118 F.3d 1542 (Fed. Cir. 1997), 94-5159, National Sur. Corp. v. United States

Docket Nº:94-5159.
Citation:118 F.3d 1542
Party Name:NATIONAL SURETY CORPORATION, Plaintiff-Appellee, v. The UNITED STATES, Defendant-Appellant.
Case Date:July 03, 1997
Court:United States Courts of Appeals, Court of Appeals for the Federal Circuit

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118 F.3d 1542 (Fed. Cir. 1997)



The UNITED STATES, Defendant-Appellant.

No. 94-5159.

United States Court of Appeals, Federal Circuit

July 3, 1997

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Richard L. Lambe, Ulin & Lambe, Seattle, WA, argued, for plaintiff-appellee.

Thomas P. McLish, Commercial Litigation Branch, Civil Division, Department of Justice, Washington, DC, argued, for defendant-appellant. With him on the brief were Frank W. Hunger, Assistant Attorney General, David M. Cohen, Director, and Anthony C. Anikeeff, Assistant Director. Of counsel was Thomas O. Mason.

Before ARCHER, Chief Judge, NEWMAN and PLAGER, Circuit Judges.

Opinion for the Court filed by Circuit Judge PAULINE NEWMAN. Dissenting opinion filed by Chief Judge ARCHER.

PAULINE NEWMAN, Circuit Judge.

The government appeals the decision of the United States Court of Federal Claims 1 holding the government liable to the surety for the improper release of retainage for a construction contract upon which National Surety Corporation served as guarantor. The decision of liability is affirmed, albeit on a different ground than that selected by the Court of Federal Claims. We remand for redetermination of the amount of damages.


National Surety furnished performance and payment bonds in connection with a contract between Dugdale Construction Company and the Department of Veterans Affairs, for construction of a water distribution system at Fort Harrison, Montana. The construction contract provided that the government would retain ten percent of all progress payments until Dugdale submitted, and the contracting officer approved, a "complete project arrow diagram," which is a detailed schedule of the critical path for performing the contract. The retainage provision was as follows:

Clause G-7(A). Payment to Contractor Clause 7 of the General Provisions (Contractor Contract) is supplemented to include the following:

Retainage: This contract shall have 10 percent retainage withheld on each progress voucher until the complete project arrow diagram has been approved. Once the schedule has been approved and the Contracting Officer has determined that the Contractor's progress is satisfactory, the Contracting Officer may elect not to withhold any additional retainage. Previous retainage will not be reduced and future payments will be made in full. If during subsequent project updates the Contracting Officer determines that the Contractor's progress is unsatisfactory, he may withhold 10 percent retainage on the current payment request and subsequent payments to protect the interests of the Government and until he again determines that the Contractor's progress is satisfactory.

Dugdale did not provide the requisite project arrow diagram. Nonetheless, the government did not withhold the ten percent retainage

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from the progress payments, as the contract required.

Dugdale abandoned the project before its completion, and the government then terminated the contract for default. National Surety completed the construction in accordance with its performance bond, and was paid the difference between the contract price and the payments that had been made to Dugdale, i.e., $126,333, less liquidated damages for late completion. National Surety then filed a claim for the funds that were required to have been retained by the government from the progress payments to Dugdale. The contracting officer did not act on the claim within the statutory period, and National Surety brought suit in the Court of Federal Claims.

On cross motions for summary judgment, the Court of Federal Claims held that National Surety was a third party beneficiary of the contract between Dugdale and the government and that the government breached this obligation when it improperly paid the retainage to Dugdale, thereby incurring liability to National Surety. The court awarded as damages the amount that should have been retained ($97,742) plus statutory interest. This appeal followed.


In the Court of Federal Claims the parties offered alternative theories of their legal relationships and ensuing liabilities. Although we affirm the court's conclusion as to liability, we do so on application of suretyship principles.


The view that the surety is a third party beneficiary of the contract whose performance it assures is not the usual premise of surety claims against an obligee, although, to be sure, the surety's obligations are affected by that performance. See Arthur Adelbert Stearns, The Law of Suretyship § 1.1 (1951) ("Suretyship may be defined as a contractual relation whereby one person engages to be answerable for the debt or default of another"); Balboa Ins. Co. v. United States, 775 F.2d 1158, 1160 (Fed.Cir.1985) ("suretyship is the result of a three-party agreement").

Suretyship law derives from a different legal premise than whether the bonded contract, or any provision thereof, was made for the surety's direct benefit. The surety bond embodies the principle that any material change in the bonded contract, that increases the surety's risk or obligation without the surety's consent, affects the surety relationship. The principles are set forth in, e.g., Gritz Harvestore, Inc. v. A.O. Smith Harvestore Prods., Inc., 769 F.2d 1225, 1230 n. 7 (7th Cir.1985):

Where, without the surety's consent, the principal and the creditor modify their contract otherwise than by extension of time for payment

. . . . .

(b) the compensated surety is

(i) discharged if the modification materially increases his risk, and

(ii) not discharged if the risk is not materially increased, but his obligation is reduced to the extent of loss due to the modification.

(citing Restatement, Security § 128 at 340-41 (1941)). These principles have been elaborated upon in the Third Restatement, including a synthesis of the circumstances under which the surety is entitled to relief against the obligee based on impairment of suretyship status. See Restatement (Third) of Suretyship & Guaranty § 37 (1996). Extensive precedent illustrates the discharge or pro tanto reduction of the surety's obligation, varying in implementation based on the particular facts. The general rule with respect to retainage in construction contracts is the subject of the following example in the Third Restatement:

1. S has issued a performance bond with respect to P's contract to construct a house for O for $100,000. Pursuant to the contract between O and P, O is to pay P monthly for the portion of the work completed that month minus a 15 percent "retainage." After completing 60 percent of the project and receiving $51,000 ($60,000 minus the $9,000 retainage) from O, P defaults. S completes the project at a cost to S of $40,000. After S completes the

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project, O pays the $9,000 retainage to P, who, despite this payment, is insolvent. Had O paid the retainage to P before S completed the project, S would have been discharged to the extent of $9,000 by application of § 38 (impairment of collateral). S has a claim against O for $9,000 because the payment to P would have discharged S from the secondary obligation to that extent.

Id. § 37, illus. 1. See, e.g., Home Indem. Co. v. United States, 180 Ct.Cl. 173, 376 F.2d 890, 895 (1967) (United States liable to surety despite the fact that the government had disbursed the retainages); Hochevar v. Maryland Cas. Co., 114 F.2d 948 (6th Cir.1940) (improper release of 15% retainage in construction contract released the surety pro tanto); Maryland Cas. Co. v. Board of Water Commissioners, 66 F.2d 730 (2d Cir.1933) (same).

The surety's rights and obligations are not based on third-party beneficiary concepts, but on principles of suretyship law. Applying these principles we conclude, as did the Court of Federal Claims, that the government has incurred liability to the surety. However, on the facts of this case we conclude that damages are fairly measured not by the calculated amount of the required retention, but by the injury, loss, or prejudice to the surety due to the government's failure to implement the required retention.


National Surety argued at trial that, based on principles of suretyship and the doctrine of subrogation, it was entitled to the retainage security that was required to have been withheld from the contractor. We agree that this is the appropriate theory of liability. The Supreme Court explained the subrogation right in an early case concerning retainage in a construction contract with the government:

[The surety's] right of subrogation, when it became capable of enforcement, was a right to resort to the securities and remedies which the creditor (the United States) was capable of asserting against its debtor, had the security not satisfied the obligation of the contractors; and one of such remedies was the right, based upon the original contract, to appropriate the 10 per cent. retained in its hands. If the United States had been compelled to complete the work, its right to forfeit the 10 per cent., and apply the accumulations in reduction of the damage sustained, remained. The right of [the surety] to subrogation, therefore, would clearly entitle him, when, as surety, he fulfilled the obligation of [the contractor] to the government, to be substituted to the rights which the United States might have asserted against the fund.

Prairie State Nat'l Bank v. United States, 164 U.S. 227, 232-33, 17 S.Ct. 142, 144, 41 L.Ed. 412 (1896). See also Balboa Insurance, 775 F.2d at 1161 (discussing the equitable doctrine of subrogation as applied to a bonded government contract).

The retainage provision in a bonded construction contract serves to protect the surety as well as the government, and...

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