TWENTY THIRD ANNUAL NORTHEAST SURETY AND FIDELITY CLAIMS CONFERENCE SEPTEMBER 20th - 21st, 2012

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1 TWENTY THIRD ANNUAL NORTHEAST SURETY AND FIDELITY CLAIMS CONFERENCE SEPTEMBER 20th - 21st, 2012 OVERPAYMENT CLAIMS IN LIGHT OF RECENT FEDERAL AND STATE DECISIONS: IT'S NOT OVER PRESENTED BY: CHRISTOPHER J. BRASCO, ESQUIRE VIVIAN KATSANTONIS, ESQUIRE CHRISTOPHER M. HARRIS, ESQUIRE Watt, Tieder, Hoffar & Fitzgerald, L.L.P Greensboro Drive, Suite 100 McLean, VA LEONARD J. GERACI, ESQUIRE Chartis Claims, Inc. DOUGLAS J. WILLS, ESQUIRE Chubb & Son Insurance Group

2 I. Introduction Following a default termination and performance bond demand, a surety will occasionally have grounds to assert an overpayment claim or defense. While overpayment, when asserted as a defense, and the underlying doctrine of impairment, continue to find widespread support in the case law, a surety seeking to assert overpayment as an affirmative claim may encounter additional obstacles depending upon prevailing authorities in the jurisdiction in which it is forced to litigate its claim. For example, the Federal Circuit s relatively recent decision in Lumbermens Mutual Casualty Company v. United States, 654 F.3d 1305 (Fed. Cir. 2011), though inconsistent with a number of prior United States Supreme Court and other decisions, purports to impose new restrictions upon a Miller Act surety s ability to assert an affirmative overpayment claim against the federal government. Nonetheless, with careful planning and mindful of recent developments in applicable law, the prudent surety will find that overpayment, whether asserted as an affirmative claim or a defense, remains a powerful weapon in its arsenal. This paper examines the impact that Lumbermens and other recent decisions may have upon the surety s ability to assert overpayment as a claim or defense in various jurisdictions and related strategies to increase the surety s likelihood of success. II. Overview of the Surety s Overpayment Claim Generally, a surety may assert an overpayment claim or defense when the bond obligee has improperly or prematurely depleted the contract balance prior to the surety s involvement. Often, this occurs when a project owner releases payments to the bonded contractor in contravention of an express contractual provision, such as a provision requiring the owner to retain a certain percentage of the contract funds pending the contractor s satisfaction of certain conditions. See, e.g., Nat l Sur. Corp. v. United States, 118 F.3d 1542 (Fed. Cir. 1997) (overpayment claim accrued to surety where government failed to obtain a required arrow diagram before releasing retainage). Overpayment may also occur where the obligee pays for patently defective, noncompliant and incomplete work, including work that has not actually progressed to the extent that progress payments have been made e.g., where 80% of the contract funds has been paid to the contractor though only 40% of the contract work has been completed. See, e.g., United Pacific Ins. Co. v. United States, 16 Cl. Ct. 555 (1989) (surety entitled to recover overpayments for materials that the government failed to inspect as required by contract); Transamerica Ins. Co. v. City of Kennewick, 785 F.2d 660 (9th Cir. 1986) (holding that payments by the obligee to the principal for installation of materials that were never installed prejudiced the surety and resulted in pro tanto discharge); Blackfeet Tribe of the Blackfeet Indian Reservation v. Blaze Constr., Inc., 108 F.Supp.2d 1122 (D. Mont. 2000) (discharging surety due to obligee s failure to act with due care in making payments for work not performed, which prejudiced surety by depleting its security and reducing the incentive for the principal to complete the work). 1

3 Under the doctrine of impairment, where there has been an overpayment, the surety is generally entitled to a discharge from liability. See RESTATEMENT (THIRD) OF SURETYSHIP AND GUAR. 37, One way in which a surety may prevail on such a defense occurs where it can prove that the obligee has materially modified the bonded contract, increasing the surety s risk. See, e.g., Southwood Builders, Inc. v. Peerless Ins. Co., 366 S.E.2d 104 (Va. 1988) (affirming that making substantial payments before contractually due constitutes a material deviation from contract terms, discharging surety from bond obligations) Based upon the nature and extent by which its risks have been increased by such a modification e.g., whether the increased risks are measurable the surety may be entitled to either a complete or pro tanto discharge of its bond obligations. The surety may likewise obtain a pro tanto discharge where it has been prejudiced by the obligee s depletion of contract funds through premature payments or overpayments in contravention of the terms of the bonded contract. When seeking only a discharge from bond liability, the surety asserts overpayment as a defense. Sureties have also been successful in asserting overpayment as an affirmative claim. Beyond requesting only a discharge from liability, the surety s affirmative claim of overpayment seeks to recover from the obligee, as damages, the contract funds that the obligee prematurely and/or improperly disbursed to the bond principal. See, e.g., Continental Ins. Co. v. City of Virginia Beach, 908 F.Supp. 341 (E.D. Va. 1995) (determining that overpayments to the principal rendered obligee liable for surety s resulting additional costs to complete). The surety s overpayment claims and defenses are generally rooted both in contract and in equity. For example, an overpayment claim is essentially contractual in that it involves a failure by the obligee to comply with its contractual obligations regarding the disbursement of contract funds. Overpayment claims and defenses also generally implicate the equitable duties imposed upon the obligee by the impairment doctrine, including in particular the owner s duty to preserve the surety s collateral and to refrain from taking actions that would unfairly diminish the surety s collateral or otherwise increase the surety s risk of loss. See Argonaut Ins. Co. v. United States, 434, F.2d 1362, 1367 (Ct. Cl. 1970) (subrogation right is equitable, both in origin and implementation); U.S. Fid. & Guar. Co. v. United States, 475 F.2d 1377, 1384 (1973) ( [d]uring the performance of the contract, the Government has a duty to exercise its discretion responsibility and to consider the surety s interest in conjunction with other problems encountered in the administration of the contract. ) Because contractual and equitable claims may be treated differently in a given case or jurisdiction e.g., sovereign immunity may shield a public obligee from liability for purely equitable claims the surety should carefully consider how to frame its overpayment claim. As always, a surety seeking to assert overpayment should consider thoroughly how the relevant jurisdiction treats such claims and defenses, including, for example, whether overpayment claims are treated differently from overpayment defenses and whether the surety must demonstrate actual or specific injury or prejudice. The surety must also consider whether the terms of the bond or the bonded contract, such as a 2

4 provision affording the obligee with broad discretion as to how payments will be made, may serve to enhance or diminish the surety s likelihood of success on an overpayment claim or defense. III. Developments in Federal Law Lumbermens Impact on Overpayment Claims In advancing a meritorious claim for overpayment against the federal government, the surety must consider the Federal Circuit s relatively recent decision in Lumbermens Mutual Casualty Company v. United States, 654 F.3d 1305 (Fed. Cir. 2011), which purports to restrict the surety s ability to assert overpayment as an affirmative claim in the federal arena. While the long-term impact of the Lumbermens decision on the surety s potential claims and defenses remains to be seen, in the interim, the surety is advised to carefully consider the court s holdings in developing its strategy for pursuing a potential overpayment claim, immediately upon the appearance thereof, and in subsequently framing any resulting claims for litigation. In Lumbermens, the Navy contracted with Landmark Construction Company ( Landmark ) for the repair and renovation of 160 military family housing units. Pursuant to the Miller Act, Lumbermens Mutual Casualty Company ( Lumbermens ), as surety, issued payment and performance bonds in connection with the project, naming Landmark as bond principal and the United States as bond obligee. When Landmark abandoned the project, citing financial problems, the Navy terminated the principal for default. As of the termination date, Landmark had only completed 12% of the housing units. At that point, however, the Navy had already paid out 40% of the contract price to Landmark, creating a significant disparity between the amount of contract funds disbursed and the amount of work actually performed, giving rise to an overpayment claim by the surety. Following the principal s default, the United States made a demand upon Lumbermens performance bond for completion of the work. Thereafter, Lumbermens entered into a takeover agreement whereby Lumbermen s agreed, in accordance with its bond obligations and under a reservation of its rights, to undertake completion of the project through a replacement contractor, Atherton Construction ( Atherton ). Lumbermens, Atherton and the Navy were all parties to the takeover agreement, and Lumbermens and Atherton separately executed a bilateral completion agreement. Lumbermens subsequently filed suit against the United States under the Tucker Act, seeking recovery of damages incurred in performing and completing the contract work. The surety advanced three theories of recovery, two of which presented alternative theories of recovery on its affirmative overpayment claim, one under the doctrine of equitable subrogation and the other under the doctrine of impairment/pro tanto discharge. Under both theories, Lumbermens essentially argued that the Navy made improper overpayments to Landmark in violation of various FAR provisions related to payment that were incorporated in the underlying contract, and that as a result of the overpayments, prematurely depleted the contract funds thereby increasing 3

5 the amount the surety had to spend to complete the contract work. Id at Specifically, as preconditions to payment under the contract, Landmark was required to submit a Schedule of Prices and Network Analysis Schedule, setting forth a detailed itemization of the contract price and explaining where, how and when the contract funds would be spent. As an additional condition to payment, Landmark was required to submit certifications with each invoice, certifying that each submitted invoice requested payment only for services within the contract; that previous payments were used to pay subcontractors; and that no funds were withheld from subcontractors. The Navy proceeded to pay Landmark without enforcing the Schedule of Prices and Network Analysis Schedule requirements e.g., Landmark s submissions omitted significant required information regarding quantities and unit prices. The Navy s failure to enforce these contractual conditions precedent to payment effectively precluded the Navy from effectively monitoring Landmark s performance and from preserving contract funds and purchased materials, the collateral for Lumbermens bonds. 1 In addition to its overpayment claims, Lumbermens asserted a contractually based claim, essentially alleging that the Navy had violated the terms of the parties takeover agreement by improperly withholding a portion of contract funds as liquidated damages, which Lumbermens contended were the result of delays attributable to the Navy and otherwise pertained to work that was not covered under Lumbermens bond. 2 In response to Lumbermens lawsuit, the Navy filed a motion to dismiss, arguing that the Court of Federal Claims lacked jurisdiction over the equitable subrogation and impairment of suretyship counts because the United States had not waived sovereign immunity as to either claim. Id at The Navy also moved to dismiss the breach of contract claim for lack of jurisdiction alleging that Lumbermens had failed to meet the jurisdictional prerequisites of the Contract Disputes Act ( CDA ). Id at At the trial level, the Court of Federal Claims dismissed Lumbermens equitable subrogation claim, citing Insurance Company of the West v. United States, 243 F.3d 1367, 1375 (Fed Cir. 2001) ( ICW ) for the proposition that the [t]he Government s equitable duty to retain contract funds for the surety is triggered upon notice from the surety that the contractor is in default or that payment should be made to the surety, and finding that Lumbermens had failed to notify the Government of Landmark s default prior to the Navy s alleged overpayments. See Lumbermens Mut. Cas. Co. v. United States, 67 Fed. Cl. 253, 255 (2005) (citations omitted). Nonetheless, the trial court subsequently awarded damages to Lumbermens on its alternative impairment of suretyship/pro tanto claim, finding that the Navy s overpayments impaired the surety s collateral. Id. The court also awarded damages to the surety on its breach of contract claim, concluding that the jurisdictional prerequisites of the CDA were inapplicable to Lumbermens claims 1 Additional factual detail is found in the lower court s prior, overruled decision, Lumbermens Mut. Cas v. United States, 90 Fed. Cl. 558 (2009). 2 Prior to the default termination, Landmark s contract was modified to add 21 housing units, with a corresponding increase in the contract price, but Lumbermens did not provide performance or payment bonds in connection with this additional work. Under the takeover agreement, however, Atherton agreed to complete the additional work and to obtain bonds from another surety regarding the same. Under the separate completion agreement between Lumbermens and Atherton, Lumbermens agreed to reimburse Atherton for liquidated damages incurred within eight months following the completion date. 4

6 arising from a takeover agreement, which Lumbermens had entered in its capacity as a surety. Id at The Navy appealed the determinations on Lumbermens impairment of suretyship/pro tanto discharge and breach of contract claims on jurisdictional grounds, and Lumbermens cross-appealed on its equitable subrogation claim. A. Lumbermens on Equitable Subrogation On its cross-appeal, Lumbermens argued that the Court of Federal Claims independently had jurisdiction over its claims for damages resulting from the Navy s overpayments to Landmark by virtue of Lumbermens status as an equitable subrogee. In response, the United States Court of Appeals for the Federal Circuit (the Federal Circuit ) first expressly acknowledged that the United States has waived sovereign immunity as to a surety s claims arising from equitable subrogation and that a surety may therefore bring suit under the Tucker Act based upon its principal s contractual privity with the United States. The Federal Circuit proceeded to reject Lumbermens argument, however, based upon the surety s failure to notify the Navy that Landmark was approaching default and/or that the Navy should withhold or divert progress payments. In doing so, the Federal Circuit held that [e]quitable subrogation can be used to recover improper payments to a principal obligor only if made after the obligee received notice of the principal obligor s default. Lumbermens, 654 F.3d at The latter conclusion is arguably inconsistent with the Federal Circuit s prior decision in National Surety Corp. v. United States, 118 F.3d 1542 (Fed. Cir. 1997) and other authorities, including several United States Supreme Court decisions, which have consistently acknowledged a surety s equitable subrogation rights without imposing any notice requirements upon the surety. See, e.g., Pearlman v. Reliance Ins. Co., 371 U.S. 138 (1962); Hennsingsen v. United States Fid. & Guar. Co., 208 U.S. 404 (1908); Prairie State Nat l Bank v. United States, 164 U.S. 227 (1896). In National Surety, the Federal Circuit held that the government was liable to the surety, under a subrogation theory, for its losses resulting from the government s improper release of retainage. With reference to the above-cited Supreme Court decisions and other authorities, the National Surety court noted that the surety s longstanding right of subrogation relates back to the date of bond execution, imposing equitable duties upon the obligee to preserve the surety s interests throughout the course of the project. 118 F.3d at National Surety further explicitly rejected the notion that Fireman s Fund Insurance Co. v. United States, 909 F.2d 495, 498 (Fed. Cir. 1990), a case and notion upon which the Lumbermens decision relies, changed the rules of subrogation so as to impose a requirement of notice upon the surety s right to equitable subrogation. 118 F.3d at As National Surety logically explained, notice was required in Fireman s Fund because, in that case, the surety claimed that the government had violated a contract provision requiring the government to exercise reasonable discretion when disbursing funds i.e., the surety could not prove that the government breached its discretionary contractual obligation where it lacked notice of the default. National Surety expressly limited Fireman s Fund s notice rule to the facts of that case and made clear that notice would not be required in all cases, including for 5

7 example, where the government breached a mandatory i.e., non-discretionary payment provision. Nonetheless, in light of the more recent Lumbermens decision, which hypothesizes that the National Surety panel may have misapprehended the facts of [Fireman s Fund], the surety s affirmative overpayment claim against the federal government, at least when premised upon equitable subrogation, will be best postured where it seeks to recover payments made after the surety has provided notice to the government of its principal s actual or likely default and/or a request that the government withhold or divert funds from the principal. That said, a surety seeking to assert an overpayment claim to recover disbursements made prior to its having provided notice to the federal government might also argue for the application of National Surety, which has not been overruled. 3 In this regard, if the surety can show that the obligee had notice of the principal s default but nonetheless continued to pay the principal, the surety will have a greater likelihood of success in pursing its overpayment claim. The surety might also prevail if it can persuade the court that the obligee s failure to comply with mandatory contract payment provisions amounted to a material breach. As long as Lumbermens remains undisturbed, the surety faces an uphill battle. The Lumbermens decision on the equitable subrogation claim is further problematic in that it suggests that the surety s right of equitable subrogation may be limited to the assertion of claims that the principal could have made, implying further that Lumbermens could not have made a claim against the government for funds that the government had paid to Landmark simply because, Landmark, itself, could not make a claim for funds that it had already received. This suggestion flies in the face of numerous prior federal decisions in which the surety, on the basis of equitable subrogation, has been permitted to recover payments that were improperly made to the contractor. See, e.g., ICW, 243 F.3d 1367 (Fed. Cir. 2001); Nat l Am. Ins. Co. v. United States, 498 F.3d 1301 (Fed. Cir. 2007). Moreover, equitable subrogation affords the performing or financing surety a superior right to contract funds, pursuant to which the surety may step into the shoes of a wide array of claimants, as necessary, in order to assert those rights. See, e.g., Pearlman v. Reliance Ins. Co., 371 U.S. 132 (1962). Under the considerable weight of contrary authorities, it seems unlikely that a surety s overpayment claim would be defeated solely by reason of the fact that the principal had already received the funds and therefore could not make a second claim for them. B. Lumbermens on Impairment of Suretyship/Pro Tanto Discharge As to Lumbermens impairment of suretyship/pro tanto discharge claim, the Federal Circuit reversed the lower court s judgment in favor of Lumbermens, for lack of jurisdiction. Specifically, the court ruled that the United States had not waived 3 The Federal Circuit denied a subsequent request for rehearing of Lumbermens en banc, seeking, among other things, to resolve the apparent inconsistency with National Surety. As of this writing, no reported decisions have issued, post-lumbermens, that address prior notice as a condition to recovering overpayments under equitable subrogation under either National Surety or Lumbermens. 6

8 sovereign immunity as to the surety s impairment or pro tanto discharge claims. The court reasoned that any affirmative right of recovery for overpayments must stem from a state law cause of action based upon an implied-in-law or quasi-contract theory and that, while the Tucker Act waives sovereign immunity over implied-in-fact contracts with the United States, the Act does not waive sovereign immunity over contracts that are implied in law or quasi-contractual claims such as quantum meruit. Id. at Therefore, the court concluded that it lacked jurisdiction to consider an implied-in-law contract theory against the Navy. Id. at In reaching this conclusion, and in responding to Lumbermens contention that the court s rejection of its overpayments left the surety without a remedy, the court acknowledged that impairment/pro tanto discharge may be asserted as a defense to the government s claim under the bond. Id. at Thus, the court determined, [i]f a surety concludes that the government has improperly impaired its collateral, the surety has the right to withhold payment on the bond, to the extent the surety has been prejudiced, based on the defense of impairment of suretyship/pro tanto discharge. Id. at At least one federal court, in a customs bond case, has followed Lumbermens in dismissing a surety s affirmative impairment of suretyship/pro tanto discharge claim that sought to recover an obligee s overpayments to the principal. See Hartford Fire Ins. Co. v. United States, F. Supp.2d, 2012 WL , (Ct. Int l Trade Aug. 13, 2012) (holding that while federal statute 28 U.S.C granted jurisdiction and waived sovereign immunity over tariff and trades laws claims, 1581 did not waive sovereign immunity as to surety impairment claims, which have been barred in other contexts). Inasmuch as the Lumbermens court s rejection of the surety s second overpayment theory hinges on the court s unsupported characterization of the impairment/pro tanto discharge claim as a state law claim based upon an implied-in-law or quasi- contract, a surety may have more success presenting its overpayment claim as a purely contractual one. To this end, where possible, the surety should emphasize that its overpayment claim arises directly from the government s breach of an express contract provision. Alternatively, as a defensive strategy specifically contemplated by the Lumbermens court, the surety considering completion of the project in response to a performance bond demand should fully investigate and determine the extent of the government s liability for any overpayment prior to agreeing to complete; and if it elects to do so, the surety should consider attempting to negotiate a provision in its takeover agreement that obligates the government to pay over, or deduct from the remaining completion obligation, the amount of the surety s losses sustained as a result of overpayment. As a final note on this issue, Lumbermens expressly acknowledged the availability of affirmative claims based upon impairment of suretyship/pro tanto discharge in other jurisdictions, and thus, its impact on such claims is arguably confined to federal public contract cases. C. Lumbermens on Breach of Contract Claims Following the Execution of a Takeover Agreement 7

9 As to the surety s breach of contract claim, the United States argued that the Court of Federal Claims lacked jurisdiction over the surety s claim because the surety failed to submit a certified claim to the contracting officer as required by the CDA. Id. at Lumbermens, which had brought all of its claims under the Tucker Act, argued that to the extent its claims arose from the takeover agreement, they did not fall under the purview of the CDA because Lumbermens expressly entered into the agreement in its capacity as a surety rather than as a contractor and because the takeover agreement did not directly provide for construction services by Lumbermens. Id. at While the Court of Federal Claims agreed with Lumbermens, the Federal Circuit rejected this argument. The appellate court held that a takeover agreement in which the surety obligates itself to undertake completion of the project in accordance with its bond obligations even where it purports to disclaim any notion that the surety is acting as a contractor and instead identifies a separate replacement contractor that is also a party to the takeover agreement makes the surety a contractor for purposes of the CDA and that the takeover agreement constitutes a contract for the procurement of construction services under the CDA. Id. As such, the Court ruled that Lumbermens could not bring its claims arising from the takeover agreement under the Tucker Act, but instead must bring them under the CDA and that the surety must therefore satisfy all statutory prerequisites to bringing such claims. The court further held that any claims of the surety arising after the execution of a takeover agreement must proceed under the CDA because at that point, the surety became a contractor under the Act. Id. at Accordingly, the surety is advised to comply with all prerequisites of the CDA, including for example the submission of a certified claim for final decision by the contracting officer, prior to initiating any litigation against the government involving claims arising after its issuance of a takeover agreement. In sum, while the Lumbermens decision certainly creates some obstacles to the surety s ability to assert overpayment claims, the doctrine of sovereign immunity does not bar such claims when based upon a theory of equitable subrogation (provided that the obligee had notice of the default prior to issuing the alleged overpayments) or the assertion of impairment/pro tanto discharge as a defense to liability on the bond. Thus, while the surety s ability to recover overpayments has certainly been made more difficult by Lumbermens, through careful planning, the vigilant and prudent surety may still be able to obtain a remedy. IV. Developments in State Law The Safe Harbor and Other Obligee Defenses While the difficulties presented in Lumbermens may be limited to the arena of federal government contracts, private and non-federal public obligees have enjoyed some measure of success in asserting other defenses to surety s overpayment claims, which are worthy of consideration. The remainder of this paper focuses upon on one such defense, which is referred to herein as a safe harbor and occasionally elsewhere as the good faith reliance defense, and related recent developments in the law. 8

10 A. Owner s Potential Safe Harbor from Overpayment Courts in several jurisdictions have recognized a defense for obligees facing overpayment claims whereby an obligee that, in making payments to the principal, has relied in good faith on erroneous payment certifications of its architect or other designated agent may be essentially shielded from overpayment liability to the surety. See e.g. RLI Ins. Co. v. Indian River Sch. Dist., 556 F.Supp.2d 356 (D. Del. 2008). Notwithstanding that this defense contravenes well-established principles of contract law that prevent one party from escaping liability by contracting away its obligations to a third party stranger to the original contract, a surprising number of jurisdictions have recognized some form of this safe harbor defense. See e.g. Aetna Cas. & Sur. Co. v. Aniero Concrete Co., 404 F.3d 566 (2d Cir. 2005); Ruckman & Hansen, Inc. v. Contracting & Material Co., 328 F.2d 744 (7th Cir. 1964) (applying Indiana law) (surety not discharged because overpayments based on agents progress estimates did not depart from the term of the contract nor prejudice the surety); Cont l Realty Corp. v. Andrew J. Crevolin Co., 380 F.Supp. 246 (D. W.V. 1974) (owner not liable where payments made pursuant to contract upon certification of design professionals); Balboa Ins. Co. v. Fulton County, 251 S.E.2d 123 (Ga. App. 1978) (owner protected from suit where owner made overpayments based on judgment and certification of architect); Lippert Bros., Inc. v. Nat l Union Fire Ins. Co., 247 F.Supp. 874 (D.C. Okl. 1965); Phillips v. Am. Liab. & Sur. Co., 309 Pa. 1, 11 (1932) ( we do not think that [owner] ought to lose his security because of an error of judgment by the [design professional]. ); but see Transamerica Ins. Co. v. City of Kennewick, 785 F.2d 660 (9th Cir. 1986) (rejecting the safe harbor defense and finding the owner did not act in good faith where its employee responsible for certifying payments acted negligently). B. Considerations for the Surety in Overcoming a Safe Harbor Defense As a preliminary matter, it is axiomatic that in order to garner protection under the safe harbor, the obligee must have relied on the certifications of the architect or other design professional in good faith. Thus, where the surety can demonstrate fraud, bad faith, or collusion between the obligee and the certifying design entity, then the obligee s safe harbor defense necessarily fails. See British Am. Tobacco Co. v. U.S. Fid. & Guar. Co., 177 A.D. 582, 585 (N.Y. App. Div. 1917). Thus, the surety facing a safe harbor defense should investigate any circumstances suggesting such type of improper conduct. When evaluating the strength of an obligee s safe harbor defense, a surety should also determine whether the bond or underlying contract expressly requires the obligee to make payments upon certification by the design entity; whether the obligee is absolved from the certifying entity s negligence; or if the obligee waived any claims premised upon overpayments. Where the contract language absolutely requires the owner to issue payments upon certification, the court is more likely to look favorably on an obligee s safe harbor defense. See Cont l Cas. Co. v. Public Bldg. Auth., 381 F.2d 10 (5th Cir. 1967). The court may also view a safe harbor defense more favorably where the bond or underlying contract contains a provision expressly absolving the 9

11 owner for any liability due to its reliance on the design entity or from making prepayments. See e.g. Aetna Cas. & Sur. Co. v. Aniero Concrete Co., 404 F.3d 566 (2d Cir. 2005) (holding that surety could not challenge whether owner s reliance was in good faith where the bond expressly provided that prepayments would not discharge bond liability); Nat l Am. Bank of New Orleans v. Southcoast Contractors, Inc., 276 So.2d 777, 783 App. 1973) (owner not liable where contract specifically absolves owner from any responsibility for mistakes, errors, and omissions of the architect in preparing certificates). The surety should be mindful of certain other potentially significant factors that courts may consider when evaluating an obligee s safe harbor defense to an overpayment claim. For example, some courts have focused upon the comparative knowledge of the parties in determining whether to excuse an obligee from overpayment liability. See Argonaut Ins. Co. v. Town of Cloverdale, 699 F.2d 417, 420 (7th Cir. 1983). Other courts have limited the application of safe harbor protection to instances in which the payment certifications relied upon by the obligee were reasonably accurate, concluding that otherwise the obligee s good faith reliance is called into question. Lippert Bros., Inc. v. Nat l Union Fire Ins. Co., 247 F.Supp. 874, 876 (D.C. Okl. 1965). Because courts in the different jurisdictions that recognize some form of the safe harbor defense have taken varied approaches and emphasized different factors, the surety must analyze the applicable law in the jurisdiction where its overpayment claim will be litigated to fully evaluate the obligee s likelihood of success. C. The Surety s Alternative: Claiming Against the Architect/Engineer When faced with a safe harbor defense by the obligee, the surety may be able to pursue a claim directly against the design entity upon whose erroneous certifications the obligee relied in making overpayments. While in some instances the surety may be able to recover its resulting losses in an action based on a contract theory, sureties have had greater success with claims based in tort. 1. Contract-Based Claims Against the Culpable Design Entity The most significant obstacle to a contract claim against a design entity is lack of privity. Very rarely will a contractor or surety find itself in direct contractual privity with the owner s design entity. Nevertheless, in a handful of jurisdictions, courts have indicated that contractors and sureties may successfully assert contract-based claims against design professionals under breach of implied warranty and third party beneficiary theories, despite the absence of privity. See, e.g., Tommy L. Griffin Plumbing & Heating Co. v. Jordan, Jones & Goulding, Inc., 320 S.C. 49, 56 (1995) ( [O]ne who [undertakes] to design and oversee a construction project for another impliedly warrant[s] the design and quality of construction despite the lack of privity between the parties ); E. Steel Constr., Inc. v. Salem, 549 S.E.2d 266, (W. Va. 2001) (recognizing contractor s right to assert breach of warranty claims against third party design professionals). 10

12 For example, in a recent Arizona case, North Peak Construction, LLC v. Architecture Plus, Ltd., an appellate court held that a contractor had stated a valid claim for breach of implied warranty against an architect with whom it was not in contractual privity and reversed the trial court, which had granted the architect s motion to dismiss. 254 P.3d 404 (Ariz. Ct. App. 2011). During the course of construction of a residence designed by an architect, the contractor discovered that the architect had erroneously designed the home to face a water tank and a mountain, rather than the homeowner s desired view of the city. The contractor was required to tear down the work performed to date and, as a result, it incurred additional costs and expenses in completing the project. In an effort to recover its resulting losses, the contractor claimed that it had relied upon the architect s design in constructing the residence and that the architect breached its implied warranty by designing the house to face the wrong direction. Id. at 406. The architect s motion to dismiss the breach of implied warranty claim argued both that the contractor could not maintain a negligence-based claim against it and that, because no privity existed between the parties, the contractor was similarly precluded from setting forth a contract claim for breach of implied warranty. Id. In reversing the trial court s decision in favor of the architect, the appellate court held that under Arizona law, the contractor could maintain both a claim for negligence and a claim of contractual breach of implied warranty claim, notwithstanding the lack of privity, against a design professional where the architect failed to exercise due care in designing the residence. Id. at 408. Thus, under North Peak Construction, it is certainly arguable in Arizona, and potentially other jurisdictions, that a design professional s failure to exercise due care in certifying payment applications would similarly give rise to both contract and tort liability. see also Rocky Mountain Fire & Cas. Co. v. Biddulph Oldsmobile, 131 Ariz. 289 (1982). 2. Tort-Based Claims Against the Design Entity While a handful of jurisdictions allow for contract-based claims against design professionals even in the absence of direct contractual privity, contractors and sureties have generally enjoyed greater success in pursuing claims against the owner s design professional under tort law theories, principally by arguing that the network of interrelated construction agreements among the owner, contractor and design professional give rise to a special relationship between the contractor and the design professional that obviates the requirement of direct contractual privity. Under such concepts, a surety may be able to maintain an overpayment claim directly against the design entity given that the surety bond is a significant part of the interrelated network of contracts. As its first line of defense, however, the design professional is likely to assert the economic loss rule to any such tort claim. Notwithstanding, contractors and sureties have overcome the economic loss doctrine by asserting claims for negligent misrepresentation and/or for professional negligence arising from the special relationship existing between the contractor/surety and the design entity. a. The Economic Loss Rule 11

13 The economic loss rule derives from the notion that parties to a contract have the freedom to allocate risk under the contract as they see fit. Thus, the economic loss rule generally bars recovery under a tort theory of purely economic, or monetary losses that result from the breach of a duty arising solely from a contract. Courts in many jurisdictions have applied the economic loss rule to bar claims by parties not in direct privity of contract with the design entity. See, e.g., BRW, Inc. v. Dufficy & Sons, Inc., 99 P.3d 66 (Colo. 2004) (holding that contractor s tort claim against the owner s engineer was barred by the economic loss rule on theory that engineer s duties arose from the set of interrelated contracts). In contrast, courts in other jurisdictions have allowed tort claims to proceed against design professionals notwithstanding the economic loss rule, focusing on the special relationship between contractor and architect, and in particular, the contractor s necessary reliance upon the architect, rather than upon the owner s actual contract with its design professional. See, e.g., Bilt-Rite Contractors, Inc. v. Architectural Studio, 581 Pa. 454 (2005) (holding that absence of contractual privity was no bar to tort claim in that the architect has a special duty to contractor and contractor relies upon architect s plans in formulating bids). b. Overcoming the Economic Loss Rule As always, the key to overcoming the economic loss rule is to identify a duty that arises independent of any underlying contract. In this regard, courts have recognized claims against design professionals despite the prevailing economic loss rule based upon theories of negligent misrepresentation and of professional negligence as part of a special relationship between the parties. For example, in a number of jurisdictions, courts have upheld contractor claims for negligent misrepresentation, notwithstanding the economic loss rule, where the design professional supplied defective plans and specifications. See, e.g., Donnelly Constr. Co. v. Oberg/Hunt/Gilleland, 677 P.2d 1292 (Ariz. 1984); First Florida Bank v. Max Mitchell & Co., 558 So.2d 9 (Fla. 1990); Jim s Excavating Serv., Inc. v. HKM Assocs., 878 P.2d 248 (Mont. 1994); John Martin Co. v. Morse/Diesel, Inc., 819 S.W.2d 428 (Tenn. 1991). It should be noted, however, that some courts have determined that a contractor cannot maintain a claim for negligent misrepresentation unless the design professional is in the business of supplying information for the guidance of others. See, e.g., Fireman s Fund Ins. Co. v. SEC Donohue, Inc., 679 N.E.2d 1197 (Ill. 1997) (recognizing negligent misrepresentation as an exception to the economic loss rule, but refusing to apply it to a design professional because the ultimate purpose of the design services is the construction of a tangible project, distinct from the information supplied in the process). i. Negligent Misrepresentation The latter limitation is likely to arise in jurisdictions that have adopted Section 552 of the RESTATEMENT (SECOND) OF TORTS, which expressly recognizes a claim for negligent misrepresentation against those in the business of supplying information for 12

14 the guidance of others. To establish a claim for negligent misrepresentation, a contractor must show: (1) that the design professional is in the business of supplying information for the guidance of others; (2) that due to either a lapse in competence or a lack of care, the information supplied by the design professional was false or constituted a misrepresentation; and (3) the information from the design professional was supplied specifically for the benefit of the contractor, or for a limited group that includes the contractor. RESTATEMENT (SECOND) OF TORTS 552 (1977). Courts have struggled to define the meaning of businesses that supply information under Section 552, and have acknowledged that the determination of whether a party is indeed in the business of supplying information is a precise, casespecific inquiry. Rankow v. First Chicago Corp., 870 F.2d 356, 361(7th Cir. 1989). See Tolan & Son, Inc. v. KLLM Architects, Inc., 719 N.E.2d 288 (Ill. App. 1999); Miller v. De Witt, 208 N.E.2d 249 (Ill. App. Ct. 1965), aff d in part and rev d in part on other grounds, 226 N.E.2d 630 (indicating that the architect charged with the authority to supervise and stop work should labor under a duty to the contractor to supervise the project with due care). A recent Illinois decision highlights the factors considered in this analysis, but unfortunately, provided no help to the surety seeking to recover losses sustained as a result of a design professional s negligent certification of payment applications. Specifically, in Hartford Fire Ins. Co. v. Henry Bros. Constr. Mgmt. Serv., LLC, No. 10-cv-4746, 2012 U.S. Dist. LEXIS (N.D. Ill. July 3, 2012), the court interpreted the concept of businesses that supply information by imposing a continuum, where on one end, there are entities that are solely in the business of supplying information, and on the other end, there are entities solely in the business of supplying products or tangible things. Id. at *11. In Henry Bros., the surety completed the project pursuant to its bond obligations after the principal s default and filed a complaint as an equitable subrogee against the owner s construction manager. The surety asserted a claim for negligent misrepresentation based on the construction manager s failures in supervising the project and improperly certifying applications for payment for incomplete or defective work. Id. at *4. The surety argued that while performing its services, the construction manager provided incomplete, misleading and false information, which resulted in improper payments made by the owner to the principal. Id. at *5. Under Illinois law, as in other jurisdictions, in order to maintain a claim for negligent misrepresentation, the surety must establish that: (i) the construction manager was in the business of supplying information; and (ii) that the information supplied was for the guidance of others. Id. at *9. The test utilized by the court hinged upon whether the end product is a tangible or intangible product. Id. at * The court held that because the end product was a building a tangible product and not the information supplied by the construction manager, the construction manager was not in the business of supplying information. Id. at *17. As such, the court determined the surety failed to state a claim for negligent misrepresentation. Id. at *18. 13

15 Thus, while some jurisdictions recognize negligent misrepresentation as a cause of action against design professionals, as exemplified in the recent Illinois decision, the success of any such claim may hinge on the degree to which the claimant can establish that the culpable design professional was in the business of supplying information. ii. Negligence based on Special Relationship Some courts have allowed claims to proceed against design professionals on negligence theories based upon the special relationship existing between the various parties to interrelated contracts in a construction project, absent direct privity between the design professional and the claimant. See, e.g., Auto-Owners Ins. Co. v. Mid- America Piping, Inc., No. 4:06CV1029SNL, 2007 U.S. Dist. LEXIS (E.D. Mo. Sept. 27, 2007); Ellis-Don Constr., Inc. v. HKS, Inc., 353 F.Supp.2d 603, 605 (M.D.N.C. 2004) (finding an independent duty of care based upon the power of economic life or death an architect holds over a contractor ); United States ex rel. Los Angeles Testing Lab. v. Rogers & Rogers, 161 F. Supp. 132, 136 (S.D. Cal. 1958) (holding that the architect s power of economic life or death over the contractor necessitates a duty imposed on the architect to supervise and inspect the project without negligence); Ossining Union Free Sch. Dist. v. Anderson, 539 N.E.2d 91 (N.Y. 1989) (negligent misrepresentation may be found where the architect provided faulty structural inspections knowing that they would be relied upon by the injured party). In a recent decision from the United States District Court for the Southern District of Florida, the court determined that although the economic loss rule did not bar a contractor s claim for negligent misrepresentation, the contractor nonetheless failed to state a claim. Recreational Design & Constr., Inc. v. Wiss, Janney, Elstner Assoc., Inc., No. 10-cv GOLD/McAliley, 2011 U.S. Dist. LEXIS (S.D. Fl. Jan. 21, 2011). In Recreational Design, the court granted the engineer s motion to dismiss the general contractor s complaint, which alleged professional malpractice and negligent misrepresentation based upon an engineer s report that recommended the removal and replacement of a waterslide built by the general contractor. The court found that the general contractor had failed to satisfy the standard of proof for negligent representation as set forth in Section 552 of the RESTATEMENT (SECOND) OF TORTS and that specifically, the contractor: (i) failed to show the existence of a special relationship between it and the engineer, particularly considering that the engineer was hired by the owner of the project, for its own benefit, and not for that of the general contractor; and (ii) failed to demonstrate how the engineer s report misrepresented the general contractor s work on the project. Id. at * While the Recreational Design does not further the surety s cause, a number of decisions from other jurisdictions have recognized a surety s right of action against design professionals in one form or another. See, e.g., Mid-State Sur. Corp. v. Thrasher Eng g, Inc., 2006 WL (S.D. W. Va. May 16, 2006) (denying obligee s summary judgment motion on surety s negligence claim because, based on special relationship, engineer owed foreseeable duty of care to both contractor and surety); Travelers Cas. & Sur. Co. v. Dormitory Auth. of New York, 2005 WL (S.D.N.Y. 14

16 May ) (holding that surety s claim survived economic loss rule, notwithstanding lack of actual privity, in light of surety s having pled the functional equivalent of privity. ); Designed Ventures, Inc. v. Housing Auth. City of Newport, 132 B.R. 677, 679 (Bankr. D. R.I. 1991) (disallowing surety s claim would essentially condone A/E s right to do its job negligently and with impunity as far as innocent third parties who suffer economic loss are concerned ); Am. Fid. Ins. Co. v. Pavia-Byrne Eng g, 393 So.2d 830, 835 (La. App. 1981) (surety permitted to sue engineer); Aetna Ins. Co. v. Hellmoth, Obata & Kassabaum, Inc., 392 F.2d 472, 475 (8th Cir. 1968) (Mo.) (noting surety s right to assert claim against A/E and entitlement to rely upon A/E s inspection and supervision obligations); Peerless Ins. Co. v. Cerney & Assoc., Inc., 199 F. Supp. 951, 955 (D. Minn. 1961) (surety permitted to sue architect); State ex. rel. Nat l Sur. Corp. v. Malvaney, 72 So.2d 424 (Miss. 1954) (surety permitted to sue engineer). Thus, the advancement of a tort claim based upon the special relationship between the contractor and architect resulting from the interrelated contracts may provide a basis for a direct cause of action for an overpayment claim. Accordingly, in considering an affirmative overpayment claim, and particularly where the obligee finds refugee within the good faith reliance safe harbor, the surety should be mindful of how the relevant jurisdiction will consider a potential claim against the obligee s design professional. V. Conclusion In summary, as case law evolves in federal and state forums, the surety faces new challenges to some of its favored claims and defenses, including the affirmative claim of overpayment/impairment of suretyship. Some recent case law has unfortunately bolstered some of the arguments and defenses that may be presented by an obligee in response to such claims. Notwithstanding, a thorough analysis of the governing law and facts and careful planning will maximize the surety s likelihood of success in prosecuting an overpayment claim. 15