Surety’s Subrogation Claims Against Design Professionals
February 14, 2023
In this Surety Today Blog post we will visit the issue of the surety’s subrogation claims against design professionals. Design professionals, such as architects and engineers, have extensive involvement in nearly every aspect of a construction project. When the obligee is the owner and asserts a claim against the performance bond, the design professional may have been responsible for some, or even all, of the surety’s losses. That responsibility may arise from deficient plans or specifications; the failure to properly review the work; the wrongful certification of payments for the work; or other negligent acts. Under those circumstances, the surety may want to assert the design professional’s wrongful conduct as a defense to the obligee’s performance bond claim or as a basis for recovering the surety’s performance bond losses.
In some jurisdictions, a cause of action may be permitted directly by the surety against the design professional, even when there is no direct contractual relationship or right of subrogation. In these jurisdictions, the requirement of privity has been relaxed or abandoned. However, in the jurisdictions where privity is still required in order to maintain a claim for professional negligence against a design professional, how can the surety make a claim? One option is to obtain an assignment of the rights of the party in contract with the design professional. While I cannot cite to an example, there may be concerns about the assignment of malpractice claims in some jurisdictions. The second option, and the one we will focus on in this blog post, is through equitable subrogation. If the surety has satisfied its performance bond obligations to the obligee and the obligee was in privity of contract with the design professional, the surety, through its right of equitable subrogation, can stand in the shoes of the obligee and assert the rights of the obligee against the design professional for the design professional’s deficient performance as a way of achieving recovery. In those jurisdictions that strictly enforce privity requirements and thus rule that the design professional only owes a duty to the party with whom they have contracted, equitable subrogation allows the surety to circumvent privity by asserting the rights of the obligee in order to pursue a claim against the design professional. Courts in a variety of circumstances and in a variety of jurisdictions have upheld the surety’s subrogation rights against design professionals.
In Carolina Casualty Insurance Co. v. R.L. Brown & Associates, Inc., No Civ. A. 1:04-CV-3537, 2006 WL 3625891 (N.D. Ga. Dec. 11, 2006), the court held that the doctrine of equitable subrogation allowed the surety to assert the claims of the obligee, whose performance bond claim the surety had satisfied, against the design professional. Id. at *9-10. As stated in Pearlman v. Reliance Insurance Co., 371 U.S. 132 (1962), the surety may assert its subrogation rights to the rights of the obligee upon the principal’s default and the surety’s performance. The court observed that privity clearly exists between the owner and the design professional by virtue of their contractual relationship. The duties owed by the design professional are set forth in a written contract between the owner and the design professional. In addition, the architect and engineer owe professional duties to the owner/obligee under the common law. Thus, when the obligee is the owner and the surety is entitled to assert its subrogation rights to the rights of the obligee, the surety’s claim is based upon the contractual and common law duties owed by the design professional to the obligee, and privity is no longer an issue.
In Acuity, A Mutual Insurance Company v. McGhee Engineering, Inc., 297 S.W.3d 718 (Tenn. Ct. App. 2008), the court analyzed in depth the surety’s right to assert claims against design engineers based upon the surety’s right to equitable subrogation. That case involved the construction of tunnels and water intake pipes underneath the embankment of the Cumberland River in order to draw water from the river to a pumping station on shore. The engineer was required under its contract with the obligee to review the principal’s work and ascertain whether the work conformed with the design concept of the bonded contract documents. Contrary to that duty, the engineer raised no objection when the principal stated that it would not extend the tunnels beyond the embankment by the distance stated on the drawings. When the principal’s marine subcontractor attempted to excavate into the embankment in order to make the necessary connection with the tunnels, the embankment began to slough. Upon request of the obligee, the engineers reviewed the situation and merely recommended that tarps be placed on the embankment instead of considering other measures that could be taken to stabilize the embankment.
When the embankment completely collapsed shortly thereafter, the principal could no longer complete the bonded project. The obligee declared a default and asserted a performance bond claim against the surety. Upon completion of the bonded project, the surety asserted claims against the engineer. The trial court granted summary judgment in favor of the engineer, finding that the surety had no claim under the doctrine of equitable subrogation and that the negligent misrepresentation claim failed because the engineer supplied no information upon which the surety justifiably relied.
The Tennessee Appellate Court reversed, finding that equitable subrogation was designed to “obtain substantial justice and to prevent wrongdoing.” Id. at 724 (quoting Almany v. Nationwide Ins. Co., 1987 WL 4745, at *4 (Tenn. Ct. App. Jan. 29, 1987)). The court further ruled that equitable subrogation is based upon the principle that “substantial justice should be attained, regardless of form” and that “its basis is the doing of complete, essential, and perfect justice between all the parties.” Id. (quoting Castleman Constr. Co. v. Pennington, 432 S.W.2d 669, 674 (Tenn. 1968). Applying those principles, the court found that the engineer breached duties owed to the obligee, which caused the surety to incur additional losses under the performance bond. Therefore, equity and justice permitted the surety to assert its subrogation rights to the rights of the obligee and recover losses caused by the engineers. Id. at 724-727.
The Fifth Circuit reached a similar result in Lyndon Property Insurance Co. v. Duke Levy & Associates, LLC, 475 F.3d 268 (5th Cir. 2007), which allowed the surety to pursue a subrogation claim against the engineers based upon their wrongful inspection and approval of the principal’s work. In citing Pearlman v. Reliance Insurance Co., supra., the Fifth Circuit found that the surety could stand in the shoes of the owner, who, as the obligee, was the party benefitted by the surety’s performance, in order to prevent unjust enrichment to the engineers who purportedly caused the surety’s loss. Id., 475 F.3d at 270. The court found that the surety may assert its subrogation rights to the rights of the obligee when the surety pays a debt to the obligee on behalf of another party and the surety has an obligation to make that payment. Id. at 271 (citing Prairie State Nat’l Bank v. United States, 164 U.S. 227, 231 (1894)). The court also noted that subrogation operates to substitute one person into the place of another, whether that might be the obligee or the “‘possessor of any rightful claim.’” Id. (quoting St. Paul Prop. & Liab. Ins. Co. v. Nance, 577 So. 2d 1238, 1240-41 (Miss. 1991)). Accordingly, the surety was entitled to step into the shoes of the obligee and assert its subrogation rights to the obligee’s claim against the engineers for wrongfully approving the principal’s work.
In Unity Telephone Co. v. Design Services Co. Inc., 201 A.2d 177 (Me. 1964) the Maine Supreme Court held that the surety may assert its subrogation rights to the claim of the obligee, whose performance bond claim the surety had satisfied, against the design professional. That court referred to subrogation as a “doctrine of substitution” and an equitable means of imposing liability upon the responsible party:
In general terms and as applied to our present problem, subrogation is frequently referred to as a “doctrine of substitution” and may be defined as the substitution of one person in the place of another with reference to a lawful claim. It is a device adopted by equity to compel the ultimate discharge of an obligation by him who in good conscience ought to pay it.
Id. at 179.
The court found that subrogation was both a legal and equitable right which substitutes one person in the place of the creditor whose obligation is satisfied, “so that the person in whose favor [subrogation] is exercised succeeds to all the rights of the creditor.” Id.
In conclusion, it is well recognized that when the obligee is in privity with the design professional, the surety’s assertion of its subrogation rights allows the surety to step into the shoes of the obligee to pursue claims against the design professional, and the design professional may be liable to the surety to the extent that the design professional caused the surety’s loss. See also Restatement (Third) of Suretyship & Guar. §§ 27-28 (1996).
The author acknowledges the following resources on this issue: Martin J. Andrew, Surety Recovery from the Architect or Engineer—Why Not? 8 Forum 570 (1973); Michael L. Chapman, The Liability of Design Professionals to the Surety, 20 Forum 591 (1985); Martha Crandall Coleman, Design Professionals’ Liability for Negligent Design and Project Management (unpublished paper submitted at the ABA/TIPS Fidelity and Surety Law Committee program on Jan. 24, 1997, at the 1997 annual mid-winter meeting); Ann T. Hester & James D. Ferrucci, The Architect as a Source of Salvage (unpublished paper submitted at the 15th Annual Northeast Surety and Fidelity Claims Conference on Sept. 30, 2004); Jerome M. Joseph, Sureties’ Claims for Negligence Against Accountants, Design Professionals and Lenders, 24 The Brief 16 (1995); Bruce C. King, Claims by Surety Against Architect-Engineer (unpublished paper submitted at the ABA Forum on the Construction Industry/TIPS Fidelity and Surety Law Committee program on Jan. 22, 1987, at the annual mid-winter meeting); Brian R. Lambert, You Know It’s Their Fault, but Can You Sue Them? The Surety’s Claim Against Design Professionals: A Nationwide Survey (unpublished paper submitted at the National Bond Claims Association on Oct. 16, 2008, at the 2008 annual meeting); Gray Stiff & Scott Dickens, Design Professional Liability to the Surety (unpublished paper submitted at the 19th Annual Southern Surety and Fidelity Claims Conference on Apr. 10, 2008).
If you have any questions regarding the issues addressed in this blog post please contact Michael A. Stover, Esq. (410-659-1321/mstover@wcslaw.com) or any member of the Surety and Fidelity Practice Group.