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Monday 30th of July 2012

SURETY’S RIGHTS
Surety on Construction Project Is Not Discharged When Contractor’s Payment to Owner Is Applied by Owner to Money Contractor Owed on Prior Project

The construction project was undertaken here by contractor K for a school district (plaintiff P).  As their agreement required, K secured a performance bond from defendant D, a surety, incorporating the terms of the construction contract.  While the project was under way, P got a notice from the labor department (DOL) requiring P to withhold money to cover sums owed by K on a prior project, unrelated to the present one.  DOL later authorized P to release those moneys to K, except for $214,000 that P was to forward to DOL to satisfy K’s earlier debt.  P did forward it, with K’s president agreeing to it. 

Progress by K on the project was then so slow that P terminated and turned to the surety, D, to complete the project.  D refused, resulting in this breach of contract action.  D defended on the ground that Article 3-A of the Lien Law made all of the moneys payable to K a trust fund to cover claims by others that might arise out of this project and that P’s payment of the money to the DOL on an unrelated project was a breach that canceled the surety obligation. 

Did this payment towards K’s prior obligations release D’s surety commitment?  In an opinion by Judge Ciparick for the majority, a divided Court of Appeals says no in Mount Vernon City School District v. Nova Casualty Co., 19 N.Y.3d 28, 945 N.Y.S.2d 202 (April 3, 2012; 5-2 decision).  The payment did not commit surety D to pay so much as “a dollar more than that amount for which it bonded” contractor K, the Court says.

The dissent, written by Chief Judge Lippman, disagrees.  Answering the majority’s view that the Lien Law violation here was “irrelevant”, it says that, on the contrary, “it matters a great deal”.  The dissent sees the majority as relying on the fact that the surety did not undertake to complete the project when school district P demanded it.  D didn’t have to under these circumstances, says the dissent, adding that, anyway, D is not claiming here “as a completing surety”; it is asserting surety rights “that are enforceable well before any possibility of completion arises”. 

Early in the majority opinion, language in the surety bond itself is quoted, to the effect that

[t]he Surety shall not be liable to the Owner or others for obligations of the Contractor that are unrelated to the Construction Contract.

The majority apparently does not see that language as relevant to the application of the money to the third-party debt incurred by K in this case.  The dissent does, however, arguing that the surety sought, with that language, to insulate itself from extrinsic obligations of the contractor.  The $214,000, it says, was earned by K “as a progress payment” and that its diversion to another of K’s creditors violates the performance bond’s prohibition against

reducing or setting off the balance of the contract price for any of [K’s] unrelated obligations. 

As soon as P diverted those funds – even to the DOL – in satisfaction of K’s obligation on a different project, the risk arose that K “would run out of money prior to finishing” the present job and thus be less likely to be able to finish it.  This was an encroachment on D’s interest as surety and barred any claim by P against D for breach of contract.  Hence the dissent would dismiss P’s action.

The Lien Law article applicable here, Article 3-A, was designed to bar the practice of “pyramiding” in the construction industry.  The dissent sees its aim as violated here if the money directed into a trust for those working on the present project is applied to an obligation incurred on a different project.  The majority dismisses this reference to pyramiding as somehow suggesting that the majority thinks P could insulate itself from a proper demand by present-project beneficiaries.  There could be no such insulation, the Court says; P would still have to pay such a demand

The dissent relies heavily on the Court’s 2002 RLI decision (Digest 508), involving a similar Article 3-A trust.  The Court there said that such a trust exists for as yet unpaid workers and suppliers even “before funds are actually due and earned by a contractor”, and that, as a trust, its funds can’t be touched by any but its designated beneficiaries, not even for wages unpaid on another project that the contractor may have undertaken with the owner. 

New York State Bar Association Publication, July 24, 2012.  Editor:  DAVID D. SIEGEL