The Common Obligee Theory
July 25, 2023
In this Surety Today Blog post we begin a two-part series on the Common Obligee Theory. In this first post we discuss what the theory is and the two fundamental doctrines upon which the theory is based – subrogation and setoff. In the next post, we will discuss the application of the theory in the case law and the factors that should be considered in utilizing the theory.
First, what is the Common Obligee Theory? Under the Common Obligee Theory, a surety may, under the right circumstances, assert its subrogation rights in order to exercise the obligee’s setoff rights against the principal to recover funds the obligee would otherwise owe to the principal under other unrelated bonded or non-bonded contracts. Obviously, using the setoff rights to extend the surety’s reach beyond the bonded contract may help reduce the surety’s losses. Under the Common Obligee Theory, the surety steps into the shoes of the obligee and is entitled to assert any rights that the obligee may possess against the principal, even on other contracts.
A simple example demonstrates the point – obligee and principal enter into two contracts, Contract A to build a school and Contract B to build a shopping center. The school project, Contract A, is bonded by a surety, Contract B is not bonded. The principal completes the shopping center (the Contract B project), and is owed $100,000 by the obligee. But then the principal defaults on the school project (Contract A), and the surety steps in to complete Contract A. The surety is paid all of the Contract A funds, but incurs a loss of $100,000. Because the surety performed and completed Contract A, it is subrogated to all rights of the obligee with respect to the principal. In this example, one right that the obligee would have, if the surety did not perform, is the right of setoff between Contact A and B. It helps to think about this situation if you assume the fact pattern, but pretend that there was no surety in the scenario. In that case, the obligee would have completed Contract A and the obligee would have incurred the $100,000 loss and would have said to itself “I owe the principal $100,000 on Contract B, but the principal owes me $100,000 on Contract A, so I will set off the two amounts and keep the $100,000 owed on Contract B to cover my losses on Contract A and the principal gets nothing, but the principal would no longer owe anything either.” When the surety is present in the scenario, the surety simply does what the obligee would have done, using its subrogation rights it collect the $100,000 on Contract B to offset the surety’s loss on Contract A. The concept is simple enough in theory and it serves to further the purposes of both subrogation and setoff. However, in practice it not quite so simple.
Courts have recognized and allowed the Common Obligee Theory. Examples include: Travelers Casualty and Surety Company of America v. Paderta, 2013 WL 3388739 (N.D. Ill. July 8, 2013); Hartford Fire Ins. Co. v. United States, 108 Fed. Cl. 525, 533 (2012); 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); and there have been a number of articles written on the subject. For example, the author acknowledges and recommends the excellent work of Jarrod W. Stone, Esq. in Ch. 14, Common Obligee Theory and Other Setoff Rights—The Surety’s Subrogation Rights to the Obligee’s or Principal’s Setoff Rights, in THE CONTRACT BOND SURETY’S SUBROGATION RIGHTS 543- 557 (George J. Bachrach, James D. Ferrucci, & Dennis J. Bartlett eds., Am. Bar Ass’n 2013).
On the other hand, some courts have rejected the Common Obligee Theory under various facts. In part, these courts have rejected the theory because they take an overly restrictive view of subrogation and hold that the surety’s subrogation rights are limited solely to each bonded contract and the bonded contract funds of a single contract. In other cases, the surety was seeking to use its subrogation rights arising from payment of payment bond claims and such subrogation rights were held to be insufficient. See Lacy v. Maryland Cas. Co., 32 F.2d 48 (4th Cir. 1929) and Western Casualty & Surety Co. v. Brooks, 362 F.2d 486 (4th Cir. 1966); United States ex rel. Acoustical Concepts, Inc. v. Travelers Casualty and Surety Co. of America, 635 F.Supp.2d 434 (E.D. Va. 2009); Dependable Ins. Co. v. United States, 846 F.2d 65, 67–68 (Fed. Cir. 1988); Ram Constr. Co. v. Am. States Ins. Co., 749 F.2d 1049, 1055 (3d Cir. 1984); Liberty Mut. Ins. Co. v. SBN V FNBC LLC, No. 5:17-CV-82-BO, 2019 WL 346707, at *3–4 (E.D.N.C. Jan. 28, 2019); United States v. Jesco Constr. Corp., No. CV 04-3488, 2006 WL 8448980, at *3 (E.D. La. Jan. 30, 2006), aff’d sub nom. United States v. Jesco Const. Corp., 528 F.3d 372 (5th Cir. 2008).
To understand the issues relating to the Common Obligee Theory one must first understand the two fundamental keys to the theory – (1) the right of subrogation and (2) the right of set off. It is well established 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.” Pearlman v. Reliance Ins. Co., 371 U.S. 132, 137, 83 S.Ct. 232, 9 L.Ed.2d 190 (1962). The right of equitable subrogation thus allows a performing surety to step into the shoes of the benefitted party. Subrogation is not founded on contract, but is a creature of equity and is enforced solely for the purpose of accomplishing the ends of substantial justice.
When the surety completes the performance of a contract the surety is not only a subrogee of the contractor, and therefore a creditor, but also a subrogee of the obligee and entitled to any rights the obligee has to the retained funds. If the principal fails to complete the job, the obligee can apply the retained funds and any remaining progress money to the costs of completing the job. Subject to potential defenses, the surety is liable under the performance bond for any damage incurred by the obligee in completing the job. On the other hand, the surety may undertake to complete the job itself. In so doing, it performs a benefit for the obligee, and has a right to the retained funds and remaining progress money to defray its costs. The surety who undertakes to complete the project is entitled to the funds in the hands of the obligee, not as a creditor and subject to setoff, but as a subrogee having the same rights to the funds as the obligee.
One of the rights that obligees have is the right to set off, “to apply the unappropriated moneys of [its] debtor, in [its] hands, in extinguishment of the debts due to [it].” Munsey Trust Co., 332 U.S. at 239, 67 S.Ct. 1599 (internal citations omitted); Bank of Am. Nat’l Trust & Sav. Ass’n v. United States, 23 F.3d 380, 384 (Fed.Cir.1994). It is further recognized that a performing surety, through its equitable right of subrogation, may exercise the setoff rights of the obligee. 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. So, there is nothing in the law of suretyship or subrogation that would prevent the operation of the Common Obligee Theory.
Now we need to spend some time focusing on the right of set off. The better understanding we have of set off the better off we will be in identifying and advocating for the Common Obligee Theory. In discussing set off, one court noted that the “venerable” right of creditors to set off debts “dates back to Roman and English Law.” In re De Laurentiis Entm’t Grp., Inc., 963 F.2d 1269, 1277 (9th Cir. 1992); Stephen W. Schwab Debra David, Onset of an Offset Revolution: The Application of Set-Offs in Insurance Insolvencies, 95 Dick. L. Rev. 449, 453–54 (1991). The right to assert set off can arise by statute, common law, and contract. In its simplest form, set-off is the right between two parties to essentially net their respective debts when each party owes the other an obligation. Setoff rights exist between two parties when each party is a debtor to and a creditor of the other party. The definition of setoff 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 setoff is not part of a debt, it is an equitable remedy to secure the payment of a debt. As the Supreme Court has stated, “the right of setoff is a ‘common right, which belongs to every creditor, to apply the unappropriated moneys of his debtor, in his hands, in extinguishment of the debts due to him.’” Gratiot v. United States, 40 U.S. (15 Pet.) 336, 370, 10 L.Ed. 759 (1841); In re Chateaugay Corp., 94 F.3d 772, 780 (2d Cir. 1996). The objective of letting a party exercise its setoff 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.” Studley v. Boylston Nat’l Bank, 229 U.S. 523, 528, 33 S.Ct. 806, 808, 57 L.Ed. 1313 (1913). Thus, set off is a matter of common sense, a person should not be compelled to pay one moment what he will be entitled to recover back the next.
Courts have observed that “Setoff ‘occupie[s] a favored position in our history of jurisprudence,’ Bohack Corp. v. Borden, Inc., 599 F.2d 1160, 1164 (2d Cir. 1979), with which courts should interfere ‘only under the most compelling circumstances.’” In re Utica Floor Maint., Inc., 441 B.R. 941, 944 (N.D.N.Y. 1984). The Second Circuit has stated that “The rule allowing setoff … is not one that courts are free to ignore when they think application would be unjust.” In re Applied Logic Corp., 576 F.2d 952 (2d Cir. 1978). The Ninth Circuit has noted that “[t]he primacy of setoffs is essential to the equitable treatment of creditors. … Absent a setoff, a creditor … is in the worst of both worlds: it must pay its debt to the debtor in full, but may only entitled to receive a tiny fraction of the money the debtor owes it.” In re DeLaurentiis Entertainment Group, Inc., supra.
It is well-established at common law that the United States government, like every other creditor, enjoys the right to claim setoff. United States v. Munsey Trust, 332 U.S. 234 (1947); Malman v. United States, 207 F.2d 897 (2d Cir. 1953); Cecile Industries, Inc. v. Cheney, 995 F.2d 1052 (Fed. Cir. 1993), McKnight v. United States, 98 U.S. 179, 25 L.Ed. 115 (1878), and Barry v. United States, 229 U.S. 47, 33 S.Ct. 681, 57 L.Ed. 1060 (1913); In re Art Metal USA, Inc., 109 B.R. 74, 78 (Bankr. D.N.J. 1989); Southeastern Airways Corp. v. United States, 673 F.2d 368, 379 (Ct. Cl. 1982) (setoff common law right available to any creditor). Thus, the United States can assert a right of setoff independent of any statutory grant of authority to the executive branch. United States v. Tafoya, 803 F.2d 140, 141 (5th Cir. 1986); In re Metropolitan Hosp., 110 B.R. 731, 740 (Bankr. E.D. Pa. 1990), aff’d, 131 B.R. 283 (E.D. Pa. 1991). The government’s common law right of setoff—which is inherent in the federal government—is characterized as being a broad right. United States v. Tafoya, 803 F.2d 140, 141 (5th Cir.1986).
In addition to the common law right of set off, various statutes and regulations also provide a basis to the federal government for setoff. The tax code allows the IRS to setoff taxpayer’s overpayment of tax against tax liability for prior years. 26 U.S.C. § 6402(a). Federal agencies may refer past due debt to the Treasury Department for offset against tax overpayment. 31 U.S.C. § 3720A; 26 U.S.C. § 6402(d). Under 31 U.S.C. § 3716 the government’s set off right is codified in the administrative offset statute. The Federal Acquisition Regulations provide that the United States can setoff obligations between itself and parties contracting with the United States. 48 C.F.R. §§ 32.611, 32.612 (1992). Of course, there are many, many other examples.
In order for set off to be available there must be mutuality between the parties i.e., both obligations must be held by the same parties, in the same right or capacity. If the same parties are involved, but they “stand in different relationships in the various transactions, mutuality does not exist and setoff is impermissible.” For example, if party B, as a trustee, owes a debt to party A, arising out of party B’s breach of fiduciary duty to party A and party A owes a debt to party B personally under an unrelated breach of contract, there is no mutuality because party B’s obligation arises in his capacity as a trustee, not in his individual capacity. See, Ross–Viking Merchandise Corp. v. American Cyanamid Co. (In re Ross–Viking Merchandise Corp.), 151 B.R. 71, 73–74 (Bkrtcy.S.D.N.Y.1993); In re Westchester Structures, Inc., 181 B.R. 730, 739 (Bankr. S.D.N.Y. 1995); Darr v. Muratore, 8 F.3d 854, 860 (1st Cir. 1993). Similarly, mutuality is lacking where a partnership has a debt against an individual, but the individual has a debt against only one of the partners. In re Bacigalupi, 60 B.R. 442 (Bankr. 9th Cir. 1986). An officer, director or shareholder of a corporation is not the same as the corporation itself, thus there is no mutuality if the corporation has a debt against a party and that party has a debt against only the corporation’s CEO or President. In re Candor Diamond Corp., 76 B.R. 342 (Bankr. S.D.N.Y. 1987).
In the surety context, courts have noted that a claim acquired through equitable subrogation can satisfy the mutuality requirement for set off. Thus, when an entity acting as a surety or guarantor for the debtor has a claim for reimbursement based on payment to another creditor, as long as mutuality existed between the parties upon which subrogation is based, mutuality is satisfied through the subrogation. In re Photo Mech. Servs., Inc., 179 B.R. 604, 616–17 (Bankr. D. Minn. 1995); Corland Corp., 967 F.2d at 1077; Sherman v. First City Bank, 99 B.R. 333, 336 (N.D.Tex.1989), aff’d, 893 F.2d 720 (5th Cir.1990); Denby Stores, 86 B.R. at 780–81; In re Flanagan Bros. Inc., 47 B.R. 299, 302–03 (Bankr.D.N.J.1985); 1 Epstein, § 6–40, at 680. Similarly, a claim obtained through assignment can satisfy mutuality. In re Metco Mining and Minerals, Inc., 171 B.R. 210, 216-17 (Bankr. W.D. Pa. 1994).
The surety’s right of subrogation and the general right of set off are both well-known and well-defined, so there should be no issues with applying the two rights together under the Common Obligee Theory. The takeaway here is that 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.
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.