by Christopher M. Anzidei, Associate

The doctrine of equitable subrogation provides vital protections to sureties that perform their bond obligations.  Under federal law, a performing surety is subrogated to the security held by the Government in the form of the contract funds.  Federal courts have long acknowledged that this right of subrogation is equitable in nature, arising not from any direct contract, but rather from the tripartite agreement that is formed when the surety agrees to be liable for the debts or obligations of its principal in the event that it is called upon to do so by the obligee.

When the United States is the obligee, courts have held that the Government has a duty to administer the bonded contract in a way that does not materially increase the risk assumed by the surety when the contract was originally bonded.  These courts have relied upon principles of equitable subrogation in holding that sovereign immunity does not bar a surety’s claim against the Government for improper disbursements of contract funds to the principal prior to default.  In such cases, federal courts have held that the Tucker Act’s waiver of sovereign immunity for claims founded upon express or implied contracts with the United States extends to overpayment claims submitted by sureties as subrogees.

A recent case in Virginia, XL Specialty Insurance Company v. Commonwealth, 611 S.E.2d 356 (Va. 2005), presented the issue whether Virginia’s analogous procurement regulations include a waiver of the Commonwealth’s sovereign immunity for a surety’s overpayment claims.  At the trial level, the Circuit Court for the City of Richmond ruled that the Commonwealth was immune to such claims and dismissed the surety’s lawsuit.  Although the surety’s appeal was heard by the Supreme Court of Virginia, the unique procedural posture of the case on appeal precluded the Court from reaching the merits of the sovereign immunity question.  Instead, the Court returned the surety’s appeal to the Court of Appeals, leaving the intermediate appellate court with limited guidance on the substantive question related to the scope of the Commonwealth’s sovereign immunity.  Thus, sureties doing business in Virginia should continue to monitor the XL Specialty case as it winds through the appellate process.  The ultimate resolution of this case may ultimately impact a surety’s right to assert pre-takeover claims, including overpayment claims, against the Commonwealth.

The Pre-Default Overpayment Claims at Issue in XL Specialty

The dispute arose after XL Specialty Insurance Company ("XL Specialty") took over two Virginia Dept. of Transportation (“VDOT”) contracts that it bonded for its principal, Bravos Concrete, Inc. ("Bravos").  VDOT had declared Bravos in default of its contracts, invoked XL Specialty’s performance bond obligations, and entered into takeover agreements with the surety.  XL Specialty subsequently performed its bond obligations in accordance with the takeover agreements by arranging for another contractor to complete Bravos’ contracts.  Following project completion, however, XL Specialty concluded that VDOT had improperly paid Bravos for defective and incomplete work prior to its default.  Thus, the surety submitted claims to VDOT for the costs that it incurred in correcting and performing this work.

Virginia Law Protects Sureties from Pre-Default Overpayments by Obligees

In pursuing its overpayment claim, XL Specialty relied upon by prior Virginia decisions in which sureties were discharged from their obligations where obligees altered the obligations of the bonded contract.  For instance, the Supreme Court of Virginia held that a subcontractor’s surety was discharged from any performance and payment bond obligations that it may have otherwise owed to the general contractor where the contractor materially altered the terms of its subcontract by making progress payments to a subcontractor before they were due and without obtaining the approval of the project architect.  Southwood Builders, Inc. v. Peerless Ins. Co., 366 S.E.2d 104 (Va. 1988).  The Court in Southwood observed that this discharge rule protects sureties by ensuring that obligees will not diminish the contract funds available in case of a default and by giving contractors an incentive to finish the work in order to receive full payment.

The Supreme Court of Virginia’s decision in XL Specialty did nothing to diminish the protection offered to sureties by Southwood and other decisions in which sureties have been discharged by the overpayments of obligees.  On the contrary, citing the Southwood decision, the Court observed that "if the owner and contractor engage in practices that constitute a material change in the construction contract provisions, and the contractor subsequently defaults on the contract, the surety is entitled to discharge of its obligation to pay the contractor’s debt." XL Specialty, 611 S.E.2d at 360.  The Court in XL Specialty also reaffirmed that a surety called upon to answer for the default of its principal has the right to require an owner to prove that it has performed its obligations of the contract.  Thus, had XL Specialty’s overpayment claims arisen on a private project, there seems to be little doubt that the Court would have been more sympathetic to the merits of the surety’s claim.

The Dispute Over the Scope of the Commonwealth’s Waiver of Sovereign Immunity in XL Specialty

In XL Specialty, the Commonwealth relied upon the public nature of the project and moved to dismiss the surety’s claims on sovereign immunity grounds.  Specifically, the Commonwealth argued that the surety could not rely upon the statutory waiver of sovereign immunity applicable to contract cases with VDOT because the surety’s alleged damages did not arise from the takeover agreements, the only express contracts between the surety and VDOT.  The Circuit Court agreed with the Commonwealth and dismissed the surety’s suit, interpreting Virginia Code § 33.1-387 as providing a limited waiver of sovereign immunity that encompasses only those claims that are submitted by a contractor (either for its own benefit or for the benefit of a subcontractor) under an express contract with VDOT.  XL Specialty, 63 Va. Cir. 606 (2004).  The Circuit Court characterized equitable subrogation claims submitted by sureties as claims based upon implied contracts.  The court concluded that, unlike the analogous Tucker Act under federal law, Virginia law does not recognize a waiver of sovereign immunity for claims submitted by sureties under equitable subrogation or implied contract theories.

XL Specialty filed its appeal to the Court of Appeals, which concluded that it lacked jurisdiction and transferred the case to the Supreme Court of Virginia.  Accordingly, the limited question before the Supreme Court of Virginia was whether the Court of Appeals should have taken jurisdiction over XL Specialty’s appeal.  The Court held that jurisdiction of the surety’s appeal lies in the Court of Appeals.  While the Supreme Court of Virginia’s decision sheds some light on the substantive issues in the case, it failed to provide conclusive guidance on the ultimate question whether the Commonwealth is entitled to sovereign immunity from a surety’s overpayment claims.

The Court of Appeals in Virginia has jurisdiction over an appeal from a circuit court decision that was an appeal from an administrative agency decision.  In this case, the Supreme Court of Virginia’s decision turned on whether XL Specialty was entitled to invoke and, if so, had the surety properly invoked VDOT’s administrative claim procedures set forth in the Va. Code.  XL’s ability to file a civil action against VDOT first required compliance with VDOT’s administrative procedures.  The Commonwealth argued that the Court of Appeals lacked jurisdiction, asserting that only "contractors" submitting claims could invoke VDOT’s administrative procedures.  The Commonwealth further asserted that XL Specialty, a surety, was not a "contractor" under VDOT’s administrative procedures.  XL Specialty argued that it should be treated as a "contractor" because: (i) the bonds and construction contracts constitute an express contract between XL Specialty and VDOT; and (ii) XL Specialty should be entitled to rely upon principles of equitable subrogation in order to stand in the shoes of its principal and assert claims as a contractor against VDOT.

The Supreme Court of Virginia rejected XL Specialty’s first argument that it should be treated as a "contractor" asserting a claim under an express contract with VDOT by virtue of the tripartite agreement arising from its performance bond securing the underlying contract between VDOT and Bravos.  Relying upon analogous decisions under federal law, the Court held that the performance bond was not an express contract between VDOT and XL.

The Court then turned to XL Specialty’s second argument, that the surety should be treated as a "contractor" because it "stepped into the shoes" of the contractor through equitable subrogation. Although sureties have successfully invoked equitable subrogation to assert pre-termination overpayment claims under federal law, the Supreme Court of Virginia rejected the concept that a surety should be treated as "stepping into the shoes" of a contractor under equitable subrogation principles.  The Court did so based upon its observation that a surety claiming equitable subrogation has additional rights that would not be available to its principal.  One of these rights, according to the Court, was the surety’s right to be discharged from its obligations where the obligee had previously made payments to the principal before they were due under the contract.  In short, the Supreme Court of Virginia relied upon XL Specialty’s right to assert an overpayment claim under an equitable subrogation theory under the common law to justify its decision that a surety should not be treated as a contractor for the purposes of asserting an overpayment claim against VDOT under the relevant procurement regulations.

Although the Supreme Court of Virginia ultimately concluded that a surety should not be treated as a "contractor" for the purpose of asserting claims against VDOT under Virginia’s public procurement statutes, the Court found a separate basis under which the Court of Appeals should have taken jurisdiction of XL Specialty’s appeal on its overpayment claim.  The Court observed that a separate statute, Va. Code § 33.1-192.1, requires a contractor "or any persons claiming under him" to submit claims against VDOT to the administrative review process outlined in Va. Code § 33.1-386. Relying upon this statute, the Court held that XL Specialty was obliged to pursue its claims through VDOT’s administrative review process as an entity "claiming under" Bravos’ original contracts with VDOT.  Therefore, the Supreme Court of Virginia reversed the Court of Appeals’ transfer order and returned XL Specialty’s appeal for consideration on the merits.

The Potential Implications of the Supreme Court of Virginia’s Decision

While XL Specialty did not receive a decision from the Supreme Court of Virginia on the sovereign immunity question, it seems likely that the Court of Appeals will address this question.  The Supreme Court of Virginia offered less than definitive guidance to the Court of Appeals on this critical question.  Nevertheless, the Court of Appeals may still reverse the trial court’s ruling and find that Va. Code § 33.1-192.1 constitutes a waiver of sovereign immunity for claims submitted by XL Specialty under Bravos’ contract with VDOT.

Even if the Court of Appeals determines that the Commonwealth has waived sovereign immunity under Va. Code § 33.1-192.1, the court might still determine that any such waiver of sovereign immunity is too limited to encompass the overpayment claim submitted by XL Specialty. Indeed, the Supreme Court of Virginia observed that Va. Code § 33.1-192.1 addresses "situations where a contractor’s claims have been acquired by another and that entity seeks to assert the claims against VDOT." 611 S.E.2d at 361.  It would be counterintuitive to say the least that a contractor will assert a claim that it had been overpaid by the owner prior to its default.  Thus, even if the Court of Appeals relies upon Va. Code § 33.1-192.1 as a waiver of sovereign immunity and allows a surety to assert claims that it acquired from the contractor, it is unclear whether XL Specialty’s overpayment claim would even meet the strictures of this statute.  Any surety doing business in Virginia would be well served to monitor the resolution of the XL Specialty case because this case may ultimately affect the rights of a surety to assert pre-takeover claims against public entities in the Commonwealth.

Two Strategies for a Surety that Seeks to Avoid the Potential Sovereign Immunity Trap in Virginia

While the sovereign immunity question in XL Specialty has yet to be answered, the ruling, highlights those actions a surety may want to consider taking in order to ensure that it has preserved any pre-takeover claims against public entities.  A surety on a public project should attempt to maximize the inherent leverage that it maintains at the time of the default to perform a thorough investigation before undertaking its bond obligations.  The public obligee will no doubt want immediate performance from the surety even though sureties have a right to investigate the circumstances surrounding a default before deciding among the available performance options.  Therefore, the public obligee will have little choice but to cooperate in the surety’s investigation, and the surety should endeavor to inspect the work, review the project’s payment and inspection records, and otherwise attempt to determine whether there have been any overpayments or other actions by the obligee that may result in a discharge of the surety’s bond obligations.

No surety, however, should be forced into a position where it must rely solely upon its pretakeover investigation to determine if grounds exist to assert an overpayment claim.  Regardless of how thorough the surety is in its investigation, a surety that opts to takeover the work should also consider negotiating a takeover agreement that expressly preserves the surety’s rights to assert any overpayment claims that may be subsequently discovered.  If the surety’s takeover agreement expressly conditions its performance upon the obligee’s prior performance of all of its obligations, including the obligation to avoid making overpayments to the contractor, then the surety would likely meet the express contract requirement under which it could sue the Commonwealth.  While an express reservation of rights to assert overpayment claims may not be necessary in all cases, the surety in XL Specialty might have been able to avoid litigation over the scope of the Commonwealth’s sovereign immunity had it pursued such a strategy.

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