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By Michael J. Carrato, Esq.

A Miller Act surety needs to be aware of certain notice requirements if it decides to take over performance for its principal on a federal construction contract.  Informal or “constructive” notice that a surety intends to take over management of a project may not be enough to protect the surety’s interest in the contract balance.  A recent decision from the United States Court of Federal Claims illustrates the problems which may arise if a surety does not provide the contracting officer with formal notice.

In American Ins. Co. v. United States , 62 Fed. Cl. 151 (September 28, 2004), American acted as surety for G&C Enterprises, Inc. on an Air Force construction contract.  G&C requested and received progress payments from the Air Force during the course of construction.  However, as the project neared the contractual completion date, G&C began to experience difficulties.  Concerned that its principal, G&C, might default, American assumed de facto managerial control of the contract and engaged another contractor to complete the work.  American did not formally notify the Air Force that it had assumed responsibility for its principal’s contractual obligations.

After assuming control of the project, American discovered that G&C had been paid 97 percent of the contract price by the Air Force while only performing 80 percent of the work.  American filed a suit against the Air Force claiming damages in the amount of $842,000, which represented the difference in the amount paid to G&C by the Air Force and the value of the work it had performed.  American argued that it should be equitably subrogated to the United States in the amount of the overpayment.

In granting summary judgment for the Air Force, the Court held that before an obligation arises on the part of the Government to withhold or divert contract funds, the Government must be notified that the surety believes the contractor is in default and cannot complete the contract.  Absent such notice, the Government owes no duty to the surety to protect the contract balance.  Because the surety may decide that its interests are best served by continuing to have the Government make progress payments to its principal, constructive notice that a contractor has defaulted and that the surety has taken over the performance of the contract is insufficient.  Only when the surety becomes a party to the contract with the United States by entering into a takeover agreement with a federal agency does the Government owe the surety any duty.  Based on the undisputed facts of the case, American’s rights to equitable subrogation never attached.  It not only failed to properly notify the Air Force to stop making payments to the contractor, but instead asked the Air Force to continue making payments to G&C.

Further, the Court held that American failed to demonstrate that the Air Force departed from the terms of the contract in making the overpayments to G&C.  Under the payment provisions in the contract, the contracting officer was vested with discretion to pay a contractor in excess of the value of the work performed.  Pursuant to that language, the contracting officer could use his/her discretion in balancing the Government’s interest in proceeding with the contract against possible harm to the surety.  The Court found that the contracting officer in this case did not abuse that discretion.  The overpayments were made to provide G&C with the cash flow to complete the project.  Based on these findings, the Court held that American was not entitled to recover any amount of the overpayments made to G&C.

Comment:

According to the American Insurance decision, a surety faces a tricky decision when its principal is experiencing financial difficulties.  On the one hand, encouraging the Government to continue making progress payments to its principal could help the contractor address its difficulties and successfully complete the contract.  However, such payments reduce the funds available to the surety to complete the work in the event its principal defaults.  Diligent monitoring by sureties of their principals’ performance under their bonded contracts and financial condition is key to avoiding the situation the surety faced in the American Insurance case.  To the extent a surety is convinced that its principal cannot complete the contract, it should promptly and explicitly notify the contracting officer to stop payments to the contractor.  Additionally, once a principal has defaulted, the surety should, with the assistance of counsel, promptly negotiate an appropriate takeover agreement with the Government.

About the Author: Michael J. Carrato is an attorney with the law firm of Wickwire Gavin, P.C., located at 8100 Boone, Blvd., Suite 700 , Vienna , VA , with a practice focusing on construction law and litigation.  He is also a certified engineer.  He can be reached at 703-790-8750 or at mcarrato@wickwire.com.

ConstructionRisk.com Report, Vol. 7, No. 5 (Sep 2005)

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