Surety companies have increasingly relied upon equitable subrogation claims as a way of recovering damages they incur in completing construction projects for defaulting principals. Unfortunately, very little treatment has existed in Ohio case law defining the procedure by, and the extent to which, such claims can be litigated. The Ohio Court of Claims’ decision in the case of Jutte v. Ohio Facilities Constr. Comm., 2017-Ohio-2697, provides Ohio practitioners with some much needed guidance for pursuing, as well as defending, such claims.
Equitable subrogation is the doctrine that allows one who pays the debt of another to be substituted to the rights of the debtor. In the construction context, sureties that are called upon to finance or perform construction on behalf of a defaulted contractor-principal frequently prosecute claims based on this theory to recover unpaid contract balances owed to the defaulted principal and, in appropriate circumstances, to pursue claims of the owner against third parties whose negligence or willful conduct has made them liable to the owner for the same default.
Jutte was an electrical prime contractor to the state of Ohio that encountered significant financial difficulties shortly after the project commenced, was unable to complete the job and filed for bankruptcy. Jutte’s surety agreed to complete the project by funding Jutte to complete the work. After incurring significant uncompensated losses of nearly $1 million in completing the work, the surety ultimately filed claims against the owner/state of Ohio alleging that pursuant to the doctrine of equitable subrogation it was allowed to step into the shoes of Jutte and had standing to file claims to recover the alleged losses.
The matter was tried in the Ohio Court of Claims to a magistrate judge. The magistrate issued an extensive decision including findings of fact and conclusions of law that, in turn, were all adopted by the court as its own. Regarding the doctrine of equitable subrogation, the court found that a surety may satisfy its obligation to complete performance or finance the obligee’s completion in various ways, for example:
- By formally taking over the project.
- By allowing the project to be defaulted and letting the government contract for completion.
- By providing funds to an insolvent contractor to complete performance.
Significantly, the magistrate held that regardless of the methodology used by a surety to satisfy its obligation, the surety nonetheless has a duty to sufficiently investigate the claim before deciding which method to employ. The court found that at the very least a surety should thoroughly investigate its underwriting file, interview its principal (contractor) and review its files, investigate the owner and review any materials that demonstrate problems on the project. Once a surety agrees to complete the work (or fund the principal), the surety assumes the risk of hidden conditions or other problems that might develop in the completion process.
Applying these principles, the magistrate concluded Jutte’s surety failed to:
- Review the underwriting file.
- Visit the construction site.
- Evaluate the equipment and personnel qualifications of the principal contractor.
- Examine photographs of the work.
- Hire an architect to review plans or a scheduling expert to evaluate the quality of the schedules.
- Evaluate usage of projected labor to date.
- Consider or evaluate proposals for completion obtained from substitute contractors.
The magistrate further concluded that the damages the surety incurred were a direct and proximate result of its negligence in failing to properly investigate the project alternatives and not the direct and proximate result of any error or omission committed by the owner, the architect or the construction manager.
The magistrate also defined the rights the surety gained by virtue of the assertion of an equitable right of subrogation. The court confirmed this right entitled the surety to “step into the shoes” of its principal to recover any funds owed to it by the owner (state of Ohio). In Jutte, the surety claimed that the right to “step into the shoes” of the principal also gave it something more, i.e., the ability to file separate, additional claims on behalf of the principal against the owner. In rejecting that claim, the magistrate concluded that the surety had provided no authority supporting its claim that by virtue of its decision to fund its bankrupt principal, as opposed to formally taking over the project, the surety obtained the rights of the principal to bring claims against the owner.
The Jutte decision may encourage parties defending claims based upon equitable subrogation to do a “deep-dive” inquiry into the investigation performed by the surety. Sureties might expect increased criticisms of their investigations as a method of eliminating their standing to pursue equitable relief. The lesson to sureties from the Jutte decision is that great care should be taken to properly investigate the circumstances attendant a principal’s default on a construction project if equitable subrogation claims are anticipated.