American Insurance v. Heritage Construction Corp. (268 F. Supp. 336, 1965)

MEMORANDUM OF DECISION

SWEIGERT, District Judge.

Plaintiff, the American Insurance Company, a New Jersey corporation engaged in the business of issuing construction faithful performance and mechanics’ lien surety bonds in California, commenced this action on May 1, 1964, against defendants, Heritage Construction Corporation and others, residents of California engaged in the improvement of certain real property in San Mateo County, for a decree declaring that plaintiff has no liability to defendants under a certain surety bond hereafter mentioned, and that defendants are liable to plaintiff for any sums plaintiff may be required to pay thereunder to labor, material or subcontractor claimants.

Jurisdiction is invoked under the diversity jurisdiction of this Court.

The case is before the Court following a trial by the Court of the issues raised by the pleadings and by a pre-trial order filed herein August 6, 1965.

The following facts are either undenied or found by the Court from the evidence in the case:

On August 16, 1962, defendants entered into a contract (Plaintiff’s Ex. 2) with Ervin P. Yarwig whereunder Var-wig undertook to construct certain offsite improvements on a real estate tract in San Mateo County known as Mills Estate No. 24.

The Contractor, Varwig, had furnished a contractor’s surety bond dated August 15, 1962 (Plaintiff’s Ex. 1) issued by plaintiff herein, for Varwig’s faithful performance of the construction contract and for his payment of all labor, material and subcontractor’s claims on the job.

Varwig commenced work on August 16, 1962 and physically completed his work in December, 1963. On March 25, 1964, defendants received information to the effect that one of Varwig’s subcontractors intended to file a mechanics’ lien and subsequently received similar information from other subcontractors and materials men.

By letter of March 31, 1964, defendants gave notice to plaintiff surety company that the contractor had defaulted in his payment of labor, material and subcontractor claims. A similar letter notice, dated April 3, 1964, was delivered by hand to plaintiff on that date.

By May 1, 1964, it was discovered that a total of $115,000 of labor, material and subcontractor claims for work on the job remained unpaid by Varwig.

Plaintiff surety company refused to acknowledge liability for these claims.

Instead of paying them, plaintiff commenced this action alleging in substance and effect that defendants had failed to comply with the terms and conditions of the surety bond in that: (1) Defendants and Varwig did not abide by the terms of the construction contract, as required by the surety bond, but instead altered the terms of the construction contract in that premature payments were made by defendants to Varwig; (2) Defendants failed to notify plaintiff of the default of Varwig within the time required by the surety bond.

Disposing first of plaintiff’s contention that defendants failed to give notice of Varwig’s default within the time provided by the surety bond, the evidence so clearly establishes that defendants did give timely notice that plaintiff has not bothered to pursue in post trial briefs its contention to the contrary.

The Court, therefore, finds from the evidence that defendants did on March 31, 1964, and on April 3, 1964, give written notice of the principal’s (i. e., Var-wig’s) default and that said written notice was given as promptly as possible and also within ten days after such default became known to defendants or to their representatives authorized to supervise performance of the construction contract — -all within the meaning of and in compliance with Condition First of the surety bond.

Plaintiff’s next contention is that defendants did not abide by the terms of the construction contract, as required by the surety bond, in that certain progress payments were prematurely made.

Condition Second of the surety bond issued by plaintiff (Plaintiff’s Ex. 1) provides as follows:

“Second: That the Owner shall faithfully perform all of the terms, covenants and conditions of such contract on the part of the Owner to be performed; and shall also retain the last payment and all reserves and deferred payments until the complete performance of said contract, and until the expiration of the time within which notice of claims or claims of liens by persons performing work or furnishing materials, appliances, teams or power under said contract may be filed, and until all such claims shall have been paid, unless the Surety shall consent, in writing, to the payment of said last payment, reserves or deferred payments.”

The construction contract (Plaintiff’s Ex. 2) provides under General Conditions, p. 10, Section VIII, Par. 2, as follows:

“PARTIAL PAYMENTS: It is hereby stipulated and agreed that the First Party shall once each month cause an estimate in writing to be made by the Engineer of the total amount of work done at the time of such estimate, and the value thereof. The First Party shall retain ten per cent (10%) of such estimated value as part security for the fulfillment of this Contract by Contractor, and shall monthly pay to the Contractor the remaining ninety per cent (90%), after deducting therefrom all previous payments and other sums to be retained under the terms of this Contract. No estimate or payment shall be made when, in the judgment of the Engineer, the work is not proceeding in accordance with the provisions of this Contract or when the total value of the work done since the last estimate amounts to less than one thousand dollars ($1,000).”

Plaintiff contends that, among the progress payments made to Varwig (See Plaintiff’s Ex. 4), a payment of $64,750.-95 to the Contractor on October 31, 1962, was a premature payment and a departure from the construction contract in that it was not a “once each month” payment, as required by the contract, because the work started on August 16, 1962; Varwig received a first payment of $21,798 on September 14, 1962, a second payment of $56,282.40 on October 17, 1962 and this third payment of $64,-750.95 less than a month (i. e., 14 days) thereafter.

The evidence shows, however, that none of these three payments exceeded 90% of Varwig’s progress billings and that, in fact, after the October 31, 1962 payment, the accumulated retentions were still far in excess of the required 10% retention.

The absurdity and extreme technicality of this contention are manifest when one observes that the October 31st payment might even have been properly made concurrently with the previous October 17th payment without reducing the progress retention below the required 10%.

The Court holds and finds that neither this October 31st payment, nor any of the other progress payments made by defendants, substantially altered or breached the construction contract. Plaintiff next contends that defendants failed to retain 10% of all progress payment claims presented by Varwig, as required by the same Section VIII, Par. 2 of the construction contract, in that defendants retained 10% of only the original unit bid amounts and did not retain »

Cal.Civ.Code § 2821 provides: “The rescission of an agreement altering the original obligation of a debtor, or impairing the remedy of a creditor, does not ' restore the liability of a surety who has been exonerated by such agreement.”

In Pacific Coast Eng’r Co. v. Detroit Fid. & Sur. Co., supra, the Court considered the question of a premature payment made to a contractor and, after a review of the California cases, held that in this particular case the payment did exonerate the surety.

The Court in the Pacific Coast case, supra, however, distinguished cases in which the alleged premature payment is one upon which the plaintiff is relying and dependent upon for a recovery against the surety, and cases in which the plaintiff is not so relying or dependent. The Court in Pacific Eng’r Co. v. Detroit Fid. & Sur. Co., supra, thus distinguishes such cases as Bateman Bros, v. Mapel, 145 Cal. 241, 78 P. 734 (1904); Dunne Inv. Co. v. Empire State Sur. Co., 27 Cal.App. 208, 150 P. 405, 411 (1915); Mazzera v. Ramsey, 72 Cal.App. 601, 238 P. 101 (1925).

It is therefore, California law that, where the owner’s action is not predicated on an advance made to the principal, the payment is deemed to have been made outside the terms of the contract and not to constitute an alteration of the principal’s obligation and that in such case the surety is exonerated only if the payment has injuriously affected the surety’s rights. 46 Cal.Jur.2d Suretyship & Guaranty § 93.

In Bateman Bros. v. Mapel, 145 Cal. 241, 78 P. 734 (1904) the Court made clear the distinction between payments made under the contract and mere advancements of money to the contractor outside the terms of the contract stating at 244, 78 P. at 736:

“Thus the question whether the advancements made by Bateman Bros, were or were not within the strict terms of the contract could only affect the surety if, in fact, they were improperly made, and if a recovery was sought against the surety because of them, or because of some other change in its condition because of them. But such is not this action. Plaintiff does not plead the payments. He bases no claim for a recovery upon them, and the surety can avail himself of them to defeat a recovery only if the making of them has prejudiced him * *

In the pending case Varwig testified, concerning the February 28, 1964 $40,-000 payment, that he told Boone, Secretary-Treasurer of defendants, that he had done his job and needed the money and that Boone gave him a check. The evidence further shows that this check, unlike other payments to Varwig, made no reference to any particular bill, statement or invoice.

Boone, and also the witness Cook, testified that this payment was an advance to Varwig out of defendants’ general funds; that it was not made out of the retention fund which, in fact, remained on hand for defendants’ account with its lending agency, Citizens Federal; that this retention fund still remained on hand, so far as the relationship between defendants and plaintiff surety company is concerned, and, that defendants acknowledged that it must be applied to lien claims.

Upon the evidence, the Court finds that the $40,000 payment of February 28, 1964, was a payment outside the construction contract, rather than an alteration or breach of it or a prepayment exonerating the surety within the meaning of the law of California.

For another, separate reason this $40,-000 payment should not be held, under California law, to completely exonerate the surety. One of the reasons for the rule that premature payments exonerate the surety is that such payments eliminate or reduce the incentive of the contractor to complete the job. Calvert v. The London Dock Co., 2 Keen 638 (1838); U.Pa.L.Rev. 842 (1932); Simpson, Suretyship § 78 (1950); 20 Calif. L.Rev. 571 (1932). This may be true with respect to premature payments during performance of the contract and this rule of Calvert v. The London Dock Co., supra, has been applied in that kind of case. Such was the situation in the cases relied on by plaintiff, e. g., Pacific Coast Eng’r Co. v. Detroit Fid. & Sur. Co., supra; County of Glenn v. Jones, supra; Phoenix Indem. Co. v. Nicholas, supra.

In the pending case, however, defendants do not seek to hold that surety company on its assurance that the contractor would faithfully complete the job. Var-wig had completed the job two months before the $40,000 payment.

Assuming his further obligation to also pay his laborers, material men and subcontractors, the question whether further withholding of a final payment from a contractor, who has physically completed his job, is an incentive to the contractor to pay off outstanding labor, material men and subcontractors, is questionable to say the least. The result of any such withholding is generally to the contrary, especially when the contractor is not in a financial position to pay off his laborers, material men or subcontractors until he had the final payment funds in hand.

When a surety bond assures, as in this case, not only faithful performance of the work by the contractor, but also payment of mechanics’. lien claims, the purpose of requiring further retention by the owner, after faithful performance of the job, of a stipulated amount until expiration of lien time is, not to provide an incentive to the contractor to pay off lienable claims himself, but to give the owner and the surety company an agreed amount of financial security for that purpose in case the contractor does not pay them off.

From an examination of California law we conclude that it has not been held, and will not be held, that a premature payment or advance from the lien period retention fund after the job has been fully completed, completely exonerates the surety. In such situation, under California law as well as the law of the great majority of states, the effect of the premature advance from the retention fund could at most exonerate the surety only to the extent of the premature release of the security fund which the surety stipulated should be kept on hand pending the lien filing period. The owner, in such case, would have to reimburse the retention fund.

However, it is not necessary to rest our holding in this case upon that ground. For, this Court has found that defendants did not disburse the $40,000 from the required security fund and that such fund is now available to plaintiff surety company; that defendants merely made an advance outside the contract which, unless it can be recovered from Varwig, will be an out of pocket loss only to defendants — not to plaintiff surety company which has the full benefit of the agreed 10% security fund — $68,785.

Defendants will prepare, serve and lodge with the Court findings of fact, conclusions of law and a judgment in accordance with the views herein set forth.

ORDER

On December 22, 1965, this Court filed its Memorandum of Decision holding that defendants did not substantially alter or breach the terms and conditions of a surety bond issued by plaintiff, and therefore, plaintiff was liable to defendants upon said bond. The Court, however, found that the plaintiff was entitled to a retention fund of 10 per cent of the “as built” cost or $68,785.00 as opposed to defendants’ contention that plaintiff was only entitled to a retention fund of 10 per cent of the basis upon which the bond was written or $64,100.-00.

In said Memorandum the Court did not rule on defendants’ request that attorneys’ fees in this action and in the defense and settlement of lien claims and lien foreclosure suits brought by unpaid subcontractors be awarded to it. Subsequent to the above decision, both parties have filed briefs at the request of the Court on the question of whether defendants are entitled to attorneys’ fees.

This Court has jurisdiction of the subject matter and the parties under the diversity jurisdiction of the Court, 62 Stat. 930 (1948), as amended, 28 U.S.C. Sec. 1332(a) (1) (1964). Defendants, however, contend that this Court can award attorneys’ fees, not only if California law so authorizes, but as an “inherent power” of this Court sitting in equity. Plaintiff on the other hand, contends that unless California law permits an award of attorney fees, such an award is not authorized.

ATTORNEYS’ FEES INCURRED IN THE DEFENSE AND SETTLEMENT OF LIEN CLAIMS

This Court is satisfied that California law allows the owner to recover attorneys’ fees incurred in defending against suits and settling claims which are a direct and proximate result of the contractor’s breach of his contract, and for which the surety had given a bond to indemnify the owner against any loss or damage arising by the failure of the contractor to faithfully perform his contract, and for the payment in full of the claims of all persons performing labor upon, or furnishing materials to be used in, the work. Tally v. Ganahl, 151 Cal. 418, 90 P. 1049 (1907); Bird v. American Surety Co., 175 Cal. 625, 166 P. 1009 (1917); Cohn v. Smith, 37 Cal.App. 764, 174 P. 682 (1918). See 46 Cal.Jur.2d Suretyship and Guaranty Sec. 69 (1959).

Accordingly, the Court grants defendants’ request for judgment against plaintiff for their attorneys’ fees incurred in the defense and settlement of lien claims. The Court requests defendants to first attempt to settle the amount of reasonable attorneys’ fees with plaintiff and them, if agreement is not reached, to submit it to the Court for a determination.

ATTORNEYS’ FEES IN THE INSTANT ACTION

As to whether defendants are entitled to attorneys’ fees incurred in the present action, defendants rely most heavily on the ground that this Court, sitting in equity, has the inherent power and should award them attorneys’ fees. The Court is satisfied that under California law defendants are not entitled to attorney fees. Viner v. Untrecht, 26 Cal. 2d 261, 158 P.2d 3 (1945). See 8 Cal. Jur.2d Bonds See. 88 (1959).

It is true that in a number of cases involving diversity jurisdiction, a federal court has awarded attorneys’ fees even though state law did not so provide. Palomas Land and Cattle Co. v. Baldwin, 189 F.2d 936 (9th Cir. 1951); Bank of China v. Wells Fargo Bank & Union Trust Co., 209 F.2d 467 (9th Cir. 1953); Angoff v. Goldfine, 270 F.2d 185 (1st Cir. 1959); Taussig v. Wellington Fund, Inc., 187 F.Supp. 179 (D.Del.1960).

The basis of such an award appears to be that in a suit in equity, where the taxation of such costs is essential to the doing of justice, they may be allowed in exceptional cases. Assuming that this Court does have the inherent power to award attorneys’ fees incurred in this action, it is the opinion of this Court that it is not essential to the doing of justice that defendants be granted their attorneys’ fees. The Court is of the opinion that the bringing of this suit by plaintiff was not in bad faith, vexatious or exceptional. And, on one point, the size of the 10 per cent retention fund, the Court ruled in favor of plaintiff.

Accordingly, it is the conclusion of the Court that defendants not have judgment against plaintiff for their attorneys’ fees incurred in the instant action.

. Pending this litigation the plaintiff surety company paid out the sum of $61,900 on account of lien claims but said payment was made under stipulation that it was without prejudice to its rights asserted herein. Pending the litigation, defendants have either paid or.settled lien claims in the amount of $20,483. There are still known, unpaid lien claims in the amount of approximately $3,500.