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Expert Commentary

Proactive Surety Claims Handling

In recent years, sureties have begun more proactive claims handling. This article explains how sureties can work with the project owner, prime contractor, bond producer, underwriter, and claims personnel so that all can be in a win-win situation after a claim.


April 2001

In recent years, sureties have begun more proactive claims handling. Sureties no longer advise performance bond obligees that, because there appears to be a good-faith dispute, the surety will await a resolution before responding to the claim. Sureties no longer tender their defense to their principal without independently investigating the claim.

Surety Claim Phases

Early Warning Signals: Pre-Default. Before there is a dispute, even before the schedule begins to slip or before a vendor starts to complain about late payment, the bond producer and underwriter may see trouble signs. If they do, they should discuss those concerns with the principal as well as any personal indemnitors, possibly even with the principal's bank and the surety claims department.

At the early warning signs, a surety should consider assuming the role of facilitator. The surety is in an excellent position to facilitate the dispute's resolution. The surety is obligated to both the obligee/claimants and the principal/indemnitors. Therefore, the surety could function as a neutral to assist in dispute resolution.

Prior To a Declaration of Default or Termination. Sureties often face situations where, prior to a default declaration or termination, the obligee is dissatisfied with the principal and expresses this by letter to the principal, copying the surety. Sometimes, the obligee writes to the surety describing its complaints and demanding that the surety "do something."

Historically, sureties reacted to an obligee's letter to the principal by writing to the principal requesting that it address the situation. Similarly, sureties responded to the obligee's direct letter by advising that there has been no default, so the surety can do nothing. Sureties have taken this tact because they fear the principal's interference accusation. It is the conventional wisdom that the surety is at risk.

Interference with Contract. This means the intentional and improper interference with the performance of a contract between another and a third person by inducing or otherwise causing the third person not to perform the contract or by preventing the other from performing the contract or causing his performance to be more expensive or burdensome. Restatement (Second) of Torts §§ 766 and 766A.

The key issue is whether the surety's conduct is without sufficient justification or privilege. Arguably, the surety's financial interest in the subject of the alleged interference should be sufficient justification or privilege. In Zoby v American Fidelity Company, 242 F2d 76, 79 (4th Cir 1957), the court refused to find interference where the surety recommended to the obligee that it complete the contract with a new contractor: "Where the alleged interferer is a financially interested party, and such interest motivates its conduct, it cannot be said that [the interferer] is an officious or malicious meddler." When there is an existing, economic interest to protect, the person is privileged to become involved.

Because suretyship is a tri-partite relationship involving the obligee, the principal, and the surety, it is difficult to find a better example where the "interfering" party, the surety, has a financial interest.

In Seaboard Surety Co. v Dale Construction Co., 230 F2d 625, 630 (1st Cir 1956), the court recognized the surety's right to take over its principal's work "whenever in [the surety's] sole option such action is either desirable or necessary" provided that the surety's actions are proper. The court rejected the principal's complaint that the surety interfered with its contract by taking over the work before there had been a default determination:

This provision certainly gives [the surety] the whip-hand over the principals. But it is not suggested that the provision is in violation of any specific rule of law, or contrary to public policy, or so unconscionable that it ought not be enforced by a court of equity. And it does not make default by the contractor-principal ... a condition precedent to the right of the surety ... to take over and complete all or any part of the work the contractor engaged to perform. It provides instead that the surety has the right to step in and take over the work at the contractor's expense whenever in its sole opinion such action is either desirable or necessary. Thus the basic issue in the case is not whether [the contractor] defaulted on its ... contract. It is whether [the contractor's] prosecution of the work under the contract was so slow and so much at variance with specifications, that [the surety] in good faith believed it was either desirable or necessary for it to take over the work in order to protect its interests as surety.

In a very recent case, New York National Bank v Primalto Development & Construction Co.,703 NYS2d 480 (March 2, 2000), the principal's lender, who had received an assignment of the project owner's payment obligations to the principal, accused the surety of interfering in the principal/owner contract when the surety advised the owner to freeze further payment of contract funds because it had received payment bond claims.

The court did not analyze the question of whether the surety's conduct could constitute interference with contract. Rather, the court found that the assignment was unenforceable under New York law.

The One Lone Wolf Decision.L&A Contracting Company v Southern Concrete Services, 17 F3d 106, 111 (5th Cir 1994), is the only case that has suggested that sureties have potential exposure for interference:

Before a declaration of default, sureties face possible tort liability for meddling in the affairs of their principals. After a declaration of default, the relationship changes dramatically, and the surety owes immediate duties to the obligee.

The court had no basis for the above statement. It relied on two cases, the Restatement of Torts, and a quotation from a 1989 compendium of articles. The first case holds that a surety is justified and not guilty of interference in notifying the obligee to withhold payments to the principal when the principal does not pay subcontractors. Gerstner Electric, Inc. v American Insurance Company, 520 F2d 790 (8th Cir 1975). The second case is not an interference case. It held that a contractor had no liability to a subcontractor for the project owner's eviction of the subcontractor from the project. Cox v Process Engineering, Inc., 472 SW2d 585 (Tex 1971). The Restatement of Torts citation was to the basic law of interference.

Thus, only the quotation from the 1989 compendium, Cushman, Lawall, Miller, and Meeker, Representing the Performance Bond Surety, in Construction Defaults: Rights, Duties, nd Liabilities, note 11, § 5.2, at 106 (1989), "supports" the court's statement:

Prior to default, a surety does not have a unilateral right to intervene in a contract dispute between an owner and a principal unless the indemnity agreement between the surety and principal provides otherwise.

The above quotation cited to no authority whatsoever. Further, most indemnity agreements contain provisions allowing sureties to take over bonded contracts.

Therefore, notwithstanding conventional wisdom, it appears that sureties can argue convincingly that they do not have exposure for interference claims if they involve themselves in the obligee/principal contract should the need arise. While principals will file actions alleging interference, if the surety acts properly, the surety's exposure should be minimal.

Requirement of Declaration of Default. There appears to be no basis for the suggestion that there must be a default declaration or default termination before a surety can or is obliged to respond to a claim. A surety is liable immediately upon the principal's default. In re Ram Construction Co., Inc., 32 B.R. 758, 760 (Bankr WD Pa 1983); Royal Indemnity Company v U.S., 371 F2d 462, 464 (Ct Cl 1967); and California Civil Code section 2807, which provides:

A surety who has assumed liability for payment or performance is liable to the [obligee] immediately upon the default of the principal, and without demand or notice.

Only L&A Contracting appears to require a default. However, L&A Contracting so holds only because of the subject bond's express terms. Therefore, it cannot provide a universal rule. The court was interpreting a performance bond with language identical to an AIA Performance Bond A311 (February 1970) form, to wit: "Whenever Principal shall be, and shall be declared by Obligee to be in default under the subcontract...."

Interestingly, the newer AIA A312 performance bond (December 1984) form, requires that the obligee declare a default and formally terminate the principal. Where the bond is silent with respect to a default declaration or termination, it is doubtful whether a surety must wait until either of those occurs before it proceeds. In fact, it would seem to be prudent for a surety, at a minimum, to meet with the parties to discuss the obligee's concerns as well as methods to continue the principal's performance.

Domination. In January 1988, at an American Bar Association, Fidelity and Surety Law Committee meeting, William R. Sneed, III, and Michael Athay presented a paper entitled "Ramifications for the Surety—Domination Revisited." The article followed the seminal 1949 Harold W. Rudolph article entitled "The Domination Issue in Contract Suretyship Cases." Mr. Rudolph surveyed 10 cases alleging surety domination and control. Only one found against the surety. The 1988 article did not discuss surety cases. Rather, it discussed lender liability cases and what similar theories of liability could be and were being argued against sureties. It cited no cases where sureties had been found liable.

Principal's Bankruptcy

When the principal files bankruptcy prior to formal termination, a surety cannot begin completion without court authorization. Pursuant to the automatic stay of Bankruptcy Code section 362, all actions against a debtor's property are stayed. Under section 541, included in a debtor's property is its interest in a contract. Thus, upon the principal's bankruptcy, the obligee cannot terminate without automatic stay relief. Moreover, the surety cannot exercise control over the debtor's property and, thus, cannot complete the contract without that same relief.

In addition to the automatic stay, the Bankruptcy Code gives a Chapter 11 reorganization debtor an "exclusive" period of time within which to "assume" or "reject" its executory contracts. During that period, a debtor could take no action, leaving the contract to languish.

However, the obligee and/or the surety can seek automatic stay relief, allowing the obligee to terminate or the surety to take over. Also, under Bankruptcy Code section 365, the obligee, as a party, can petition the court to require assumption or rejection.

Effect of Proactive Surety Claims Handling on Indemnity

With proactive claims handling, it is not surprising when the principal and indemnitors argue that the surety's alleged premature actions created or increased the surety's loss. They will argue that the surety "volunteered," thereby eliminating their indemnity obligation. However, it is unusual when such an argument prevails. First, the principal and indemnitors need to demonstrate that, but for the surety's actions, the principal would have resolved the dispute. Alternatively, the principal and indemnitors would need to prove that the obligee recovered an amount greater than it would have recovered if the surety had not acted.

Virtually all issues concerning the surety's indemnity rights are addressed in the indemnity agreement. Therefore, sureties are no longer required to prove their liability in order to obtain reimbursement. They only need to prove that they had a good faith belief of their liability.

Conclusion

The project owner, the prime contractor, the bond producer, the underwriter, and the claims personnel can all become involved in the claims process. It is possible that the parties can put themselves in a "win-win" situation if they take a proactive view to that claims process.ert Content Here


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