Surety Case Law Note – The Common Obligee Theory
October 25, 2022
In this Surety Today Blog post we will provide a Case Law Note to consider the Common Obligee Theory. Under the Common Obligee Theory a surety who has suffered a loss on one project can use its right of equitable subrogation to step into the shoes of the obligee on the project with the loss and exercise the obligee’s set-off rights against any funds owed to the principal on a separate project involving the same obligee and principal. In this case, the court upheld the narrow approach adopted by the Fourth Circuit to deny the surety’s requested relief.
LIBERTY MUTUAL INS. CO. V. SBN V FNBC, LLC, 5:17-CV-82-BO, 2019 WL 346707 (E.D. NC 1/28/19).
Liberty bonded 48 projects for DeVere Construction Company in various jurisdictions around the country. A lender provided loans to DeVere for its operations and the lender obtained a security interest on all accounts receivable and general intangibles. DeVere abandoned the bonded projects forcing Liberty to complete performance and pay subs and suppliers. Ultimately, Liberty obtained a judgment against DeVere and its indemnitors for $23,274,628. DeVere’s lender was also owed $14,089,911 under its loans.
On five of the bonded projects, the contract receivables exceeded Liberty’s losses on those projects in the total amount of $865,537. It is these excess receivables that were in dispute in the case because both Liberty and the lender claimed a priority interest in the excess receivables. Accordingly, Liberty initiated a declaratory judgment action against the lender seeking a declaration that Liberty had a priority interest in the contract receivables. Liberty sought summary judgment arguing that it was entitled to the receivables under its equitable subrogation rights to assert the owner’s right to set-off. The lender contended that its perfected security interest had priority over Liberty.
Liberty only sought to recover on the projects where there were common obligees. Thus, Liberty only sought to recover on projects where Liberty had incurred a loss and the owner of that project was also the owner of a project on which there were excess contract funds. Liberty’s approach is known as the “Common Obligee Theory” of recovery. The North Carolina District Court denied Liberty’s motion and held that Liberty may not use its equitable right of subrogation to overcome the lender’s perfected security interest, as each bonded project must be treated separately. The Court observed that the Fourth Circuit had never recognized the right of a surety to use set-off rights obtained through subrogation to defeat a secured creditor. The Court also pointed to Fourth Circuit cases purportedly holding that subrogation is limited to the specific bond from which it arose. “The doctrine of subrogation arises out of the unpaid debts on each contract; relates back in time to the execution of that specific bond; and is limited in scope to the debts arising under one contract.” W. Cas. & Sur. Co. v. Brooks, 362 F.2d 486, 491 (4th Cir. 1966); see also Lacy v. Md. Cas. Co., 32 F.2d 48, 53 (4th Cir. 1929) (“The [surety], therefore, was not entitled under the principles of subrogation to the profit derived from this contract except in so far as might be necessary to reimburse it for expenditures made thereunder.”).
The Court brushed aside the fact that the Fourth Circuit cases cited did not involve a project owner’s set off rights, and one of the cases was decided under Ohio law. The Court believed that the lender’s secured right was stronger that Liberty’s subrogated rights of set-off, in the absence of clear Fourth Circuit authority. This of course is incorrect, because the secured party only takes to the extent of its debtor’s rights. The debtor (principal) would be subject to the set-off rights of the obligee holding the funds. The surety merely stands in the shoes of the obligee through equitable subrogation and exercises those set-off rights.
The “Common Obligee” theory that was rejected by this case and the Fourth Circuit has been adopted by many other courts. Set-off is a common law right, but it can also be memorialized in contracts. Set-off rights exist between two parties when each party is a debtor to and a creditor of the other party. The definition of set-off rights is that as between Party A and Party B, Party B has the right to set-off against Party A’s claim one or more independent transactions that constitute separate causes of action apart from Party A’s claim. This can occur only when the two parties’ rights are mutual – that is between the same parties in their own rights and capacities – and the amounts owed to each are due and payable. A set-off is not part of a debt, but an equitable remedy to secure the payment of a debt. The objective of letting a party exercise its set-off rights is to prevent a circuity of actions by allowing parties that owe each other money to apply their mutual debts against each other, thereby avoiding the absurdity of making Party B pay Party A’s claim when Party A owes Party B on another transaction.
Courts that have recognized and allowed the Common Obligee Theory include: Travelers Casualty and Surety Company of America v. Paderta, 2013 WL 3388739 (N.D. Ill. July 8, 2013); Transamerica Ins. Co. v. US., 989 F.2d 1188 (Fed. Cir. 1993); In re Larbar Corp., 177 F.3d 439 (6th Cir. 1999); District of Columbia v. Aetna Ins. Co., 462 A.2d 428 (D.C. 1983); USF&G v. Housing Authority of the Town of Berwick, 557 F.2d 482 (5th Cir. 1977). The Restatement Third, Suretyship And Guaranty §28(1)(C) states that the surety’s subrogation rights reach any interest in property of the principal obligor against which the obligee’s rights can be enforced. Many of these issues are covered in depth in the ABA/FSLC book, The Contract Bond Surety’s Subrogation Rights. Chapter 14 of that book is entitled Common Obligee Theory and Other Setoff Rights – The Surety’s Subrogation Rights to the Obligee’s or Principal’s Setoff Rights.
The takeaway here is that the surety, through the Common Obligee Theory, may have rights against other funds to help set-off losses on the bonded job if the common obligee has set-off rights that can be enforced. There are a number of potential hurdles to utilizing this doctrine so it is not a certainty, but it is definitely worth pursuing.
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.