit courts of appeals that have examined the issue outside of the federal claims context. Likewise, some cases, while not explicitly addressing the doctrine of subrogation, demonstrate that certain issues can impede a surety’s recovery.
Pennsylvania National Mutual Casualty Insurance Co. v. City of Pine Bluff best represents the paradigm of the surety/owner relationship and how the surety preserved its right to subrogation. The City of Pine Bluff (the “City”) hired a general contractor, David Mitchell Construction (“Mitchell”), to clean up the aftermath of severe ice storms, and the surety, Pennsylvania National Mutual Casualty Insurance Company (“Penn”), issued performance and payment bonds for the project. The work was to be paid through funds received from the Federal Emergency Management Agency (“FEMA”). Arguments between the City and Mitchell led to the termination of Mitchell’s contract. Subsequently, Penn sent the City a letter that identified its subrogation rights and demanded the City not release funds related to the project without the surety’s consent. Despite the notice, the City “approved a settlement and release with Mitchell . . . paying Mitchell and [its] creditors approximately $2 million” for work completed prior to Michell’s contract’s termination. The circuit court observed that the record did not indicate whether the settlement amount constituted funds received from FEMA prior to the letter from Penn, but it was clear that the total funds received from FEMA were only $1.8 million. Thus, the FEMA funds constituted the contract funds that should have been used to make the surety whole on claims it had paid.
Penn brought suit, and the district court found that equitable subrogation did not provide the surety a cause of action against the City—a decision which was reversed by the Eighth Circuit. The appellate court’s analysis noted the basic principles of equitable subrogation (under Arkansas law), which allows a surety “to acquire and assert the rights of those parties whom the surety pays.” The right exists when the surety’s payments achieve “full satisfaction of any underlying debt or obligation.”
The Eighth Circuit held Penn had provided the City with sufficient notice of the principal’s default, or potential default, such that the City was liable to Penn for release of the contract funds. Additionally, the contract and payment bond “created two relevant obligations: removal of specified debris and payment for labor and materials. The City unilaterally removed the former obligation, so [Penn] was charged with satisfying the latter” (payment) due to the bond—which it did. The appellate court further noted Arkansas and other states recognize when a surety satisfies its obligation under a payment bond, “equitable subrogation permits the surety to proceed against retainage and remaining contract funds for reimbursement.” Thus, Penn was entitled to the retainage the City should have held.
The court further explained that “[i]f, after appropriate notice of default, the [City] chooses to pay funds to the general contractor that are or become equitably owed to [Penn], the [City] is liable for the actual loss visited upon” Penn. Consequently, the case was remanded to the district court with directions to enter judgment in favor of Penn.
In United Bonding Insurance Co. v. Catalytic Construction Co., the surety, United Bonding Insurance Company (“United Bonding”), provided performance and payment bonds for a subcontractor, Miranti Construction Company (“Miranti”). The subcontractor’s work involved multiple contracts for a government project wherein Catalytic Construction Company (“CATCO”) was the general contractor. When Miranti notified United Bonding that it could not financially complete the projects, United Bonding financed Miranti to assure completion of the contracts and also paid multiple claims on the payment bonds. United Bonding made a telephone call to CATCO to request funds be withheld from Miranti on all the contracts and to assert its subrogation rights. Based upon instructions from the Atomic Energy Commission and the United States Attorney’s Office, CATCO continued to make progress payments to Miranti. By this point, United Bonding had taken “control of the CATCO-Miranti contracts,” and advanced money for payroll and “other expenses, and ensured that all of the contracts were fully performed.” The record does not indicate whether Miranti had been terminated.
The record indicated that the parties agreed that the equitable right of subrogation applied only to five of the contracts in the case without explicitly stating the basis for such a conclusion. Under those contracts, Miranti was to receive $32,800.00 as of the date of notice from the surety; the balance of $2,430.22 was retained by CATCO. CATCO paid the remaining funds to Miranti and a secured creditor (a bank). Although CATCO called the payments on the other contracts “progress payments,” there was evidence that, in fact, those contracts had been completed at the time of the payments.
United Bonding sued CATCO on the theory that CATCO had wrongfully disbursed the remaining funds ($25,000). The district court entered judgment for United Bonding on only one of its claims, which was for the funds still held by CATCO on one contract. The district court rejected the surety’s claims to recover funds that had been wrongfully paid to Miranti and the bank on the other contracts. In reaching its decision, the district court primarily relied on an erroneous interpretation of the Assignment of Claims Act. A small judgment was entered in favor of United Bonding for only $2,430.22 “on the basis of a scholarly and comprehensive opinion,” in the words of the appellate court.
United Bonding appealed the district court’s denial of its claims for the wrongfully paid contract funds. Although the appeal involved several issues, equitable subrogation was ultimately the key issue the court addressed. The surety’s general right of subrogation was not challenged. Instead, the court addressed how that right interrelated with the status of the work and whether CATCO “received effective notice of the bond company’s rights.”
Thus, the question on appeal was “whether CATCO is liable for having paid someone other than United Bonding after receiving notice of the bond company’s rights.” The court of appeals acknowledged that “United Bonding acquired an equitable right to payments due Miranti under the contracts, to the extent of its net costs.” The appellate court stated “[t]his right relates back in time to the bonding agreement and has priority over the rights of the contractor or an assignee.” The appellate court, however, then discussed two scenarios where the right of subrogation could be different.
If the contracts had been fully performed by Miranti by the time payment was due, CATCO would have been a “stakeholder faced with conflicting claims of Miranti” and United Bonding, and “[p]ayment to the contractor would not discharge liability if the surety subsequently established a right to the funds.” The appellate court noted that “once a construction project is physically completed, continued payment to the contractor instead of the subrogee is unlikely to be justified.”
Conversely, CATCO would not be a “stakeholder” if the project was not complete when it needed to make a progress payment because “[t]he interest in obtaining timely completion of the contracts could give CATCO a legitimate reason” for paying the contractor. In the latter situation, the appellate court noted “the contracting party has discretion to continue paying the contractor and is liable to the surety only for an abuse of that discretion.” If CATCO abused its discretion in making payments to Miranti after receiving notice from United Bonding, it is liable.
These two different scenarios also affected the appellate court’s evaluation of the notice given by United Bonding. The Ninth Circuit reasoned that “the degree of notice must be balanced against the extent of CATCO’s interest in continuing its payments to the contractor.” Where projects are physically completed, “the interest in continuing to receive performance is not likely to be substantial; thus a relatively summary notice to CATCO would be sufficient to make it liable to the bond company for subsequent wrongful disbursements.” Because the evidence was ambiguous as to whether the Miranti contracts had been completed at the time of the notice, the court remanded with instructions for the district court to determine “which, if any, of the contract payments were made after CATCO received notice that the assignment to United Bonding was effective.” As the case was being remanded, the appellate court did not address the validity of the payment to Miranti’s bank.
United Bonding offers valuable insights when a surety is acting in response to notice from its principal of an impending default and takes steps such as financing to support the principal. First, the surety should clearly notify the obligee, in writing, of the surety’s actions and subrogation rights. For contracts still in progress, the surety should also notify the obligee of the actions that the surety is taking to complete the work by supporting its principal, and demand the progress payments be made to the surety.
In a case from the Eleventh Circuit, the surety, National Fire Insurance Company of Hartford (“NFIC”), issued performance and payment bonds on behalf of Arkin Construction Company (“Arkin”), a subcontractor to the general contractor, Fortune Construction Company (“Fortune”). Arkin defaulted; Fortune and NFIC attempted to resolve how the projects would be completed. There was “a flurry of letters between attorneys for Fortune and [NFIC]” in which the parties disputed the obligations each owed the other. NFIC “made payments to payment bond claimants on both projects” and both projects were “completed by Fortune as the general contractor.” Fortune sent NFIC “an accounting of its ‘performance’ costs to complete the Arkin subcontracts.” NFIC responded with “an accounting of the net remaining contract proceeds,” which NFIC contended “exceeded Fortune’s costs of completion” and thus Fortune owed NFIC a credit for the difference.
NFIC sued Fortune for, among other things, equitable subrogation. The district court entered summary judgment for NFIC and held that it “had a right to equitable subrogation ‘under the payment and performance bonds,’” and the “right to the contract balances was superior to Fortune’s right to set off its claims against Arkin.” The lower court held that “to the extent the contract balances exceeded Fortune’s reasonable costs to complete construction. . . ‘the excess is to be paid to [NFIC] up to the amount of [NFIC]’s payment bond expenditures.’”
Fortune appealed. The court of appeals looked to the applicable Florida law, which stated “a performance and payment bond surety’s rights to equitable subrogation depend upon the nature of the obligation fulfilled by the surety under the terms of the bonds.” The appellate court also looked to the precedent from the First and Fifth federal circuit courts, both of which had previously acknowledged the right of a surety to subrogation. The Eleventh Circuit held that, in a case where surety must perform or provide payment under performance and payment bonds, “the surety’s subrogation rights exist only to extent of the surety’s performance” or fulfillment of such payment obligations. As NFIC disbursed payment to laborers and materialmen for work on the projects but did not perform according to the performance bond, “it [had] acquired equitable subrogation rights only with respect to its payment bonds.” The court concluded that such subrogation rights would not give the surety priority to receive contract funds that the obligee actually used to complete the work.
Like United Bonding, Fortune addressed the different subrogation rights a surety might obtain by acting under a payment bond versus a performance bond. A surety who elects not to perform under both the performance and payment bonds might end up with less comprehensive subrogation rights to the contract funds if the obligee is required to finish the bonded contract.
The case from the D.C. Circuit Court of Appeals, American Fidelity Co. v. National City Bank of Evansville, represents the limits of a surety’s subrogation rights. Regent Contracting Company (“Regent”) contracted with the Federal Government to construct a steam plant. The sureties, American Fidelity Company (“AFC”) and New Hampshire Fire Insurance Company (“NHFI”), provided bonds for the project.
Regent “executed a loan agreement to [t]he National City Bank of Evansville” (the “Bank”) and assigned to the Bank progress payments from the project to secure the loan,as authorized by the Assignment of Claims Act, and stated “that it would obtain a subordination agreement from the sureties,” of which the Government and the sureties were given notice. Subsequently, the sureties did not agree to subordinate their interests, and AFC’s attorney sent the Bank a letter “claiming ‘equitable rights in the contract proceeds superior to the assignment which has been given to you by the contractor.’”
Pursuant to the Assignment, the Government made three progress payments to the Bank. After these payments were made, Regent’s contract was terminated and the Government contracted out the rest of the project. Of course, the completion of the project resulted in additional costs, which the sureties paid. The sureties also paid out funds under the payment bond for labor and materials left unpaid by Regent.
After a series of lawsuits, the cases were consolidated in the D.C. federal court. In the consolidated case, the Bank’s complaint and the sureties’ counterclaim were dismissed, but judgment for the Bank was entered against Regent for $89,530 plus interest. The district court concluded that, as a result of the Act, the sureties, as a matter of law, “could not recover from the [B]ank the three progress payments made to it by the Government under the assignment,” and that the progress payments were not received by the [B]ank with an attached “equitable lien or trust in [the sureties] favor to the extent they had been forced to pay under the bonds.”
The sureties appealed and presented the issue of whether the sureties “on the contractor’s performance and payment bonds [could] recover such payments from the [B]ank to reimburse them for sums paid by them because the contractor defaulted after the [B]ank had collected the progress payments.” The sureties argued that the lower court erred when it failed “to hold that the three progress payments were received by the [B]ank impressed with an equitable lien or trust in their favor to the extent they have been forced to pay under the bonds.”
The court of appeals affirmed. While the sureties argued for an “equitable lien,” the appellate court concluded that the “lien” is, in reality, the right of subrogation. The court acknowledged the doctrine of subrogation and held that a payment bond surety on a Government contract who “makes a payment thereunder to suppliers of labor or material. . . is subrogated to the rights and preferences of such suppliers as to sums due or to become due under the contract; and again the subrogation relates back to the date of the bond.”
Ultimately, the appellate court ruled the Act preempted the sureties’ ability to recover against the Bank because the assignments were legitimate. Based upon the plain language of the Act, as the government could not recover against the Bank under the Act, neither could the surety.
While the sureties would be entitled to subrogation against others for the amounts they paid for the benefit of the contractor under the payment bond, the appellate court concluded, as to the claim against the Bank, that “neither the Government, the contractor, nor those who furnished labor or materials could recover” against the Bank on the assignments. As a result, “there was no right to or claim against those payments to which the sureties could be subrogated. . . .” Consequently, the lower court was affirmed.
There are a few takeaways from the case. First, the assignment to the Bank was authorized by the Assignment of Claims Act. Here again, timing is everything. The three payments to the Bank were made prior to the default and prior to the time the surety incurred either payment or performance bond losses. Here, the surety was suing to recover the pre-loss payments under the relation back aspect of equitable subrogation, including its notice of subrogation rights it sent to the Bank even before any progress payments were made. As this case demonstrates: (1) the surety’s subrogation rights are inchoate until the actual loss occurs; (2) the surety steps into the shoes of the owner on the performance bond loss and into the shoes of the laborers and materialmen on the payment bond loss; (3) existing prohibitions on recovery at the time of the loss also are limitations on the surety’s rights; (4) for the performance bond losses, the Assignment of Claims Act precluded the Government (whose shoes the surety stood in) from recovering from the Bank; and (5) for the payment bond losses, the laborers and materialmen (whose shoes the surety stood in) would never have had a right to recover against the Government or a third party such as the Bank that received the funds under a lawful assignment.
At the same time, the case reflects that the doctrine of “relation back” is not a magic bullet, and parties might take steps after bonds are issued—but before a loss occurs that “vests” subrogation rights—that create legal bars to a surety’s exercise of subrogation rights. It is noteworthy that the surety’s notice to the Bank, which was made before the Bank received any funds and before the surety had incurred any losses, was not sufficient to make the Bank’s rights to the funds under the assignment inferior to the surety’s subrogation rights.
A close reading of the cases demonstrates that payment or a risk of payment by the surety is the first step in effectuation of its rights. Although the common law right of subrogation seems to be well established in favor of the surety, it would appear that early annunciation to the owner of the surety’s rights is the key to protecting the surety’s entitlement to subrogation, provided the surety has made payment or otherwise performed.
