In advancing a meritorious claim for overpayment against the federal government, a surety must consider the Federal Circuit’s relatively recent decision in Lumbermens Mutual Casualty Company v. United States, 654 F.3d 1305 (Fed. Cir. 2011), which purports to restrict the surety’s ability to assert overpayment as an affirmative claim in the federal arena.  While the long-term impact of the Lumbermens decision on the surety’s potential claims and defenses remains to be seen, in the interim, the surety is advised to carefully consider the court’s holdings in developing its strategy for pursuing a potential overpayment claim, immediately upon the appearance thereof, and in subsequently framing any resulting claims for litigation.

In Lumbermens, the Navy contracted with Landmark Construction Company (“Landmark”) for the repair and renovation of 160 military family housing units.  Pursuant to the Miller Act, Lumbermens Mutual Casualty Company (“Lumbermens”), as surety, issued payment and performance bonds in connection with the project, naming Landmark as bond principal and the United States as bond obligee.  When Landmark abandoned the project, the Navy terminated the principal for default.  As of the termination date, Landmark had only completed 12% of the housing units.  At that point, however, the Navy had already paid out 40% of the contract price to Landmark, creating a significant disparity between the amount of contract funds disbursed and the amount of work actually performed, giving rise to an overpayment claim by the surety.

Following the principal’s default, the United States made a demand upon Lumbermens’ performance bond for completion of the work.  Thereafter, Lumbermens entered into a takeover agreement whereby Lumbermens agreed, in accordance with its bond obligations and under a reservation of its rights, to undertake completion of the project through a replacement contractor, with whom the Navy and Lumbermens entered into a takeover agreement.

Lumbermens subsequently filed suit against the United States under the Tucker Act, seeking recovery of damages incurred in performing and completing the contract work.  The surety advanced three theories of recovery, two of which presented alternative theories of recovery on its affirmative overpayment claim, one under the doctrine of equitable subrogation and the other under the doctrine of impairment/pro tanto discharge.  Under both theories, Lumbermens argued that the Navy made improper overpayments to Landmark in violation of FAR provisions related to payment that were incorporated in the underlying contract.  Id. at 1309.  Specifically, under the contract, Landmark was required to submit certain schedules tracking progress and where the contract funds would be spent.  However, the Navy paid Landmark without enforcing the payment provisions of the contract.  The Navy’s failure to enforce these contractual conditions precedent dissipated the contract funds – the surety’s collateral.  In addition to its overpayment claims, Lumbermens asserted a contract claim based upon the Navy’s improper withholding of contract funds as liquidated damages, which Lumbermens contended were the result of delays attributable to the Navy and otherwise pertained to work that was not covered under Lumbermens’ bond.

In response to Lumbermens’ lawsuit, the Navy filed a motion to dismiss, alleging lack of jurisdiction over the equitable subrogation and impairment of suretyship counts. Id. at 1309-10.  The Navy also moved to dismiss the breach of contract claim, alleging that Lumbermens had failed to meet the jurisdictional prerequisites of the Contract Disputes Act (“CDA”).  Id. at 1311.  The Court of Federal Claims dismissed Lumbermens’ equitable subrogation claim on the grounds that Lumbermens had failed to notify the Government of Landmark’s default prior to the Navy’s alleged overpayments.  See Lumbermens Mut. Cas. Co. v. United States, 67 Fed. Cl. 253, 255 (2005) (citations omitted).  Nonetheless, the trial court subsequently awarded damages to Lumbermens on its alternative impairment of suretyship/pro tantoclaim, finding that the Navy’s overpayments impaired the surety’s collateral.  Id.  The court also awarded damages to the surety on its breach of contract claim, concluding that the jurisdictional prerequisites of the CDA – in particular, a certified claim to the Contracting Officer, were inapplicable to Lumbermens’ claims arising from a takeover agreement, which Lumbermens had entered in its capacity as a surety.  Id. at 1311.  The Navy appealed the determinations on Lumbermens’ impairment of suretyship/pro tantodischarge and breach of contract claims on jurisdictional grounds, and Lumbermens cross-appealed on its equitable subrogation claim.

Lumbermens On Equitable Subrogation

On its cross-appeal, Lumbermens argued that the Court of Federal Claims independently had jurisdiction over its overpayment claim by virtue of Lumbermens’ status as an equitable subrogee.  Although the Federal Circuit acknowledged that the United States has waived sovereign immunity as to a surety’s claims arising from equitable subrogation, the court proceeded to reject Lumbermens’ argument, however, based upon the surety’s failure to notify the Navy that Landmark was approaching default and/or that the Navy should withhold or divert progress payments.  In doing so, the Federal Circuit held that “[e]quitable subrogation can be used to recover improper payments to a principal obligor only if made after the obligee received notice of the principal obligor’s default.”  Lumbermens, 654 F.3d at 1312.

The latter conclusion is arguably inconsistent with the Federal Circuit’s prior decision in National Surety Corp. v. United States, 118 F.3d 1542 (Fed. Cir. 1997) and other authorities which have consistently acknowledged a surety’s equitable subrogation rights without imposing any notice requirements upon the surety.  See, e.g., Pearlman v. Reliance Ins. Co., 371 U.S. 138 (1962); Henningsen v. United States Fid. & Guar. Co., 208 U.S. 404 (1908); Prairie State Nat’l Bank v. United States, 164 U.S. 227 (1896).  Nonetheless, the surety’s affirmative overpayment claim against the federal government, at least when premised upon equitable subrogation, will be best postured where it seeks to recover payments madeafter the surety has provided notice to the government of its principal’s actual or likely default and/or a request that the government withhold or divert funds from the principal.

Lumbermens On Impairment Of Suretyship/Pro Tanto Discharge

As to Lumbermens’ impairment of suretyship/pro tanto discharge claim, the Federal Circuit ruled that the United States had not waived sovereign immunity as to the surety’s impairment or pro tanto discharge claims.  The court reasoned that any affirmative right of recovery for overpayments must stem from a state law cause of action based upon an implied-in-law or quasi-contract theory and that the Act does not waive sovereign immunity over contracts that are implied in law or quasi-contractual claims such asquantum meruit.  Id. at 1316.  Therefore, the court concluded that it lacked jurisdiction to consider an implied-in-law contract theory against the Navy.  Id. at 1314.

In reaching this conclusion, the court acknowledged that impairment/pro tanto discharge may be assertedas a defense to the government’s claim under the bond.  Id. at 1314.  Thus, the court determined, “[i]f a surety concludes that the government has improperly impaired its collateral, the surety has the right to withhold payment on the bond, to the extent the surety has been prejudiced, based on the defense of impairment of suretyship/pro tanto discharge.”  Id. at 1319.

Given the Court’s holding, where possible, the surety should emphasize that its overpayment claim arises directly from the government’s breach of an express contract provision.  Alternatively, a surety should determine the extent of the government’s liability for any overpayment prior to agreeing to complete; and if it elects to do so, the surety should consider including a provision in the takeover agreement that obligates the government to pay over, or deduct from the remaining completion obligation, the amount of the surety’s losses sustained as a result of overpayment.

Lumbermens On Breach Of Contract Claims Following The Execution Of A Takeover Agreement

As to the surety’s breach of contract claim, the United States argued that the Court of Federal Claims lacked jurisdiction over the surety’s claim because the surety failed to submit a certified claim to the Contracting Officer as required by the CDA.  Id. at 1318.  Lumbermens, which had brought all of its claims under the Tucker Act, argued that to the extent its claims arose from the takeover agreement, they did not fall under the purview of the CDA because Lumbermens expressly entered into the agreement in  its capacity as a surety rather than as a “contractor” and because the takeover agreement did not directly provide for construction services by Lumbermens.  Id. at 1318-19.  While the Court of Federal Claims agreed with Lumbermens, the Federal Circuit rejected this argument.  The appellate court held that a takeover agreement in which the surety obligates itself to undertake completion of the project in accordance with its bond obligations—even where it purports to disclaim any notion that the surety is acting as a “contractor” and instead identifies a separate replacement contractor that is also a party to the takeover agreement—makes the surety a “contractor” for purposes of the CDA and that the takeover agreement constitutes a contract for the procurement of construction services under the CDA.  Id.  As such, the Court ruled that Lumbermens could not bring its claims arising from the takeover agreement under the Tucker Act, but needed to bring them under the CDA after fulfilling all statutory prerequisites.  The court further held that any claims of the surety arising after the execution of a takeover agreement must proceed under the CDA because at that point, the surety became a “contractor” under the Act.  Id.at 1321.

Accordingly, the surety is advised to comply with all prerequisites of the CDA, including for example, the submission of a certified claim for final decision by the contracting officer, prior to initiating any litigation against the government involving claims arising after its execution of a takeover agreement.

In sum, while the Lumbermens decision certainly creates some obstacles to the surety’s ability to assert overpayment claims, the doctrine of sovereign immunity does not bar such claims when based upon a theory of equitable subrogation (provided that the obligee had notice of the default prior to issuing the alleged overpayments) or the assertion of impairment/pro tanto discharge as a defense to liability on the bond.  Thus, while the surety’s ability to recover overpayments has certainly been made more difficult byLumbermens, through careful planning, the vigilant and prudent surety may still be able to obtain a remedy.