Annual survey of fidelity and surety law, 2002.

• Author: Brownstein, Bettina E.
• Position: Part 1

1. PUBLIC CONSTRUCTION BONDS

   1. Bonds under Federal Laws

      Performance bond surety on defaulted federal government contract not entitled to contract funds withheld for violations of David-Bacon Act.

      Surety that did not give notice of potential bond default did not have claim since government's disbursement of funds not in derogation of contract.

      Only performance bond surety that enters into takeover agreement with government can sue in Court of Federal Claims under Contract Disputes Act.

      In Weschester Fire Insurance Co. v. United States, (1) Weschester was surety for a contractor who defaulted on a contract to rehabilitate the U.S. Coast Guard waterfront facility at Baton's Neck, New York. The contract incorporated the Davis-Bacon Act, 40 U.S.C. [section] 276a, which requires laborers to be paid no less than rates specified by the U.S. Department of Labor. The act also mandates that these rates be a part of the contract. After the default, the surety claimed entitlement to the entire unpaid contract balance, including $60,216.58 that the government, finding the contractor had violated the act, had earmarked as restitution for wages and fringe benefits to underpaid workers.

      The contracting officer disagreed, and Weschester sued to reverse of the contracting officer's decision. Ruling on a motion for summary judgment, the Court of Federal Claims affirmed the decision of the contracting officer, finding the central and controlling fact to be the incorporation of the act in the contract with its provision that the Coast Guard was to withhold payments to the contractor if any Davis-Bacon violations were committed. Not surprisingly, the court found the workers' rights to the contract funds to be superior to those of the Coast Guard, the contractor and the surety.

      Weschester also asserted entitlement to $32,000, the amount of the last progress payment to the contractor, on the ground that at the time it made the payment, the Coast Guard already had decided to terminate the contract. The Coast Guard responded that the surety had failed to give requisite notice of the default and had not requested that further progress payments be withheld. The court agreed, holding that the government, as obligee, owes only an equitable duty to a surety when the latter notifies the former that there has been a default under the bond. In this case, the court found that the government had kept Westchester informed by copying it on cure and show cause notices, thus giving the surety opportunity to give notice of the contractor's potential default on the bonds and to request that future progress payments be withheld. Even so, the court stated that the government had a duty to Westchester, in the absence of valid notice by the surety of a default, if the government's progress payment was not in accordance with the contract provisions. In this instance, the Coast Guard's payment was held to be proper.

      The parties asserted that the court had jurisdiction over the matter under the Contract Disputes Act, 41 U.S.C. [section] 609(a). The court disagreed. Only a performance bond surety that enters into a takeover agreement with the government and thereby establishes privity with it can maintain an action under the act. This had not occurred in this case.

      Surety could not avoid liability on payment bond based on unsatisfied "pay when and if paid" clause in settlement agreement.

      Weststar Engineering was prime contractor on a federal project to repaint a Navy crane in Bremerton, Washington. In compliance with the Miller Act, Weststar obtained a payment bond from Reliance Opinion Insurance Co. Weststar and a subcontractor, Walton Technology Inc., entered into a settlement agreement providing that Weststar would be obligated to pay Walton for rental equipment only "when and if paid" by the government. Walton then sued Reliance and the contractor for the amount owed.

      The Miller Act creates an obligation on the part of a surety to pay workers and materialmen for "sums justly due." Reliance contended that since the Navy had not paid Weststar, there were no "sums justly due" for which Reliance could be liable, since a surety's liability is coextensive with that of its principal.

      In Walton Technologies Inc. v. Weststar Engineering, (2) the Ninth Circuit agreed that generally the rules of suretyship apply to Miller Act cases, but it stated that in the context of the act, a court must look beyond the principal's contractual obligations to the act itself to define the surety's liability. Rights provided by the Miller Act will not be delimited by the contract between the contractor and subcontractor, it stated, and thus Walton's right to recovery on the bond accrued 90 days after it completed its work and not "when and if" the government paid Weststar. The court further found that the subcontractor had not clearly and explicitly waived its right to sue under the act.

      A sharply critical dissent declared that the majority's holding appeared to "stand the general rule of suretyship law on its head" in not allowing the surety to occupy the shoes of the principal and avail itself of the principal's defenses. It noted that the majority had determined that a Miller Act surety could be liable to a subcontractor even though the principal owed it nothing.

   2. State and Local Bonds

      1. Procedural

         12-year statute of limitations for action on performance bond began to run on date of final loan closing.

         The owner of a public housing facility constructed pursuant to an October 22, 1982, contract, sued Seaboard Surety Co. over faulty construction on October 16, 1996, The trial court granted Seaboard summary judgment on the ground that the claim was barred by Maryland's 12-year statute of limitations for actions on bonds.

         The court first disregarded, as against public policy, the bond's two-year limitations period in favor of the Maryland statute, but it looked to that bond provision to determine the parties' intent as to when the accrual time commenced and found it to be the date on which the final payment under the contract fell due. This date was October 10, 1984, it concluded, when the state's Community Development Administration requested final payment from the Maryland Housing Fund and stated its belief that the money from the fund was now "payable." Since the contractor had filed suit after October 10, 1996, its claim was time-barred.

         This decision was affirmed in Hagerstown Elderly Associates Limited Partnership v. Hagerstown Elderly Building Associates Limited Partnership by the Maryland Court of Appeals. (3) The court agreed that the 12-year period applied, but disagreed that this limitation barred the action against the surety. Instead, the appellate court held that, pursuant to the terms of the building contract, the accrual period commenced November 1, 1984, the date of the final loan closing. Embarking on a definitional exploration of the word "payable," it concluded the word meant a sum "that is to be paid" and not that final payment was due.

      2. Substantive

         Surety liable for defaulting subcontractor's unpaid employment taxes to federal and state governments as intended beneficiaries on bond.

         In a 2-1 decision with a strongly worded dissent, a panel of the Ninth Circuit, having considered conflicting precedent and relying on the plain language of a subcontract, found the United States and Hawaii to be intended third-party beneficiaries of a subcontractor's bond. As a result, the subcontractor's surety was obligated to pay Hawaii and the U.S. federal government the defaulting subcontractor's employment taxes. Island Insurance Co. v. Hawaiian Foliage & Landscape Inc. (4)

         Oahu Construction Co. had contracted with the City and County of Oahu to build a golf course. Oahu subcontracted landscaping work to Hawaiian Foliage & Landscape, which obtained a performance/ payment bond from Island Insurance Co. Hawaiian defaulted. Island refused to pay its principal's tax debts. The federal district court granted the surety's motion for summary judgment. 2000 U.S.Dist. Lexis 16749 (D. Haw.).

         The Ninth Circuit reversed, applying Hawaiian law and adopting the argument that the terms of the subcontract required Hawaiian to pay all taxes. The bond, in turn, covered its principal's complete performance of the subcontract, which included payment of taxes. Having determined the extent of the surety's duty, the court easily found that the federal and state governments were intended third-party beneficiaries of the bond.

         It did so by applying Section 302(1) of the Restatement (Second) of Contracts, which provides that an entity is an intended beneficiary if the "performance of the promise will satisfy an obligation to the promisee to pay money to the beneficiary." Island, the promisor, had promised to ensure Hawaiian's performance, including payment of taxes. This made the governments intended beneficiaries who could bring a direct action against Island.

         Island contended that it should not be liable because its intended beneficiary was Oahu, and Oahu could not be responsible for the taxes. The court gave this argument short shrift, instead emphasizing that the language of the subcontract controlled in that it reflected the parties' intention to make the bond responsible for the subcontractor's tax liabilities.

         Characterizing the majority's decision as "inequitable and unusual" and describing a contract "into which no reasonable man or woman would likely enter," the dissent found, adopting a "reasonable, probable, and natural interpretation" of the contract terms, that the language did not evince an intention that Island be responsible for the taxes. The dissent also contended that the purpose of the bond was to protect the contractor (who had no liability for the unpaid taxes) from Hawaiian's failure to perform and not to protect the federal or Hawaiian governments.

         Surety's tender of substitute contractor with new surety did not satisfy surety's obligation to school board.

         In...