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Thelen LLP
The City of Pine Bluff, Arkansas, contracted with a general contractor to clean up after severe ice storms in December 2000. A surety issued a performance and payment bond for the project. The city and the contractor got into commercial disputes. On March 6, 2001, the city terminated the contract. The surety did not learn of this until June 5, 2001, when it received a disputed status inquiry form from the city. The form stated that the final contract price was disputed and that the city had $2.8 million in claims from unpaid subcontractors. On June 15, 2001, the surety sent a letter requesting that the city not disperse any contract funds to the general contractor without the surety's consent because the surety was investigating the unpaid subcontractor claims and because the surety was asserting potential subrogation claims. Even so, a few days later, the city approved a settlement and release with the general contractor and paid nearly $2 million to the contractor and certain of its creditors.
In its investigation of subcontractor claims, the surety determined that two subcontractors had valid claims. The surety settled with one subcontractor for an unconditional payment in full. The surety settled with the other subcontractor in a different manner. The surety made an unconditional payment, and it escrowed the remaining amount of the claim. If the surety recovered more than the unconditional payment amount, the subcontractor would receive that difference up to the full amount escrowed. The subcontractor and surety would equally split any recovery above the escrowed amount. The subcontractor would get nothing if the recovery did not exceed the unconditional payment already made. In that case, the escrowed funds would be returned to the surety. Both subcontractors assigned their rights to the surety.
The surety brought an action against the city. The U.S. District Court held that the surety did not have actionable rights against the city. The 8th U.S. Circuit Court of Appeals reviewed the case and overturned the District Court ruling. Pennsylvania National Mutual Casualty Insurance Co. v. City of Pine Bluff, 354 F.3d 945 (8th Cir. 2004).
The Court of Appeals found that the surety had a right of equitable subrogation. Equitable subrogation is the doctrine that permits a surety to acquire and assert the rights of the parties that are paid by the surety. A prerequisite is that the surety must fully satisfy the underlying debt or obligation. The city contended and the District Court held that the surety had not fully satisfied the second subcontractor's claim with a settlement involving both guaranteed and contingent payments. The 8th Circuit held otherwise. It found that the settlement eliminated any claims by the subcontractor against the city and that the subcontractor had a contract right to accept the deal as full payment.
The 8th Circuit then addressed the issue of "what happens when a government entity with notice from a surety that there may be outstanding claims on the bond, ignores the notice and disburses the funds to the [general] contractor and his creditor."
Finding there was no controlling Arkansas law on this issue, the 8th Circuit followed federal decisions and held that if the owner, after notice, pays funds to a general contractor that are owed or become owed to the surety, then the owner becomes liable to the surety for the loss. Here, in the face of competing claims from the general contractor, the subcontractors and the surety, the city paid the general contractor – impairing the surety's rights and increasing its risks even though the surety was obligated by its payment bond to satisfy the subcontractor claims and was entitled to reimbursement from unpaid contract sums.
The 8th Circuit reasoned: " ' [t]he surety bond embodies the principle that any material change in the bonded contract, that increases the surety's risk or obligation without the surety's consent, affects the surety relationship.' By settling with the general contractor and releasing payments and retainage before they are due or not due at all, the obligee increases the surety's risk and impairs the surety's ability to be made whole through subrogation if the surety is later called upon to discharge the underlying obligation. '[W]here collateral which has been pledged to secure the repayment of bonds is removed, then the obligation of the contract between the bondholder and the bond issuer has been impaired.' These principles, considered with the equitable rights of laborers and material suppliers (and therefore the subrogated surety) to payment from remaining funds, have led federal courts to recognize the obligee's duty as a 'stakeholder' to ensure proper application of collateral (contract funds and retainages) upon appropriate notice of the general contractor's default."
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©2006 Thelen LLP
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