Surety Case Law Note: Obligee Payment Bond Claim
November 7, 2023
In this Surety Today Blog post we consider a Case Law Note addressing the issue of an Obligee’s claim against a payment bond under the AIA A-312 bond form. The case is:
McMillan McGee Corp. v. Third Site Tr. Fund, No. 121CV01988TWPMJD,
2023 WL 6276067, at *1–7 (S.D. Ind. Sept. 26, 2023)
You see these types of cases pop up occasionally and usually the court gets it right and rejects an obligee’s claim against a payment bond. See Blog post – Surety Case Law Note: Non-Compliance with the A312 and Obligee Attempted Claim Against the Payment Bond, April 18, 2023. However, this case is one of those rare times when the court gets it wrong – spectacularly wrong. The case arose out of a contract for remediation services of a contaminated property in Indiana between the Third Site Trust and McMillan McGee Corp (“McMillan”). The Trust was created pursuant to orders of the EPA to investigate and fund the cleanup at a property known as the Third Site. McMillan obtained a performance bond and payment bond from the Guarantee Company for the project. Disputes arose between McMillan and the Trust, and McMillan initiated the lawsuit. McMillan contended that changed conditions and other breaches by the Trust caused in excess of $3 million in damages. The Trust then filed counterclaims against McMillan and the Guarantee Company.
The Counterclaim asserted by the Trust against the Guarantee Company alleged breach of performance bond (Count I); breach of payment bond (Count II); and declaratory judgment (Count III). The surety filed a partial motion to dismiss, seeking dismissal of only Count II of the Counterclaim – the Payment Bond claim, because: (a) the Trust, as the obligee, lacked authority to sue for recovery under the Payment Bond; (b) the Trust did not allege a “Claimant” filed a “Claim,” which is a prerequisite for obtaining relief under the Payment Bond; and (c) the Trust failed to sufficiently allege that any of McMillan’s subcontractors have not been paid or are seeking payment.
The Guarantee Company cited decisions from several federal courts holding that obligees generally may not recover from the surety under a payment bond. See Travelers Cas. & Sur. Co. v. Dormitory Auth.-State of N.Y., 735 F. Supp. 2d 42, 87 (S.D.N.Y. 2010); Fed. Ins. Co. v. Maine Yankee Atomic Power Co., 183 F. Supp. 2d 76, 87 (D. Me. 2001); BT Granite Run, LP v. Bondex Ins. Co., No. CV 17-1584, 2017 WL 4642090, at *2 (E.D. Pa. Oct. 17, 2017); Ayers Enters, Ltd. v. Exterior Designing, Inc., 829 F. Supp. 1330, 1332–33 (N.D. Ga. 1993). However, the court stated that “[a]lthough one purpose of a payment bond is to ensure that subcontractors are paid in the event of a contractor’s default, that is not its only purpose. As several courts have recognized, payment bonds also serve to protect the obligee from claims by unpaid subcontractors.” Citing cases. The court noted that in this case, the Payment Bond serves to protect the Trust from claims for amounts owed to McMillan’s subcontractors, even though McMillan, and not its subcontractors, was the one allegedly asserting those claims? So, just to be clear here, because McMillan’s damage claim against the Trust included amounts for damages incurred by McMillan and its subcontractors as a direct result of the Trust’s own breaches, the court construed such damages as claims against the Trust that could be covered under the payment bond! So, under the court’s analysis any damages caused to the principal by an obligee’s breach is also a potential claim against the bond?
The Guarantee Company also argued for dismissal because the Trust had not identified a “Claim” filed by a “Claimant,” as those terms are defined by the Payment Bond. The Guarantee Company asserted that its contractual obligations to the Trust are not triggered until and unless a “Claim” is filed by a “Claimant.” The court disagreed stating that under the Payment Bond, the Guarantee Company owed the Trust two obligations: a payment assurance obligation and an indemnity obligation. The payment assurance obligation is found in Section 1, which provides that the Guarantee Company and McMillan “jointly and severally, bind themselves … to the Owner to pay for labor, materials and equipment furnished for use in the performance of the Construction Contract.” The indemnity obligation according to the court is found in Section 4, which states that upon satisfaction of the conditions in Section 3, “the Surety shall promptly and at the Surety’s expense defend, indemnify and hold harmless the Owner against a duly tendered claim, demand, lien or suit.”
The court stated that Count II alleged that the Guarantee Company “breached the Payment Bond by failing to honor its obligations to the Trust” to ensure McMillan’s subcontractors are paid and to indemnify the Trust against claims for nonpayment by those subcontractors. The court observed that the counterclaim stated that “[t]he Trust is not seeking recovery of the subcontractor payments for itself. Rather, it demands only that these payments be issued to McMillan’s unpaid vendors and subcontractors.” Because of the nature of the Trust’s allegations the court held that the prerequisites in Sections 5 and 7 – “Claim” and “Claimant” were not applicable.
Further, the court noted that the defined terms of “Claimant” and “Claim” do not appear in Sections 1, 3 or 4 of the Payment Bond. Rather, the court stated that the Guarantee Company’s indemnity obligations to the Trust are triggered by “claims, demands, liens or suits” against the Trust by “any person or entity seeking payment,” not just a “Claim” by a “Claimant.” The court held that “[t]o assert its breach claim, then, the Trust must only have alleged that it provided prompt notice of ‘claims, demands, liens or suits against the Owner … by any person or entity seeking payment for labor, materials or equipment furnished for use in the performance of the Construction Contract.’” The court believed that McMillan’s “special damages” statement was a claim, demand, lien or suit by any person or entity seeking payment, and that the Trust provided prompt notice of this claim to the surety. The court held that “[a] claim for payment under Section 3 need not be from an unpaid subcontractor or vendor; the claim need only be from ‘any person or entity’ seeking payment for costs incurred in performance of the Contract.”
The absurdity of the court’s position and the illogical conclusions asserted by the court are usually prevented by the application of the language in the A312 payment bond which states that the surety has no obligation under the bond unless the obligee is not in default. Here, the Trust was alleged to be in default in that it caused damages to McMillan by its own breach. Thus, the court should never have engaged in this intellectually dishonest exercise of claiming that the surety is liable for the very damages the obligee itself caused. The bond has no place in such circumstances. Unfortunately, there will likely not be an appeal any time soon because the decision is interlocutory.
I wish I had some sage advice for how a surety could address this type of situation, but there is a famous line from the movie Forest Gump that applies here – “stupid is as stupid does.” If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321 or mstover@wcslaw.com) or any member of the Surety and Fidelity Practice Group.