TWENTY FOURTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS CONFERENCE Charleston, South Carolina April 18th & 19th, 2013

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1 TWENTY FOURTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS CONFERENCE Charleston, South Carolina April 18th & 19th, 2013 DON T BE PUT OFF BY SETOFF PRESENTED BY: Toby Pilcher The Hanover Insurance Group David Harris Bovis, Kyle, Burch & Medlin, LLC

2 Introduction Setoff claims can arise in a variety of situations. Two common ways for them to arise are when the principal has bonded and unbonded work with an owner and the surety either provides financial support for a principal to complete its work or pays bills on the bonded a bonded project. In whatever situation the setoff claim arises it is never convenient and it is rarely disposed of quickly. Setoff claims are difficult to resolve because the funds at issue are in the hands of the party asserting a contrary claim. It is important to know that the surety is not left empty handed. This paper addresses the surety s defenses to owner setoff claims and also what happens when the table turns and it is the surety who is the beneficiary of contractual setoff. I. A Typical Foe: Owner Setoff Claims. Owner setoff claims typically arise through the contract with the surety s principal. A contract provision providing that the owner or general contractor has the right to setoff funds owed under one contract and apply those sums to losses incurred on another contract is quite common. The language of these provisions varies and may not use the term setoff. Below is an example of a subcontract setoff provision: Contractor has the right to withhold, as an extraordinary reserve, and without limiting other rights and remedies, and an amount reasonably sufficient to remedy a default by subcontractor under any other subcontract, purchase contract, or purchase order between Contractor and Subcontractor on this or any other project. In addition, the right to setoff is a common law remedy that does not require a contractual right. The Supreme Court has recognized this right under federal common law: The right of setoff (also called offset ) allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding the absurdity of making A pay B when B owes A. 1 Federal common law setoff requires (i) a decision to effectuate a setoff, (ii) some action accomplishing the setoff, and (iii) a recording of the setoff. 2 In Applied Companies v. United States, 3 the Federal Circuit allowed the United States as owner to apply federal common law setoff rights. The contractor sued the government to 1 Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 18, 116 S.Ct. 286, 289 (1995)(quoting Studley v. Boylston Nat. Bank, 229 U.S. 523, 528, S.Ct. 806, 808 (1913)). 2 Citizens Bank, 516 U.S. at F.3d 1470 (Fed. Cir. 1998). 1

3 recover settlement money the government withheld to setoff overpayments on two other contracts. The Federal Circuit held that the settlement agreement ( an agreement to pay a certain amount ) did not preclude the government from exercising its common law right of setoff against the agreed-to-obligation. 4 To effectuate a settlement that did not allow the government to assert its common law setoff rights the contractor could have negotiated to bar the government from exercising its setoff right against the proceeds of the... settlement agreement, but it did not. 5 Owner setoff claims attempt to reduce the contract funds available to the surety and increase the loss. Owner Setoff Claim Example: Reliable Surety provides a performance bond for Painter s subcontract with General to paint the Bridge to Nowhere. Painter has also entered into an unbonded purchase order to provide materials for use on the Pork Barrel project. Painter encounters financial difficulty defaults on both contracts. Reliable provides financial assistance to Painter to compete its work on the Bridge to Nowhere and obtains an assignment from Painter to the contract funds remaining. General refuses to pay any of the remaining contract funds on the Bridge to Nowhere. General argues that the Bridge to Nowhere contract funds were setoff, pursuant to the Painter subcontract, and applied to the Pork Barrel project to offset additional costs incurred by General as a result of Painter s default on the purchase order. General s argument in the above example as to why it has the right to setoff losses on an unbonded contract with bonded contract funds is simple: the bonded contract funds were used pursuant to the agreement with the principal. General argues that the surety bonded that contract and incorporated its terms and conditions into the bond. Thus, General concludes that because no money is owed under the terms of the agreement with the principal, the surety has no recourse. An owner or general contractor s argument with a surety as to its right to setoff is based on the assumption that the surety has no greater right to the contract funds then the principal would have if it had not defaulted. An owner or general contractor who has setoff bonded contract funds to offset loses on other contracts with the principal will not respond well to a fairness argument. The owner believes it should not be in a worse position with any of its accounts with the bonded principal simply because a surety is involved. To the extent contract funds were used, they were used 4 Id. at Id. 2

4 pursuant to that agreement to offset other losses. The owner argues that it is a contract right to use those funds and the surety bonded the contract. II. Defenses to Setoff Claims: Equitable Subrogation. If the surety is going to have any defense to an owner setoff claim it must assert some right superior to that of the owner. The surety left in the position of the principal is stuck with the setoff. The owner is right in its assertion that the principal has no defense to the setoff. But the surety has at least one claim it can make to the contract funds that is superior to the owner s setoff rights. That claim is the equitable right of subrogation. A. The Completing Surety. The beginning point of this discussion must be U.S. v. Munsey Trust. 6 In Munsey Trust a payment bond surety sought to recover contract funds that the government had setoff against unpaid taxes owed by the principal. The surety insisted it was entitled to recover all of the contract funds. The government argued that its right of setoff was superior. The Court ruled in favor of the government and held that it had the right to offset the contract funds. Munsey Trust is critical because it turned on the question of how a surety s right of equitable subrogation arises. The Court recognized that the payment bond surety was subrogated to the rights of the principal and to the suppliers whom it pays. The Court, however, found that the surety, standing in the shoes of the principal and suppliers, had inferior rights to the setoff rights of the government. Munsey Trust left open the question of whether the performance bond surety would stand in the shoes of the government and have priority over its setoff rights. In Trinity Universal Insurance Co. v. U.S., 7 the Fifth Circuit held that where the surety incurs a performance bond loss, its right of equitable subrogation gives it a priority to retained earnings held by the government even in the face of the government s setoff for taxes owed by the principal. The court stated that the performance bond surety is entitled to the funds in the hands of the government not as a creditor and subject to setoff, but as subrogee having the same rights to the funds as the government. 8 The performance bond surety who performs under its bond steps into the shoes of the owner. The court went on to hold that implicit in the agreement providing for the surety to complete is the right of the surety to all retained sums. Id. at 321. A surety s equitable subrogation rights allow it to step in the shoes of a general contractor as well and preclude the setoff of bonded contract funds against unbonded contract losses. In Miller-Staunch Construction Co. v. Williams-Bungart Electric, Inc., 9 the court held that even though the bonded subcontract had a setoff provision allowing the general contractor U.S. 234, 67 S.Ct (1947) F.2d 317 (5th Cir. 1967). 8 Id. at S.W.2d 490 (Mo. App. 1989). 3

5 to do just that, this provision did not give the general contractor the right to withhold funds from the surety to offset damages elsewhere. For the completing surety who has incurred losses as a direct result of taking action under the performance bond, the law of equitable subrogation is relatively clear the surety s right of equitable subrogation will defeat an owner s setoff claim. B. The Non-Completing Performance Bond Surety. The problem of the non-completing surety has its origins in the early cases establishing a surety s equitable right of subrogation. In Prairie State Bank v. U.S., 10 the Court determined that the completing surety s right of equitable subrogation had priority over a bank s equitable lien even though the bank s lien on the contract funds arose prior to the work performed by the surety. The Court held that when the surety performed under the bond, it stepped into the shoes of the government, who would otherwise have to perform, and thus the surety s equitable subrogation right arose through the government s claim to the contract funds and not the principals. If the government had performed it would have had a superior right over the bank. The Court placed special emphasis on the performance of the surety and the fact that the performance relieved the government of the obligation to perform. Thus, when a surety performs it obtains the same right as the government because it relieves the government of the obligation to complete the project. National Fire Insurance Co. v. Fortune Construction Co., 11 helps to explain why the emphases on performance may be misplaced. In Fortune Construction the general contractor completed two bonded contracts after default by the principal and demanded payment from the surety for the cost to complete. The surety had paid the payment bond claims but had not taken on the completion of the work. The accounting submitted by the general contractor offset the contract funds available on the two projects to cover losses sustained as a result of the breach of unbonded obligations by the principal. The surety argued that it should receive a credit for all contract funds remaining with no setoff. The court held that because the surety did not complete the bonded projects that the surety was not entitled to any equitable subrogation rights to the contract funds. In dicta the court noted that the surety would have had equitable subrogation rights had the performance bonds been indemnity-type bonds. The dicta in Fortune Construction stands for the proposition that the surety ability to claim equitable subrogation rights to contract funds depends not on performance of the bonded contract but on the discharge of its obligations under the bond. When a surety fulfills its bond obligations without performance it obtains the right of equitable subrogation without performing the contract. Performance of the bonded contract is not necessary for obtaining equitable subrogation rights but rather performance under the terms of the bond. Ultimately, whether a surety must complete or only incur performance bond losses in order to obtain equitable subrogation rights to defeat an owner setoff claim will depend on the law of the jurisdiction and the wording of the performance bond at issue U.S. 227, 17 S.Ct. 142 (1896) F.3d 1260 (11th Cir. 2003). 4

6 C. The Payment Bond Surety. The issue of the payment bond surety s rights in equitable subrogation to contract funds over and above the setoff claims of the owner are made clear in Munsey Trust. 12 There the Supreme Court found that the payment bond surety does not have a superior claim to the government when it pays claims by materialmen and suppliers. The issue of the payment bond surety s right of equitable subrogation was revisited by the Supreme Court in Pearlman v. Reliance Insurance Co. 13 Pearlman did not involve a setoff claim. Instead, Pearlman involved the competing claims between the payment bond surety and trustee of the principal contractor s estate to retained funds held by the government. The trustee in bankruptcy argued that the surety only stepped into the shoes of the laborers and materialmen whose claims it had satisfied. The court held that by paying claims the surety became equitably subrogated to the rights of the principal to the retainage and thus had a superior right to those funds than the principal s trustee. There has been no shortage of case law analyzing the Munsey Trust and Pearlman decisions. This is not the place to brief all the facets of that jurisprudence. What is clear is that when a payment bond surety pays claims it is equitably subrogated to the rights of the claimant whose claims it pays and to the rights of its principal. This was summarized by the Federal Circuit: Simply put, Munsey Trust did not change the established precedent that a payment bond surety that discharges a contractor's obligation to pay a subcontractor may be equitably subrogated to the rights of the contractor. 14 The real issue is whether there is any distinction as to a surety s right to assert equitable subrogation rights to contract funds held by an owner or general contractor when the surety only has payment bond losses. Pearlman did not address this and some courts have continued to distinguish between payment bond and performance bond losses. Other courts have held that the payment bond surety does have equitable subrogation rights to funds held by the owner or general contractor and thus have eliminated the distinction between performance bond and payment bond losses when analyzing a surety s claim. 15 The payment bond surety s best argument is when it pays claims of laborers and materialmen who have lien claims against an owner or trust fund rights to the general contractor. The surety who steps into the shoes of claimants with these rights is able to assert those claims against the owner or general contractor. Because the owner or general contractor s setoff claim does not trump the lien or trust fund rights the surety s right of equitable subrogation is superior U.S. 234, 67 S.Ct (1947) U.S. 132, 83 S.Ct. 232 (1962). 14 National Am. Ins. Co. v. United States, 498 F.3d 1301, 1307 (Fed. Cir. 2007). 15 Argonaut Insurance Co. v. C&S Bank of Tifton, 140 Ga. App. 807, 232 S.E.2d 135 (1976). 16 National Shawmut Bank of Boston v. New Amsterdam Casualty Co., 411 F.2d 843 (1st Cir. 1969). 5

7 D. Potential New Territory the AIA A Bonds. The AIA A performance bond attempts to eliminate an owner s setoff rights so long as there is no breach by the surety. The model bond provides: 9 The Surety shall not be liable to the Owner or others for obligations of the Contractor that are unrelated to the Construction Contract, and the Balance of the Contract Price shall not be reduced or set off on account of any such unrelated obligations. The AIA A payment bond does not reference setoff but does provide: 9 Amounts owed by the Owner to the Contractor under the Construction Contract shall be used for the performance of the Construction Contract and to satisfy claims, if any, under any construction performance bond. By the Contractor furnishing and the Owner accepting this Bond, they agree that all funds earned by the Contractor in the performance of the Construction Contract are dedicated to satisfy obligations of the Contractor and Surety under this Bond, subject to the Owner s priority to use the funds for the completion of the work. The elimination of owner setoff claims by 9 of the AIA A performance bond is clear. There are no published cases addressing this provision. Case law may develop to illuminate the impact of this provision in light of 5.4 s provision allowing the surety the option to waive its right to complete and to tender the amount it determines it may be liable to the owner. In light of 9, the calculation for such payment would likely include an accounting for all contract funds remaining and would not allow the owner to setoff for loses on unrelated projects. The AIA A payment bond does not say that the owner may not setoff for unrelated obligations. Instead, the payment bond provides that contract funds earned by the Contractor may only be used by the owner for completion of the work. An owner may argue that pursuant to the terms of the contract, amounts that are setoff are not earned by the Contractor. The better view which is supported by a reading of the entire provision is that the owner can only claim superior right to the contract funds to the extent used on the project at issue. III. On Offense: When the setoff is in the Surety s Favor. The surety s right of equitable subrogation, which allows it to step into the shoes of the owner or general contractor and have priority over their setoff claims, presents an interesting scenario when the owner or general contractor has multiple projects with the principal, and the principal is owed money on a contract in which the surety does not have a loss. The question is whether the surety s right of equitable subrogation will allow it to assert the setoff rights which the owner or general contractor has and capture funds owed to the principal. 6

8 Surety Setoff Claim Example: Reliable Surety provides a performance bond for Painter s subcontract with General to paint the Bridge to Nowhere. Painter has also entered into an unbonded purchase order to provide materials for use on the Pork Barrel project. Painter encounters financial difficulty when owner claims unsuitable materials were provided on the Pork Barrel project. Reliable provides financial assistance to Painter to compete its work on the Bridge to Nowhere and gives General notice of its interest in all monies owed to Painter. Painter sues owner under the Pork Barrel purchase order. General and Painter enter into a settlement agreement that requires General to pay Painter for the material that was previously claimed to be unsuitable. The amount of the settlement is less than the amount of Reliable s performance bond loss on the Bridge to Nowhere project. The recognition of a stakeholder duty is the principle undergirding a surety s right to assert setoff rights, and thus have priority to funds owed to the defaulted principal on other projects. The Court of Federal Claims has recognized that once a surety notifies the government of the principal s actual or potential default, the Government assumes a stakeholder duty to act with reasoned discretion to protect the interests of the surety in the remaining contract funds. 17 After such notice, the Government has an obligation to take reasonable steps to determine for itself that the contractor had the capacity and intention to complete the job. 18 If the Government improperly pays out the money at issue after receiving notice of the surety s equitable rights, the surety is entitled to judgment. 19 There is nothing inherent in the stakeholder duty as recognized by federal courts that would not cause this duty to be equally applicable to a general contractor or to a private owner. In Transamerica v. United States, 20 a surety completed construction on one bonded project and notified the government that its right of equitable subrogation entitled it to the payment of settlement funds the government owed to the contractor on another project bonded by the surety. Despite this notice, the government disbursed the settlement funds to the contractor. The Federal Circuit held that the surety stated a valid cause of action for damages caused by the government s disregard of the surety s equitable subrogation rights, which 17 Insurance Co. of West v. United States, 83 Fed. Cl. 535, 538 (2008). 18 Balboa Inc. Co. v. United States, 775 F.2d 1158, 1164 (Fed. Cir. 1985). 19 Id. at F.2d 1188 (Fed. Cir. 1993). 7

9 extended to the settlement funds for the other project. The court noted that the government had no competing claim to the settlement funds and that the surety should be able to offset through equitable subrogation its losses against these funds. 21 The Transamerica case shows that a surety is equitably subrogated to contract funds the owner owes to the contractor. The recent decision by the Court of Federal Claims in Hartford Fire Insurance Company v. U.S., 22 expands upon the Transamerica holding. In Hartford the surety filed a claim against the United States Army Corps of Engineers ( Corps ) for wrongfully disbursing funds owed to the surety s principal. Surety performed under one bonded contract and had incurred losses. After the surety gave the Corp notice of its right of equitable subrogation and requested that no funds be distributed to the principal, the Corp settled a claim brought by the principal under another bonded contract and paid the principal $700,000. The court held that the performing surety succeeds to the contractual rights of both the defaulted contractor and the government itself. 23 Therefore, [t]he surety is entitled to the funds in the hands of the government not as a creditor subject to setoff, but as a subrogee having the same right to the funds as the government. 24 Next, the court found that the government has the right to setoff money owed to the principal to extinguish debts owed to it by the same party. This right of setoff applies to funds owed under contract and to funds owed pursuant to a settlement agreement. 25 The court concluded that the surety stepped into the shoes of the government when it incurred losses on one of its bonded contracts and therefore it could assert the government s setoff rights as to funds owed under a settlement agreement to the principal. 26 IV. Practice Tips. When a completing surety enters into a Tender Agreement or Takeover Agreement with the owner or general contractor it is customary for such agreements to include an accounting of contract funds remaining and an assurance by the owner or general contractor to make these sums available for completion. As the experienced claims professional know it is not always possible to complete under a Tender or Takeover. One such situation is the when the surety funds the completion of the project through the principal. In this situation, particularly where principal has non-bonded work for the same owner, it is important that the owner or general contractor acknowledge that the 21 Id. at Fed. Cl. 525, (2012). 23 Id. at Id. (citations omitted). 25 See Applied Companies v. United States, 144 F.3d 1470 (Fed. Cir. 1998). 26 Hartford, 108 Fed. Cl. at

10 surety is completing under the performance bond and to provide that the contract funds will be paid to the surety without setoff. When setoff is encountered on the front end before the surety has completed and perhaps before the owner has incurred losses on the unbonded work the surety will save itself the time and expense of fighting a later setoff. When the surety is facing an owner setoff claim there are several questions which must be asked to determine whether the surety has priority to the funds through equitable subrogation. Those questions include: What kind of loss has the surety incurred? (Rights may differ if there are payment bond losses only.) Does the bond say anything as to performance/setoff? (Does the bond prohibit setoff or allow the surety to perform by tendering the costs of completion?) Who is the obligee? (In a payment bond situation does the obligee have lien and trust fund obligations?) What is the jurisdictional law on point? When attempting to assert an owner s setoff right to seek damages for an improper payment to the principal, a key factor will be whether the surety has given the owner notice of its rights. There are two factors to consider when giving notice: who should be notified and how should they be notified. Certainly the contracting officer/responsible party on the project for which losses have been incurred should be placed on notice. But proper notice does not end there. It is advisable that you notify the contracting officer on the other projects on which the principal has contracted with the owner. Also, how should notice be given? Certified mail with return receipt requested is the preferred method. To ensure the most timely delivery send by and request delivery and read receipt. 9