Island Insurance v. Hawaiian Foliage & Landscape, Inc.

288 F.3d 1161

• Court: Court of Appeals for the Ninth Circuit
• Decided: May 3, 2002
• Docket: Nos. 00-16874, 00-16940
• Status: Published

Opinions

BERZON, Circuit Judge.

The question in this case is whether the government is an intended beneficiary, for the purpose of securing the payment of taxes due, of the surety bond that insured a subcontractor’s performance. Parties to surety contracts are free, of course, to choose whether or not to insure for tax obligations. We interpret the language of the contract in this case to have done so, and therefore hold that both the state and federal governments are intended beneficiaries of the surety contract to the extent of the subcontractor’s past due tax obligations.

BACKGROUND

Oahu Construction Co. (“Oahu” or “obli-gee” or “prime contractor”) contracted with the City and County of Honolulu to build a golf course. Oahu subcontracted some landscaping work to Hawaiian Foliage & Landscape, Inc. (“Hawaiian” or “subcontractor” or “principal”). Plaintiff-appellee Island Insurance Co. (“Island” or “the surety”) issued a “Subcontractor’s Performance and Payment Bond” (“the bond”) to insure Hawaiian’s performance. Hawaiian was required by its contract with Oahu (“the subcontract”) to obtain such a bond. The bond named Hawaiian as principal and Oahu as obligee and was for the amount of $2,698,787, the amount to be paid for work performed under the subcontract.

Hawaiian eventually defaulted on the subcontract, and Island paid various of Hawaiian’s obligations. Island refused, however, to pay the subcontractor’s tax debts. Instead, Island sought a judgment declaring that it is not liable under the bond for employment taxes owed to the United States and to Hawaii (“the governments”). The governments filed counterclaims demanding the unpaid taxes. With penalties and interest, these counterclaims amount to $426,039 by the United States and $133,259 by Hawaii. All the parties moved for partial summary judgment on the issue of the surety’s liability.

The district court granted the surety’s motion, finding that the governments were not intended beneficiaries of the bond and therefore the surety was not liable for the subcontractor’s unpaid taxes.

DISCUSSION

The Appropriate Inquiry

As this case is before us on summary judgment, we review the judgment de novo. Branco v. UFCW-Northern California Employers Joint Pension Plan, 279 F.3d 1154, 1156 (9th Cir.2002). Here, the pivotal question is one of contract interpretation.

Federal courts look to state law to construe common law surety contracts. Mai Steel Serv., Inc. v. Blake Constr. Co., 981 F.2d 414, 420 (9th Cir.1992). In construing contractors’ bonds, Hawaii law applies traditional principles of contract interpretation. See Van Dusen v. G.S. Shima Contracting, Inc., 4 Haw.App. 261, 664 P.2d 753, 754 (1983). Under those traditional contract principles, “the terms of a contract should be interpreted according to their plain, ordinary and accepted use in common speech, unless the contract indicates a different meaning.” Pancakes of Hawaii, Inc. v. Pomare Properties Corp., 85 Hawai’i 300, 944 P.2d 97, 102 (App.1997) (internal citations and quotation marks omitted). Barring ambiguity, then, our focus should be on the contractual language.

The Contracts’ Language

Appellants make a simple and convincing argument from the texts of the subcontract and bond. The subcontract mentions taxes in two places. The first sentence of Article I states: “Subcontractor agrees to pay in full for all labor, materials, equipment, supplies, superintendence, insurance, taxes, and other items used in, upon, or for the work called for in this Agreement.” (Emphasis added). Article XIV states:

“Subcontractor agrees to pay any and all taxes and contributions for unemployment insurance, old age retirement benefits and life pensions and annuities which may now or hereafter be imposed by the United States or any state or local government wpon any wages, salary or remuneration paid to persons employed by subcontractor or otherwise, for the work required to be performed hereunder. Subcontractor shall comply with all Federal and State laws on such subjects, and all rules and regulations promulgated thereunder, and shall maintain suitable forms, books and records and save OAHU harmless from the payment of any and all such taxes and contributions, or penalties. Subcontractor agrees to pay any and all taxes, excises, assessments or other charges levied by any governmental authority on or because of the work to be done hereunder, on any equipment, supplies, materials, freight, or other matter used in the performance thereof.” (Emphasis added).

It is apparent from these two passages that the subcontract required the subcontractor to pay its payroll taxes.

The bond states:

“Now, therefore, if the said Principal [Hawaiian] shall duly and truly perform and complete said subcontract and pay for all materials used in the performance of same and shall hold the said Obligee [Oahu] free and harmless from and against all claims for any and all labor and materials used in the performance of said subcontract, which may or shall arise by reason of the failure of the said Principal to furnish, deliver and pay for any and all labor and materials in connection with the said subcontract, then this obligation shall be null and void; otherwise to remain in full force and effect.” (Emphasis added).

The bond’s language is archaic and awkward. As we read it, the bond lists three conditions in parallel, the breach of any of which will create an obligation on the part of the surety. The first of these conditions incorporates the entire subcontract: “Principal shall duly and truly perform and complete said subcontract.”¹ So, taken together, the texts of the two contracts do designate the payment of federal and state taxes as one of the bond’s conditions for discharge. The subcontractor was bound to pay its taxes, the surety insured the subcontractor’s obligations under the subcontract, and so the surety is now bound to pay the taxes the subcontractor defaulted upon.

Once we accept that the surety was bound to cover the subcontractor’s tax obligations, it follows that the federal and state governments are intended beneficiaries of the surety contract. Under the Restatement (Second) of the Law of Contracts² an individual or entity is an intended beneficiary of a contract if “recognition of a right to performance in the beneficiary is appropriate to effectuate the intention of the parties and either (a) the performance of the promise will satisfy an obligation to the promisee to pay money to the beneficiary or (b) the circumstances indicate that the promisee intends to give the beneficiary the benefit of the promised performance.” Restatement (Second) of Contracts § 302(1) (1979 Main Vol.).

Term (a) applies in this case. Island, the promisor, has promised to ensure the performance of the subcontract entered into by Hawaiian, the promisee. That subcontract includes a commitment to pay taxes. Island will therefore “satisfy an obligation to the promisee to pay money to the beneficiary” by paying Hawaiian’s unpaid taxes. And because the governments are intended beneficiaries, “a direct action by beneficiary against promisor is normally appropriate to carry out the intention of promisor and promisee.” Restatement (Second) of Contracts § 302 Comment b. On this view, the governments are in an analogous position to that of other creditors — those that supplied materials, for example — who would suffer from the subcontractor’s default.³

The Contracts’ Purpose

One of Island’s arguments to the contrary is based not on the text of the contracts but on assertions concerning the purpose of surety bonds. Island maintains that the bond’s primary beneficiary is the contractor, and the contractor is not liable for the subcontractor’s unpaid taxes, so the government cannot be a third-party beneficiary to the bond.

A Tenth Circuit case, United States Fidelity & Guaranty Co. v. United States, 201 F.2d 118, 120 (10th Cir.1952), did rely on similar reasoning, noting that an employer’s duty to pay taxes is his alone, and concluding from that premise that the surety and bond did not confer that obligation. There are, however, certain circumstances under which a third party can be held liable for unpaid withholding taxes, see 26 U.S.C. § 3505(a) & (b) and Haw. Rev.Stat. § 235-61(a)(3)(B), although these statutory provisions apply only when the third party either pays wages directly or controls the payment of wages. The taxes sought in this case, however, accumulated at a time when Hawaiian controlled its funds and payment of wages.

The premise that the contractor was not liable for the subcontractor’s unpaid taxes in this case is quite correct. But to rely on the way that the facts actually played out, giving short shrift to the actual language of the pertinent agreements, is to view matters from the wrong vantage point.⁴

First, it is worth keeping clear that the bond agreement is between the subcontractor and the surety. The bond is required of the subcontractor by the subcontract, and is presumably designed to satisfy the principal contractor’s interests. But these interests only inform the interpretation of the bond; it is the contractual language that ultimately controls. Whether or not there could have been any motive to designate the governments as intended beneficiaries is only relevant to the extent that it influences our contractual interpretation. That is to say, the complete absence of a motive might lead us to conclude that the contracts could not possibly mean what they seem to mean.

Second, the proper inquiry regarding potential tax liability should not have been whether the contractor could be held liable today, but rather whether, at the time of contracting, the possibility of unpaid taxes would have posed any threat to the contractor’s interests. If so, it seems that the parties to the bond could have reasonably intended to insure against the subcontractor’s potential future default, and there is no anomaly in reading the bond to have done so.

At the time of contracting, it could well appear to a principal contractor that the possibility that the subcontractor would not pay his payroll taxes would pose a threat to the contractor’s interests. A risk-adverse primary contractor could hypothesize several circumstances in which a subcontractor’s default on its tax obligations could wind up costing the primary contractor money.

For example, if the principal contractor were to assist the subcontractor in payment of wages at any point during the relationship, the contractor could be held liable under federal and state law for any unpaid taxes related to such wages. In United States v. Algernon Blair, 441 F.2d 1379 (5th Cir.1971), for example, a contractor made payroll advances to a financially strapped subcontractor and was held liable for withholding taxes under 26 U.S.C. § 3505(b). Viewed from the time of contracting, this is exactly the kind of occurrence that a cautious primary contractor would want to insure against in a surety bond.

Also, there is the possibility that tax authorities could seize either the assets of a defaulting subcontractor, precluding the subcontractor from completing the contract, or those assets of the primary contractor owed as payments to a defaulting subcontractor, impairing the ability of the primary contractor to complete the contract should the subcontractor fail to do so. The latter was the case in Wynne Co. v. Phillips Construction Co., 641 F.2d 205 (5th Cir.1981), which upheld an IRS levy on a contractor’s assets for the progress payments owed to a sub-contractor. Progress payments are also part of the subcontract agreement in this case.

Again, a careful primary contractor, intent upon assuring against all species of default by a subcontractor that could cause it financial loss, would want a sub-contractor’s bond to cover the subcontractor’s tax liabilities in order to avoid these possible outcomes.⁵

Our conclusion that there could well have been such a motive is not a claim about what the parties were actually thinking. In fact, there is some evidence in the record that neither of the parties gave any thought at the time of contracting to whether the bond would cover the subcontractor’s taxes. But such evidence is barred by Hawaii’s parol evidence rule, based on the “well-settled principle that an agreement reduced to writing serves to integrate all prior agreements and negotiations concerning the transaction into the written instrument which then represents the final and complete agreement of the parties.” State Farm Fire and Casualty Company v. Pacific Rent-All, Inc., 90 Hawai’i 315, 978 P.2d 753, 762 (1999). Accordingly, our ruling rests on the language of the contracts. The bond plainly incorporates the subcontract, which in turn covers the subcontractor’s tax obligations. To ignore the express contractual language would be to endanger the reliability and clarity of surety contracts.

Island also argues that because tax obligations arise at law (that is, they are created by statute) rather than by contract, such obligations just recite preexisting legal duties. Two appellate court cases with facts similar to the one before us found this consideration relevant. See United States v. Maryland Casualty Co., 323 F.2d 473, 475 (5th Cir.1963), United States Fidelity & Guaranty Co. v. United States, 201 F.2d 118, 119 (10th Cir.1952).

As discussed, however, there are reasons why parties might want to contract to insure the fulfillment of the tax obligations that arise under law; the legal obligation thereby becomes a contractual obligation as well. None of the cases cited suggests that parties should be disallowed from insuring such an obligation. So the definitive question remains one of contractual intent — what were the parties trying to do — for which the contract itself is most relevant.

Conflicting Precedents

Both parties cite cases, none of which is binding authority, which support their position. The governments rely largely on two appellate court cases. See United States v. Phoenix Indemnity Co., 231 F.2d 573 (4th Cir.1956) (holding sureties liable to the United States for tax obligations in a construction contract for which the sureties provided performance and payment bonds); Home Indemnity Co. v. F.H. Donovan Painting Co., 325 F.2d 870, 873-74 (8th Cir.1963) (holding surety liable for the tax obligations of a subcontractor where bond incorporated subcontract and subcontract specified tax obligations). These cases are indeed pertinent and persuasive, Island’s attempts to distinguish them notwithstanding.

Island invokes several cases. See, e.g., United States v. Maryland Casualty Co., 323 F.2d 473 (5th Cir.1963), United States v. Seaboard Surety, 201 F.Supp. 630 (N.D.Tex.1961), United States Fidelity & Guaranty Co. v. United States, 201 F.2d 118 (10th Cir.1952), United States v. Crosland Construction Co., 217 F.2d 275 (4th Cir.1954), Oklahoma Tax Commission v. Seaboard Surety Company, 327 F.2d 709, 711 (10th Cir.1964), Westover v. William Simpson Constr. Co., 209 F.2d 908 (9th Cir.1954). The general thrust of these cases is in accordance with Island’s position that the government is not an intended beneficiary with regard to surety bonds similar to the one in this case, and therefore the surety may not be held liable for the subcontractor’s tax obligations.

Some of the cases Island cites barred possible recovery because of contractual language not present in the contracts before us. See, e.g., United States v. Crosland Construction Co., 217 F.2d 275 (4th Cir.1954) (bond specified that “the principal shall promptly make payment to all persons supplying labor and material,” presumably without incorporating entire subcontract); United States v. Maryland Casualty Company, 323 F.2d 473, 476 (5th Cir.1963) (bond was specified to benefit “laborers, materialmen, and other creditors of the Principal whose indebtedness arises out of said contract,” and court held that Government was “not a creditor in the usual sense”); Oklahoma Tax Commission v. Seaboard Surety Company, 327 F.2d 709, 711 (10th Cir.1964) (bond assured payment to “claimants,” and a “claimant” was defined as “one having a direct contract with the Principal or with a subcontractor of the Principal who has furnished labor, material, or both”). Others of appellee’s authorities involved bonds entered into under the Miller Act, which protects only suppliers of labor and material. See 40 U.S.C. § 270a(a)(2), Westover v. William Simpson Constr. Co., 209 F.2d 908 (9th Cir.1954), United States Fidelity & Guaranty Co. v. United States, 201 F.2d 118 (10th Cir.1952).⁶ In any event, none of these authorities is binding upon us, and we are obliged to decide the case based on contract principles and the language the parties have chosen.

CONCLUSION

Relying on the plain language of the contracts in question, we hold that the state and federal governments are designated as intended beneficiaries of the surety bond. Parties are free, of course, to create surety bonds that do not insure for tax liabilities. They need only embody their intentions in the language of their contracts.

REVERSED.

1 . On our reading, the second condition is "pay for all materials used in the performance of same” and the third condition is "shall hold the said Obligee free and harmless from and against all claims for any and all labor and materials used in the performance of said subcontract, which may or shall arise by reason of the failure of the said Principal to furnish, deliver and pay for any and all labor and materials in connection with the said subcontract.”

2 . “[S]ince Hawaiian case law regarding contract interpretation is sparse, we will have to assume that a Hawaii state court would apply general contract principles. This assumption is justified by reference to the Restatement of Contracts in several Hawaii cases. In re Taxes, Aiea Dairy, Ltd., 46 Haw. 292, 380 P.2d 156 (1963); Kaiser Hawaii Kai Development Co. v. Murray, 49 Haw. 214, 412 P.2d 925 (1966). We will look to the Restatement (Second) of Contracts as a primary source for the most recent statement of these general principles.” United States v. Haas and Haynie Corp., 577 F.2d 568, 571 n. 1 (9th Cir.1978).

3 . The dissent offers no reason why suppliers of materials and labor, whose claims are mentioned explicitly in the bond language, are not intended beneficiaries of the bond. Indeed, Island did pay such suppliers directly after Hawaiian defaulted. The dissent’s only attempt to distinguish the governments from such suppliers is that it is more rare for a contractor to be liable for a subcontractor's unpaid taxes than it is for a contractor to be liable for a subcontractor’s unpaid-for supplies. As we will elaborate further below, it is for the parties to assess their risks.

4 . This is exactly the perspective adopted by the dissent. The dissent does not refute the possibility that a contractor could be held liable for a subcontractor’s unpaid taxes. The dissent only explains that Oahu did not turn out to be liable in this case. If judicial interpretation of contracts swayed with the wind of post-contract history, contracting parties would not know the legal meaning of their agreements at the time they enter them.

5 . It is also worth noting that the idea that the bond insures tax liabilities comports with economic common sense. The bond was for the same amount — $2,698,787—that was to be paid the subcontractor for its work. Presumably, the subcontractor would charge the contractor for its employment tax liabilities as for any other expense, so the $2.7 million likely included payment for tax liabilities. If the bond was not meant to insure tax liability, then one would imagine that the bond amount would be lower than the full subcontract amount.

The fact that the bond amount and subcontract amount are identical makes it difficult to accept the dissent's economic reasoning. The dissent invokes the golf course’s potential claim for defects in Hawaiian’s work, and argues that Oahu would have rather saved money for such claims than spend it on unpaid taxes. This of course assumes, improperly, that Oahu could have known beforehand that it would face such liability later on. Moreover, it seems improbable that the subcontract amount would include money for a job badly done. A subcontractor would normally calculate its charge to a contractor on the assumption that its work would be completed properly.

6 . United States v. Seaboard Surety, 201 F.Supp. 630 (N.D.Tex.1961); a district court case, is not distinguishable in either of these ways. The Seaboard court considered and rejected the textual reasoning that we adopt here, and invoked the distinction between legal and contractual obligations that we discussed and rejected above. Id. at 635. Seaboard concluded that "the language of the instruments construed in the light of the purposes, reasonable intent of the parties, the cases and statute brings the court to the conclusion that the defendant Seaboard Surety Company did not [promise to pay subcontractor's unpaid taxes].” Id. at 636. Our approach abides more strictly by the contractual language.