The Common Obligee Theory (Part Two)
August 22, 2023
In this Surety Today Blog post we provide part two in our two-part series on the Common Obligee Theory. In the first post, we discussed what the theory is and the two fundamental doctrines upon which the theory is based – subrogation and setoff. In this post, we discuss the application of the theory in the case law and the factors that should be considered in utilizing the theory.
A good case to discuss that upholds the principles of the common obligee theory is the case of Transamerica Ins. Co. v. United States, 989 F.2d 1188 (Fed. Cir. 1993). This case does an excellent job of distinguishing many of the cases that refuse to uphold the common obligee theory and in discussing the reasoning supporting the theory. In Transamerica, the U.S. Army Corps of Engineers, entered into two separate contracts with the principal, who was a general contractor. Both contracts related to projects at Fort Bragg in North Carolina. One contract was for construction of the Commissary Warehouse and Store (“Commissary Project”), the other contract was for construction of the Bowley Elementary School (“School Project”). Transamerica issued payment and performance bonds for both of the contracts.
The principal defaulted on the School Project. Transamerica, pursuant to its performance bond, took over and completed the School Project and incurred over $1,000,000 in losses. The principal managed to complete the Commissary Project, and filed a claim with the Corps of Engineers for equitable adjustment in an amount exceeding $500,000 and eventually reached a settlement with the Corps. Transamerica sought the funds owed by the government to the principal pursuant to the settlement. Transamerica gave written notice to the government that it was seeking the funds under the doctrine of equitable subrogation. However, the government disbursed the funds to the principal. This case presents the classic set up – two contracts, same obligee, same principal, same surety, a loss on one project and a profit on the other.
Transamerica sued the government in the Court of Federal Claims, arguing that it had been damaged by the government’s disregard of Transamerica’s right of equitable subrogation. Transamerica argued that it was entitled to set off its losses incurred on the School Project because the government could have set off any losses it incurred through completion of the School Project against funds it owed to the contractor on the Commissary Project. Transamerica asserted that under equitable subrogation, it could step into the government’s shoes and set off the losses it incurred through completion of the School Project against the Commissary Project funds. The Court of Federal Claims rejected the surety’s arguments and reasoned that a “surety’s rights and remedies are limited to recovery of retained funds from the contract generating the claim,” and that such a result is not changed just because the surety enters into a number of construction bonds with the same contractor. Therefore, at the trial level, Transamerica was not permitted to set off its losses against the funds owed to the principal because those losses arose out of a different contract.
Transamerica appealed challenging the Court of Federal Claims’ decision. On appeal, Transamerica relied upon the case of District of Columbia v. Aetna Ins. Co., 462 A.2d 428 (D.C. Ct. App. 1983), which was almost identical to the facts in Transamerica. In the Aetna case the D.C. Court of Appeals held that:
where, as here, the only claimants to monies held by a government agency are the surety and a defaulting contractor, the surety who has performed under a public works performance bond agreement, upon full satisfaction of its surety obligation, is subrogated to all of the rights and remedies which the government might have had against the principal had the government been forced to complete the project itself. Among these remedies is the common law right of setoff.
462 A.2d at 432.
The Transamerica court agreed with and adopted the reasoning of the Aetna case. The Transamerica court stated “[t]he general rule is that ‘a surety who pays the debt of another is entitled to all the rights of the person he paid to enforce his right to be reimbursed.’” 989 F.2d at 1194 (citing Pearlman v. Reliance Ins. Co., 371 U.S. 132, 137, 83 S. Ct. 232, 235, 9 L. Ed.2d 190 (1962)). The Transamerica court saw that if the surety were not allowed to exercise the obligee’s set off rights the surety would incur a loss, and the principal, who caused that loss, would receive the benefit of the claim payment at the same time on the other project. Further, the court understood that if the surety had not completed, but the government did, the government would have been entitled to set off the amount owed on the Commissary Project by the loss on the School Project. Accordingly, the court noted that “on the facts before us, we find nothing in the law of suretyship to cause us to favor allowing [the principal], the defaulting contractor, to be better off simply because the surety, rather than the government, completed a contract and thereby incurred damages.” Id. at 1194. The court also noted that if the surety was not allowed to assert the set off “a surety would rarely undertake to complete a job if it incurred the risk that by completing, it might lose more than if it had allowed the government to proceed.” Id. at 1192. What the court was referring to is that if the government had completed, incurred the loss and set off against the amount it owed, there would be no loss to the surety. But, if the surety completes and cannot assert the set off, the surety suffers a loss. So, a reasonable surety would analyze that situation and would decline to complete to avoid the loss. The Transamerica court observed that it is generally preferable to the government to have the surety complete and that is the purpose of the Miller Act performance bond. The court did not think that in enacting the Miller Act, Congress intended to create a situation in which the surety would have an incentive not to complete.
The Transamerica court also noted that “unlike much of government contract law, the doctrine of equitable subrogation finds its roots not in statutory law but in the judicial commitment to providing fairness and equity among competing claimants.” Id. at 1194. It stated that “[t]he equities here strongly support Transamerica’s position. Had the government chosen to itself complete the work on the School contract, and had it incurred any losses or extra expense in so doing, it clearly would have had the option to set off its claim against the monies it owed [the principal] on the Commissary contract. . . . We see no reason to allow [the principal] to profit, at Transamerica’s expense, from the government’s choice to have Transamerica complete the work. And we see no reason to harm Transamerica simply because of that same choice.” Id.
The Transamerica court systematically analyzed and distinguished each of the case authorities that the government and the Claims Court relied upon. It noted that each of the cases all had elements that were not present in the Transamerica facts which led to the result of rejecting the common obligee theory in those cases. A surety in a situation where it is arguing in favor of the common obligee theory will no doubt be confronted by the list of cases that were distinguished by the Transamerica case, thus, the case is a good resource to consult.
Factors to Consider
Based on the case law there are a number of issues that can potentially affect whether a given jurisdiction will recognize the theory. Some of those factors are:
- In jurisdictions where the distinction is recognized between the subrogation rights of a payment bond surety versus a performance bond surety, a payment bond surety may not have the necessary subrogation rights to obtain the obligee’s setoff rights, especially as to other projects. So, the surety must analyze what is the nature of its subrogation rights.
- The obligee must be a mere stakeholder with respect to the other contract funds. Thus, if the obligee has independent rights against the principal, for example the IRS seeking taxes, that may result in rejection of the common obligee theory. This was a point that the Transamerica court noted very clearly in its analysis because in that case, and the Aetna case, the government was a mere stakeholder of the funds on the profitable project and there were no competing interests.
- The obligee must actually possess setoff rights against the principal. There may be contractual or statutory rights that could limit or prevent setoff. So, the surety needs to analyze that issue in each case.
- The principal does not dispute the obligee’s rights. If there is a dispute between the principal and the obligee over whether the principal owes the obligee anything, such as the principal is challenging the default or asserting change orders or affirmative claims, those facts may result in rejection of the application of the common obligee theory, at least until the disputes are resolved.
In conclusion, the surety, through the common obligee theory, may have rights against other funds to help offset 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 considering.
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.