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Impairment of Collateral and Overpayment Defenses Upheld

In Lumbermens Mutual Casualty v. United States, the Court of Federal Claims entered a substantial judgment in favor of a performance and payment bond surety for impairment of collateral and improper withholding of contract funds. Lumbermens issued Miller Act performance and payment bonds on behalf of its principal, Landmark Construction (Landmark), pursuant to a nearly $10 million contract between Landmark and the United States Department of the Navy to repair and renovate 160 military housing units. Several months after the parties executed the contract, the Navy and Landmark entered into a contract modification for $1.8 million for work on an additional 21 housing units without any extension of the contract completion deadline. The contract contained a liquidated damages provision of $75/day per unit. Lumbermens declined to bond the contract modification.

Slightly over a year into the project, Landmark abandoned the project. The Navy terminated Landmark for default and made demand upon Lumbermens’ bonds. Lumbermens, its completion contractor, Atherton Construction, and the Navy entered into a takeover agreement. Lumbermens entered into a separate completion contract with Atherton in which Lumbermens agreed to reimburse Atherton for any liquidated damages assessed by the Navy up to an agreed date. Atherton completed the work seven months after the original completion date. In addition to paying Landmark’s subcontractors and suppliers under its payment bond, Lumbermens paid over $3 million to Atherton in excess completion costs and reimbursed Atherton an additional $1 million in liquidated damages assessed by the Navy.

The evidence reflected that Landmark had completed roughly 15% of the work prior to its default termination but had been paid 40% of the contract funds. The Navy had no records of the payments it made to Landmark and had undertaken no verification that it had received the materials for which it had paid Landmark. After Atherton started work, it encountered a critical path delay related to pre-existing electrical issues of which the Navy had prior knowledge and had ignored. Eventually, the Navy issued a contract modification for the cost of repairs to Atherton but refused to give any time extension for the resulting delay in the modification and assessed liquidated damages.

After Lumbermens filed suit, the Navy argued that the court lacked subject matter jurisdiction because Lumbermens had not submitted a verified claim under the takeover agreement pursuant to the Contract Disputes Act, 41 U.S.C. § 601 (“CDA”). The court rejected this argument, finding that the CDA applies only to procurement contracts and that the takeover agreement was not a procurement contract, “but an agreement by which the surety agrees to fulfill its obligations under a performance bond.” The court further found that it had subject matter jurisdiction pursuant to the Tucker Act, 28 U.S.C. § 1491, which provides for a limited waiver of sovereign immunity granting jurisdiction for certain non-tort monetary claims against the United States based on an actual or implied contract with the federal government.

After determining that it had jurisdiction, the court found that the Navy failed to follow the contract terms and incorporated provisions of the Federal Acquisition Regulation when it failed to require Landmark to submit a conforming Schedule of Prices, a proper Network Analysis Schedule and certifications on each payment application even though the contract required Landmark to provide such items as a condition precedent to receiving payment. The Navy’s failure to enforce these contract requirements allowed Landmark to overcharge the Navy and continue to receive progress payments even though it had failed to pay its subcontractors and suppliers from previous payments. The court held that the Navy’s failure to enforce the contract provisions amounted to a pro tanto discharge of the surety’s liability because the Navy’s material modification of the contract terms without Lumbermens’ knowledge or consent increased Lumbermens’ risk by impairing Lumbermens’ collateral.

The court found that Lumbermens proved that it suffered damages in the amount of $1,375,420.11 as a result of the Navy’s overpayments, because the surety had to pay for materials for which the Navy had already paid but for which the Navy never obtained title or possession, with the result that the materials were unavailable to Atherton for use in completing the work.  The court also awarded Lumbermens $326,700 for the improper assessment of liquidated damages by the Navy because Lumbermens had reimbursed Atherton for these liquidated damages and was subrogated to Atherton’s rights under the takeover agreement.

The Lumbermens case is a significant, positive development in the area of surety discharge.  Prior to Lumbermens, sureties were forced to rely primarily on National Surety Corporation v. United States, a case dealing with retainage.  In National Surety, the contract explicitly required the government to withhold 10% retainage until the government had approved the contractor’s performance schedule.  Even though the contractor’s schedule was not approved (or even submitted), the government did not withhold the retainage.  The court held that, because the contract gave no discretion to the government to depart from the retainage requirement, the surety could recover from the government even though the surety had not notified the government to refrain from making payments to the contractor.

Other prior cases, however, rejected surety impairment/overpayment claims against the federal government despite compelling facts.  A prime example is United States Fire Insurance Company v. United States, in which the bonded contractor was allowed to stumble along for years after the original completion date without being default terminated by the government and was paid amounts vastly in excess of the work actually completed.  After the surety took over and completed the work through a completion contractor and was paid what little remained of the contract balance, it sued the government alleging that the Air Force made improper payments for work not performed or improperly performed.  After withstanding the government’s jurisdictional attacks, the surety lost on the merits, with the Claims Court finding that the government’s payments to the principal were not in violation of the terms of the contract which gave the contracting officer discretion in making payments to the contractor and that the payments made were reasonable under the facts and circumstances of the case.

With the addition of the Lumbermens decision, sureties have gained stronger footing in their argument that the government must abide by its own contract terms regarding payment or face substantial risk of the surety’s discharge due to impairment of collateral.

By:  Cynthia Rodgers-Waire

Published in:  American Bar Association, Fidelity & Surety Law Committee Newsletter, Winter 2010

Cynthia Rodgers-Waire is a partner with Wright, Constable and Skeen, LLP in Baltimore, MD.