Surety Case Law Note – Can the Surety Sue the Obligee for Breach of the Bond?
October 11, 2022
In this Surety Today Blog post we will provide a Case Law Note to discuss two dueling Texas federal court decisions on what should be a relatively simple issue – can an obligee be sued by the surety for breach of the bond? Of course, we have heard repeatedly in jurisdictions all around the country that a bond is a contract; and indeed, is a tripartite agreement between the surety, principal and obligee. But, can an obligee be sued for breach of the bond? These two cases come down on opposite sides of the issue.
HUNT CONSTRUCTION GROUP, INC. V. COBB MECHANICAL CONTRACTORS, INC.,2018 WL 5114151 (W.D. Texas 10/18/18)
In Hunt Construction, the Court said no cause of action existed. This case grew out of the construction of a hotel project on which the surety bonded a mechanical subcontractor. The principal defaulted and Hunt notified the surety of the default and termination and advised that Hunt intended to arrange for another subcontractor to perform the work. The surety investigated and advised Hunt that the bond had been released by Hunt’s actions in completing the principal’s work.
Hunt sued the surety and the surety filed a counterclaim against Hunt, alleging, among other things, that Hunt breached the bond. Hunt moved to dismiss the breach of bond claim arguing that Texas law did not recognize such a claim. The Court agreed with Hunt that Texas law did not recognize such a claim and that Hunt owed no duties to the surety under the bond, the bond was a one-way agreement. The Court explained that while certain actions of an obligee may provide the surety with a defense, that is the most that is available. The Court stated that Hunt was a beneficiary of the bond, but it took on no affirmative obligations and cannot be liable for breach.
Unfortunately, there was no discussion of the bond form or terms. There are many bond forms where the obligees do have numerous obligations to the surety – to hold a meeting, to satisfy conditions precedent, to pledge the contract balance to completion, to not have been in default under the contract. Additional obligations can also be included in the bond through the doctrine of incorporation by reference.
TRAVELERS CASUALTY & SURETY COMPANY OF AMERICA V. HARLINGEN CONSOLIDATED INDEPENDENT SCHOOL DISTRICT, 2018 WL 7204025 (S.D. Tex. 11/2/18)
In this second case, the surety bonded the general contractor and the School District was the obligee on a project to build a school. The project was deemed substantially complete, however, the School District identified $2,382,899 in unfinished work, the punch list was not completed and serious defective work had been discovered. Notwithstanding these circumstances, the School District, without the consent of the surety, released $1,238,493 in retainage, leaving only $100,000 in retainage. Thereafter, the surety paid $272,730 in payment bond claims. The surety contended that the School District breached the bond by releasing the retainage without its consent.
The Court found that the contract required the School District to obtain the consent of surety before releasing retainage. The Court further observed that a public entity-obligee may be found liable for a surety’s losses on a payment bond where the public entity fails to hold retainage as provided for under the bonded contract. The Court stated “[t]he duty devolves upon the project owner to administer the contract during the course of its performance in a way that does not materially increase the risk that was assumed by the surety when the contract was bonded.” This duty arises because in contracts for services that include payment in installments or upon completion, “unearned progress payments and retainage are security or collateral ensuring discharge of the obligations created by the underlying contract.” The Court found that the School District’s release of retainage was a material breach and that the surety had a cause of action for breach of the bond.
Numerous cases recognize these general principles of surety law. Nat’l Sur. Corp. v. United States, 118 F.3d 1542, 1546 (Fed. Cir. 1997), citing U.S. Fid. & Guar. Co. v. United States, 201 Ct.Cl. 1, 475 F.2d 1377, 1384 (1973); Argonaut Ins. Co. v. United States, 434 F.2d 1362, 1368, 193 Ct.Cl. 483 (1970)(the government has a duty to exercise its discretion with respect to the contract balance responsibly and to consider the surety’s interest in the administration of the contract); Balboa Ins. Co. v. U.S., 775 F.2d 1158, 1164 (Fed. Cir. 1985).
The doctrine of “impairment of suretyship” began as a defense that a surety could assert to avoid enforcement of its bond obligation on the grounds that the obligee had taken improper actions which prejudiced the surety by increasing its financial risk. One ground for discharge is when the obligee has prejudiced the surety by improperly overpaying the principal in a manner inconsistent with specific payment schedules, conditions, or retainage provisions in the bonded contract. Overpayments to the principal prematurely deplete the bonded contract fund to which the surety has a right of equitable subrogation in the event that the principal defaults and the surety is required to perform. Thus, by wasting the contract funds in contravention of the contract’s terms, the obligee impairs the surety’s future right of equitable subrogation and increases its risk of loss, thereby discharging it from its bond obligation pro tanto. See, e.g., United States v. Cont’l Cas. Co., 512 F.2d 475, 478 (5th Cir. 1975) (“[A] surety is entitled to be subrogated to the benefit of all securities and means of payment under the [obligee’s] control, and any act by the [obligee] depriving the surety of this right discharges it pro tanto…. [The obligee] … must act in good faith and not unreasonably prejudice the surety’s right to subrogation.”); Fort Worth Indep. Sch. Dist. v. Aetna Cas. & Sur. Co., 48 F.2d 1, 4 (5th Cir. 1931) (“It is well settled that a stipulation in a building contract that a percentage of the price shall be retained until the final completion and acceptance of the work, is as much for the benefit of the surety as for the protection of the [obligee], and a failure to comply therewith releases the former in so far as the rights of the latter are concerned.”).
Over time, the doctrine has evolved to encompass not only a defense, but also an affirmative cause of action that allows a surety to seek damages from an obligee after performing its bond obligation despite having an impairment of suretyship defense. See Restatement (Third) of Suretyship and Guaranty § 37(4) (“If the obligee impairs the [surety’s] suretyship status … the [surety] has a claim against the obligee with respect to such performance to the extent that such impairment would have discharged the [surety] with respect to that performance.”); id. cmt. a (noting that “this section and §§ 39– 44 provide rules discharging the [surety] from liability … and providing for recovery from the obligee if the loss has already occurred because the [bond] obligation has been performed”). When a surety performs even though it would have had a right to withhold some amount of performance had it asserted a pro tanto discharge defense, the surety has effectively overpaid on its bond obligation. In such cases, “the [surety] is harmed and, but for [a cause of action to recover the excess amount paid], the obligee would receive a windfall.” Id. at § 37(4) cmt. D; see also RLI Ins. Co. v. Indian River School Dist., 556 F.Supp.2d 356, 363 -364 (D. Del. 2008)(citing Nat’l Union Indem. Co. v. G.E. Bass & Co., 369 F.2d 75, 77 (5th Cir. 1966).
The takeaway is that in the right circumstances a surety may have a claim for breach of the bond against the obligee and this right should be explored.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321/mstover@wcslaw.com) or any member of the Surety and Fidelity Practice Group.