Introduction

The doctrine of equitable subrogation is one of the most important legal doctrines at a surety’s disposal in the event a contractor defaults and the surety takes over performance. The doctrine provides that if a bonded contractor defaults and the surety takes over performance of the bonded contract, the surety “steps into the shoes” of the contractor and becomes subrogated to the contractual rights of the contractor. This allows a Miller Act surety to recover the contract funds held by the Government as retainage, as well as the contract funds disbursed to the contractor after the surety notifies the Government of the contractor’s default. Significantly, before a surety becomes entitled to recover under the doctrine of equitable subrogation, the Miller Act requires the surety to give notice to the Government of the contractor’s default or imminent default. The importance of this notice requirement was recently highlighted in United Surety & Indemnity Co. v. United States, 87 Fed. Cl. 580 (2009). In United Surety & Indemnity Co., the United States Court of Federal Claims held that the surety failed to provide adequate notice to the Government of the contractor’s default, despite the Government’s knowledge that the surety was performing and therefore, the surety failed to state a claim for equitable subrogation. 87 Fed. Cl. At 594. This holding illustrates the importance of providing adequate notice to the government of a contractor’s default or imminent default, so as to ensure the Government’s equitable duty to the surety under the doctrine of equitable subrogation.  

Relevant Factual Background

In United Surety & Indemnity Co., the Plaintiff, United Surety & Indemnity Company (“United Surety”) provided two bonds, a payment bond and a performance bond, on behalf of Selpa Construction & Rental Equipment Corporation (“Selpa”) for the construction of a post office in Fajardo, Puerto Rico. United Surety & Indemnity Co., 87 Fed. Cl. at 584. As partial consideration for the two bonds, Selpa executed a General Agreement of Indemnity (“General Agreement”). Id. Pursuant to the terms of the General Agreement, Selpa assigned and declared United Surety’s rights to be subrogated to Selpa’s rights. Id. The agreement also provided that United Surety had the right to “control, administer, operate or manage any matters connected with the performance of any contract [covered by such bond or bonds] for the purpose of minimizing any possible loss or ultimate loss to [United Surety].” Id. (internal quotations omitted).

Due to Selpa’s financial condition during construction of the post office, Selpa was unable to perform under the contract and United Surety agreed to provide Selpa with the funds necessary to complete the project. United Surety & Indemnity Co., 87 Fed. Cl. at 584. In doing so, United Surety became a performing surety. On November 12, 2002, United Surety informed the United States Postal Service (“USPS”) that United Surety had provided two bonds to Selpa for the construction of the post office and that pursuant to the terms of a General Agreement executed by Selpa, USPS was required to make all future payments due under the contract to Selpa and United Surety. Id.

Approximately two and a half months after United Surety notified USPS of the assignment, Scotiabank de Puerto Rico (“Scotiabank”), Selpa’s bank, notified USPS that all contract payments should be made jointly to Selpa and Scotiabank. United Surety & Indemnity Co., 87 Fed. Cl. at 584-85. These payments were to be made to Scotiabank pursuant to a valid assignment of contract payments signed by Selpa. Id. at 585. In light of Scotiabank’s request and a subsequent telephone conversation with Selpa in which Selpa requested that all future payments be made to United Surety and Selpa, USPS sent a letter to Selpa on February 4, 2003 requesting payment instructions. Id.

On March 26, 2003, USPS made a progress payment under the contract to Selpa and Scotiabank in the amount of $201,795.00. United Surety & Indemnity Co., 87 Fed. Cl. at 585. At the time of the progress payment, United Surety had spent approximately $168,482.00 to complete the project and claimed that USPS was aware that United Surety had been financing the project. Id. Selpa sent a letter to USPS on April 3, 2003 stating that Selpa intended to finish the project with the assistance of United Surety and requesting that fifty percent of the retainage be paid to United Surety. Id. On April 8, 2003, United Surety’s counsel sent a letter to USPS requesting that United Surety be reimbursed for all funds disbursed to Selpa and Scotiabank on March 26, 2003. Id.

Selpa was eventually terminated for default and United Surety and USPS entered into a takeover agreement. United Surety completed the project at a net loss of $2,034,936.42. United Surety & Indemnity Co., 87 Fed. Cl. at 585. United Surety was never reimbursed for the $201,795.00 progress payment made to Selpa and Scotiabank. Id.

United Surety filed a Complaint against the Government in the United States Court of Federal Claims on November 4, 2008, alleging wrongful disbursement of contract funds based upon its right to equitable subrogation. United Surety & Indemnity Co., 87 Fed. Cl. at 585. In response, the Government filed a Motion to Dismiss, arguing that United Surety failed to give adequate notice of Selpa’s default or imminent default and therefore, United Surety had failed to state a claim for equitable subrogation. Id. at 585. The issue was before the Court on the Government’s Motion to Dismiss.  

The Parties’ Arguments

• The Government’s Argument

In support of its Motion to Dismiss, the Government argued that United Surety’s November 12, 2002 failed to provide adequate notice because Selpa’s letter to not provide “facts giving rise to the equitable subrogation by the surety, including the facts related to the contractor’s default or imminent default.” United Surety & Indemnity Co., 87 Fed. Cl. at 588. Without the required notice, the Government argued, USPS was not required to make progress payments to United Surety. Id. Furthermore, the November 12, 2002 letter was invalid as an assignment of contract funds because such an assignment was prohibited by the contract between Selpa and USPS. Id. Therefore, as United Surety’s letter was insufficient as a matter of law, and there existed no valid assignment of funds, United Surety failed to state a claim for equitable subrogation and was not entitled to the funds disbursed on March 26, 2003 to Selpa and Scotiabank. Id. at 588-89.

• United Surety’s Response

In response to the Government’s argument that United Surety failed to provide adequate notice to trigger USPS’ equitable duty, United Surety argued that technical compliance with the notice requirements was unnecessary because USPS was aware that United Surety was performing under the contract at the time the progress payment was made. United Surety & Indemnity Co., 87 Fed. Cl. at 589. Although United Surety acknowledged that USPS would have no legal obligation to suspend progress payment based solely on an unsupported request of a surety, United Surety argued that because USPS was aware of United Surety’s performance notice would have been “superfluous and unnecessary.” Id. United Surety further argued that once a surety pays or performs a contract, subrogation becomes effective so that funds left in the project become security for the surety. Id.  

Holding of the Court

After a detailed review of the parties’ arguments, the United States Court of Federal Claims rejected United Surety’s argument that notice was unnecessary, and granted the Government’s Motion to Dismiss for Failure to State a Claim. United Surety & Indemnity Co., 87 Fed. Cl. at 594. In so holding, the court explained that the doctrine of equitable subrogation permits a performing surety to “step into the shoes” of the contractor and become subrogated to the contractual rights of the contractor. Id. at 591. This allows the surety to recover the contract funds held by the government as retainage and funds disbursed after notice to the Government of the contractor’s default. Id. Significantly, before the surety is entitled to recover under the doctrine of equitable subrogation, the surety has a duty to notify the Government of the contractor’s default or imminent default and inability to complete the contract. Id. The court emphasized that this requirement is “not an overly stringent requirement.” Id. at 594. Importantly, however, independent knowledge of a contractor’s default is insufficient to trigger the government’s equitable duty to act with reasoned discretion. Id. at 593.

In the present case, the court found that United Surety’s November 12, 2002 letter failed to notify USPS that Selpa was in default or in danger of being in default under the contract. Instead, the letter referred only to an invalid assignment of funds. United Surety & Indemnity Co., 87 Fed. Cl. at 593. Furthermore, none of the additional communications regarding the assignment of funds to United Surety were between United Surety and USPS. Id. As the United Surety failed to provide any evidence of Selpa’s default or imminent default, United Surety did not meet its duty to notify USPS of Selpa’s default and thus United Surety failed to state a claim for equitable subrogation. Id. at 594.

Conclusion

The Court’s holding in United Surety & Indemnity illustrates the importance of notifying the Government of the surety’s belief that the contractor is in default or is in danger of being in default and the facts and circumstances related to the default or imminent default. Although there are no “magic words” that must necessarily be used, the surety must provide sufficient information to put the Government on notice of its subrogation rights. Only after the required notice is given to the Government does the surety become equitably subrogated and the Government become obligated to act equitably towards the surety.

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