While surety bonds have always been required for most public projects, they are being used extensively in many large private construction projects by project owners to secure faithful performance (or payment via settlement) of the contract if the contractor defaults. But does the contractor have the same standing and rights against the Surety as an insured would have under an insurance contract? In a short and pithy decision by the Eastern Division of the U.S. District Court for the Northern District of Illinois, interpreting California law, the District Court plainly affirmed that the answer was “no.” In U.S. Surety Co. v. Stevens Family Ltd. Partnership, No. 11-C-7480 (N.D. Ill. Jan. 8, 2014) (slip op.), an action by the Surety against the indemnitors on the indemnification and collateralization of the issued bond, the indemnitors asserted affirmative defenses against the Surety, claiming that it impermissibly settled a bond claim for $440,000 without consideration of the indemnitors’ interests. In ruling on a motion to strike, the District Court reflected that under California law, “a surety that puts up its own major money commitment through a bond is entitled to define and enforce the remedies specified in its agreement with the indemnitors on whose liabilities it has had to make good – a relationship inherently different from that created by the issuance of an insurance contract,” slip op. at 3 (citing Cates Constr., Inc. v. Talbot Partners, 980 P.2d 407, 418-25 (Cal. 1999)). Citing further to a recent decision in the Southern District of California, Travelers Casualty & Surety Co. of America v. Highland, No. 10cv2503, 2012 WL 5928139 (S.D. Cal. Nov. 26, 2012), the District Court likewise “torpedoed” the claim that the Surety had an obligation similar to that of an insurer’s obligation under the covenant of good faith and fair dealing, and further affirmed that the indemnitors may not “second guess” the Surety’s decisions where the contract at issue vested “sole discretion” in the Surety. Reviewing the indemnitors’ agreement, which stated that it vests “sole and absolute discretion” in the Surety, the District Court noted that the express language made the Surety’s rights clear “without hedging it with the possible qualification” identified in the Highland decision. U.S. Surety, slip op. at 6. “And just as Highland P’ship held that the indemnitors there flunked that test, the indemnitors here have struck out for the same reason.” Id. at 6-7. Finally, in addressing the defense of estoppel, the District Court quoted the Bible, Matthew 7:3 (KJV), denouncing the indemnitors’ “attempt to fault [the] Surety for its good faith exercise of its sole and absolute discretion, while totally ignoring the fact that they themselves took no action available to them to deal with the problems that had resulted from their own corporation’s contractual defaults.” Id. at 7.
Let the contractor (principal on the bond) beware: the courts will uphold those strict provisions in the bond terms. It is therefore best for the contractor to make every effort to properly respond to potential or actual claims against it prior to any bond claim being made while the contractor still has some control and discretion to parlay into a possible resolution or evidence to sway the Surety to defend against the claim.