Krysta Gumbiner is a litigation partner at Dinsmore. She co-wrote this article for DRI's June issue of For The Defense.

A surety may allow its bond principal to negotiate settlements with claimants after the surety has received a payment or performance bond claim. The surety must, however, avoid certain pitfalls that may expose it to liability, because the surety has a simultaneous obligation of good faith to the obligee and intended beneficiaries of its bonds as well as to the principal and indemnitors of its indemnity agreements. This article will explore the surety’s added and altered involvement in claims handling when a bond principal’s ability to do so may be impaired as a result of a lack of willingness or ability to exercise sound business judgment and/or poor or inadequate accounting practices. These issues can compromise the surety’s best interests as to adequate collateral and completion.

The Surety’s Independent Obligation, and Unique Opportunity, to Investigate Claims:

The Principal Must Not Act on Behalf of the Surety, and the Surety Must Be Cautious About Acting on Behalf of or Giving Deference to the Principal

The principal must not misrepresent to a claimant that it is negotiating on behalf of the surety, or vice versa; and neither party may indicate that the principal is the ultimate authority as to the merits of a bond claim. In instances where contract balances are deposited into a funds control account, the principal is generally allowed greater control over to whom it makes payment and the amount of that payment. The surety must be careful not to exert “domination and control” over the principal’s operations, as doing so could expose the surety to a claim of tortious interference or potentially provide an indemnitor with a defense in a subsequent indemnity action. Such interference may also arise when a surety voluntarily investigates and acts on an alleged performance issue before notice from an obligee or a proper claim is asserted pursuant to the terms of the bond. In so doing, a surety may forfeit in full or pro tanto its right for indemnification from the principal and indemnitors for those actions (although it may not necessarily forfeit the surety’s receipt of contract balances for those efforts if the owner is pleased to have the surety involved). Investigation is one thing and generally unassailable; however, the surety must exercise caution to avoid inviting claims, when acting, and/or when actually proceeding to take over the principal’s work.

The surety may allow a bond principal to represent that it remains in control of its own finances while negotiating a settlement; however, the surety should not imply blind deference to the bond principal as to the merits of a claim. Based on the regulated nature of the surety industry, such conduct may expose the surety to liability under breach of fiduciary duty and bad faith claims involving unfair dealing and deception. These fiduciary duties tend to speak to actions, recommendations, representations, prompt service, and denial of coverage, all of which are affirmative acts. R.W. Granger & Sons v. J & S Insulation, 435 Mass. 66 (2001); see also Fla. Admin Code Ann. R 69B-220.201 (Ethical

Requirements for All Adjusters and Public Adjuster Apprentices); Fla. Stat. 626.9541 (2017) (Unfair Claims Settlement Practices Act). When you get into unfair claims settlement practices by omission, that may not be a breach of fiduciary duty but includes examples like failing to use proper standards and procedures to handle claims, failing to promptly communicate, or failing to provide a clear or reasoned explanation of the basis for denial or need for more information. W. Sur. Co. v. Cooper River Constr.

Co., No. 2:12-cv-2561-PMD, 2013 U.S. Dist. LEXIS 91753 (D.S.C. July 1, 2013); see also, e.g. O.C.G.A §10-7-30 (2020) (Georgia Commercial Code’s 60-day bad faith provision for Surety failure or refusal to perform); but see Ch. 2 Liability to Indemnify and Reimburse the Surety in THE SURETY’S INDEMNITY AGREEMENT – LAW & PRACTICE 66-67 (Marilyn Klinger, Gary Judd & George J. Bachrach eds., ABA 2002) (citing Hartford v. Tanner, 910 P.2d 872, 881, Ct. App. An. 1996) (Holding the surety’s reimbursement may be reduced or eliminated if its failure to mitigate damages constituted unreasonable conduct and practically eliminating the principal’s ability to raise defenses to obligee claims). Unfair settlement practices may carry fines even for unintentional violations, and bad faith can result in punitive damages if found to be willful, wanton, and malicious or in reckless disregard. K-W Indus. v. Nat'l Sur. Corp., 231 Mont. 461, 754 P.2d 502 (1988).

Practical Approaches to Preserve the Surety’s Independence and Claim Defenses

A sureties should protect itself by affirming that it cannot tacitly commit any wrongdoing or commit to any position, other than through its express written statements waiving its rights. Rather than stating a position on what portion of a claim is undisputed or disputed, the surety can in the interest of litigation avoidance and prompt resolution, identify potential disputes and their potential worth (citing ambiguities in the contract, applicable law, or proof of claim documentation) and invite the claimant to propose a fair resolution within that range of possibilities.

Alternatively, a surety can and often does announce the results of its investigation by stating that it is not a final finder of fact (e.g., not a judge, jury, or arbiter) and does not determine whether the principal’s defenses are true, only whether they appear to be made in good faith, as the standard on which the surety can rely for subrogation purposes. In either approach, the surety can add that the position taken is open for further review and comment if the claimant supplies proof of claim documentation or applicable contract or legal standards to the contrary. Notwithstanding the above, a surety should not knowingly rely on a disingenuous contract interpretation or circumspect legal standards in denying a valid claim.

Surety Non-Intervention in Principal Claim Handling; Some Reasons and Examples:

A Surety May Not Rely on a Principal’s Defense It Knows Not to Be Offered in Good Faith

Sureties are not required to intervene in a principal’s negotiations with a bond claimant to disabuse the claimant of its own ignorance or even where the bond principal may be acting in bad faith. The principal’s bad faith standing alone does not impute bad faith to the surety based on the surety’s unique/higher standards; however, the surety may not expressly incorporate the principal’s defenses by subrogation unless those defenses appear to be asserted in good faith by the surety’s standards. The exception to this occurs when the surety has knowledge of a material misrepresentation, whereby the principal cites the surety as support for a position which the surety has not overtly supported. See THE

SURETY’S INDEMNITY AGREEMENT – LAW & PRACTICE at 87 (citing Barr/Nelson, Inc. v. Tonto’s, 336 N.W. 2d 46 (Minn. 1983); Premier Elec. Const. Co. v. American Nat. Bank Trust Co. of Chicago, 603 N.E.2d 733 (Ill. App. 1 Dist. 1992)). The surety may intervene when the principal makes

material representations or statements that are or may be false or against the surety’s interests; and the surety need not intervene in instances where the principal is exhibiting poor judgment, is needlessly argumentative, or is staking out a suspect or inflammatory position for which the surety cannot reasonably be held directly accountable. The principal’s legal standard for bad faith may not be known by the surety’s representative, and a claim investigation does not require the surety to go so far as to investigate and conclude about the legal rights and obligations of other parties. The surety’s investigation need only be germane to the surety’s rights and duties. A surety representative need not go out of their way to investigate bad faith laws as they may apply uniquely to the principal.

Limits on the Reliability of the Principal’s Book and Records

Should the surety be in possession of the bond principal’s accounts payables report, the surety’s duty to resolve discrepancies may depend on the type of accounting in the A/P reports. While not a recommended

practice, some contractors post all invoices received to their accounts payable, while others only post amounts that they believe are due and owing. Accordingly, reports analogous to accrual-basis accounting (as opposed to cash-basis accounting) will more likely provide the surety with actual knowledge of what the principal believes is owed. Similarly, bond principals often post deductive change orders, credits, or offsets against otherwise valid invoices. In a perfect world, a principal would always be there to back up it deducts or disputes with evidence. Often, however, this is not the case, and the surety must investigate these offsets. Frequently, however, in the case of a failing or winding-down principal, where the principal is not communicating with the surety or cooperating with the investigation, the payables report may be the best evidence the surety can obtain reflecting the principal’s position on what is owed.

The Claimant Ultimately Bears the Burden of Proving Up its Claim

The surety is unlikely to expose itself to unfair claims settlement practices stemming from willful blindness should it choose not to seek out all documentation which may be available regarding a claim. The claimant bears the burden of proving its claim, unless the burden has been specifically shifted by law or arguably shifted due to the weight of evidence already given. E.g., Addison Urban Dev. Partners, LLC v. Alan Ritchey Materials Co., LC, 437 S.W.3d 597 (Tex. App. 2014) (Delivery tickets and invoices identifying the project for which materials were furnished provided sufficient evidence to support a construction materials lien under Tex. Prop. Code Ann. § 53.021 (Supp. 2013)). (Note, eg. under the Maryland Little Miller Act, invoicing alone creates a prima facie case and presumption of materials delivery, shifting the burden of disproof or of defective/rejected materials onto the Principal or Surety. State Finance and Procurement Code §17-101, et seq.(2019)). Additionally, the surety’s relationship to the owner/obligee does not require or even suggest the surety involve the obligee in a payment bond claim investigation, except to the extent the bond form says the obligee is to merely receive a copy of the surety’s written position on the claim. Further, because the payment bond claim investigation does not mandate discovery by the surety into the obligee’s records, the claimant and surety in such an instance are on equal footing as far as the right and capability to seek information from third parties such as the oblige (even to the extent of a FOIA request), and thus the claimant is free to seek out information to present as evidence if its claim, whereas the surety is not compelled to seek out information, regardless of what the outcome may be.

Surety Intervention in Claim Settlements due to the Principal’s Unreliability and its Impact on Surety Defenses:

The Surety and the “Friendly” Claimant

When a contractor is going out of business, it tends to wind down operations in one of a few ways: (a) being meticulous and stingy so as to mitigate any loss and indemnity obligations and shut down its operations in an orderly fashion; (b) being careless or inattentive owing to a lack of resources (time, personnel, or sophistication of methods) or lack of incentive (positive incentives like retention pay, negative incentives like loss of retirement accounts or indemnity obligations); or (c) favoring the interests of valued claimants over those of the failing company or the surety. In this last instance, the surety may determine that the bond principal is benefitting claimants who are “friendly” claimants in less than an arms lengths relationship, to the surety’s detriment, often where the principal’s personnel are overly cozy with vendors who it wants to leave pleased, whether for reasons of personal satisfaction or who may potentially employ/burnish the reputation of the principal’s personnel in the industry going forward. In such a situation, the surety can always assert any defenses available to the bond principal (through right of subrogation), not merely what the principal has asserted or is willing to assert. Great Am. Ins. Co. v. N. Austin Mun. Util. Dist. No. 1, 908 S.W.2d 415, 419 (Tex. 1995). In addition or alternatively, if the principal has still technically been left in charge of making payments, the surety can require that the principal obtain its consent to any payments to claimants or even all bonded payable vendors due to the likelihood of default.

The Surety’s Discretion Whether to Subrogate to Certain Principal Defenses

Absent specific indemnity language, it is unlikely that a surety would have a duty to invoke defenses on behalf of the bond principal. THE SURETY’S INDEMNITY AGREEMENT – LAW & PRACTICE at 64 (citing Employers Ins. Of Wausau v. Able Green, Inc., 749 F.Supp. 1100, 1103 (S.D. Fla. 1990) (holding the surety was not required to litigate claims by the principal unless the principal complied with its indemnity agreement by requesting litigation and posting collateral for litigation costs). In rare cases, such defenses may in fact be manifestly “personal” to the principal in that they conflict with a surety’s claim response obligations or preferences, such as enforcing the exhaustion of a contract’s dispute resolution procedures or the terms of a joint-check agreement. The surety generally does not or cannot require mandatory meetings, mediation, or arbitration between parties other than itself (the principal and claimant or obligee) as a precondition to answering the claim on its own merits or suit on such a claim as the bond provides, and the surety which is typically not a party to a joint-check agreement involving the principal has no business enforcing such extra-contractual obligations, unless it were stepping into the principal’s shoes by assignment. On the other hand, as mentioned in the previous section, a surety may assert defenses to a bond claim available to the bond principal which the principal was unwilling or unmotivated to assert. Connelly Constr. Corp. v. Travelers Cas. & Sur. Co. of Am., 788 F. App’x 122 (3d Cir. 2019) (credit Michael Stover & George Bachrach, A 2019 Surety Case Law Review 8-9 (“Surety Today Presentation” by Wright, Constable & Skeen, LLP, Jan. 13, 2020). Waivers provide a common opportunity for such defenses. Oftentimes, progress waivers will require that vendors specifically list any claims or extras unresolved through the effective date of the waiver or else lose the right to assert them. Similarly, unconditional waivers presume the claimant/vendor has received the relevant funds in advance of or contemporaneously with the signing of the waiver. In some instances, even a conditional waiver will be presumed fulfilled after passage of time. See, e.g., O.C.G.A § 44-14-366(c) (2018) (Georgia public works Code will convert a conditional waiver to unconditional after 60 days, conclusively deeming payment to have been made, if a conspicuous statutory notice to that effect is added to the bottom of waivers.) Although the bond principal may have direct knowledge that a waived item has not in fact been paid, or have customer-relations reasons for not enforcing the terms of a valid waiver, there is nothing prohibiting a surety from raising actual, constructive, or statutory waiver as a partial or complete claim defense.

The Surety’s Discretion to Intervene Due to Impasse, Delay, or Increased Risk

Since the surety is always secondarily liable after the principal, intervention may be prudent if the claimants face difficulty or impasse from the principal. If the reason for impasse or delay is primarily the principal’s cash-flow problems, rather than substantive disputes, then the surety should reconsider waiting for the principal to resolve on its own, much less tendering defense to the principal in a lawsuit (whether in defense of a claim or pursuing an affirmative claim) which principal’s business may not be capable of mounting or maintaining. Sureties have also been known to directly pay or reimburse key personnel of the principal with intimate knowledge of the project or claim and/or access to the principal’s records for helping them sustain affirmative claims or mount their own defense. Although sureties tend to avoid the

appearance of volunteering their efforts, it can be opportune to intercept this situation before the claimants are completely frustrated, to avoid their lawsuit, lien (perhaps requiring a separate release bond or else holding up multiples of contract funds) or walking off the job. Further, the surety’s role in resolution and responsibility to communicate with the claimant increases after the claimant has provided proof of claim documents and time is passing without the principal’s response. In instances where sureties do pay claimants directly, they commonly require releases that exclude the release of the principal and instead give the claimant’s assignment of rights against the principal to the extent of payment by the surety. This allows the surety to be “double-breasted” in its actions against the principal, both on indemnity rights and assigned subcontract or purchase order rights.

The Surety’s Discretion to Waive Strict Proof of Claim and its Possible Results

Whether there exists a duty for the surety to require that claimants prove their claims will depend on the jurisdiction’s position on what constitutes good faith. Some courts require that the surety act in a “reasonable manner,” a more lenient standard. Philip L. Bruner & Patrick J. O'Connor, Jr., Bruner & O'Connor on Construction Law § 10:107 (2002, supp. ann.). The other standard, more favorable to sureties, is one in which the surety is only denied indemnity upon a showing of bad faith, which requires an “improper motive” or “dishonest purpose.” PSE Consulting, Inc. v. Frank Mercede & Sons, Inc., 267 Conn. 279, 838 A.2d 135 (2004); Fireman's Ins. Co. v. Todesca Equip. Co., 310 F.3d 32 (1st Cir. 2002).

In addition to the GAI controlling these terms and the surety’s self-interest to investigate proof of claims, it is possible that if the surety’s payment triggers an event of default under the GAI, thereby impairing or eliminating the principal’s future bonding or credit with that surety or more broadly with other sureties, vendors and/ or project owners by damage to reputation, the principal could assert, as mentioned at the beginning of this article, (affirmatively) tortious interference of contract, domination and control, or the like by the surety for paying claims over the principal’s objection or at least without evidence of the principal’s default (a defensive, GAI argument). Selective Ins. Co. of Am. v. Moseley, No. 19-cv-01054 (APM), 2021 U.S. Dist. LEXIS 142147 (D.D.C. July 30, 2021). Most modern GAIs are well-written enough to the surety’s benefit to avoid loss of indemnity over such defenses by the principal, but sureties should anticipate these defenses regardless.

The Surety’s Right to Thwart or Intervene in a Principal-Negotiated Settlement

Lastly, should the surety have advance notice that a settlement attempt by the principal may impair the surety’s rights to a mitigated loss and the principal’s obligation to mitigate it, the surety can intervene by attaching the bond principal’s assets or obtaining a mandatory preliminary injunction forcing the bond principal to post collateral. A principal owes three equitable duties to its surety, whether or

not expressly found in the GAI: exoneration, reimbursement, and indemnification. Exoneration is the proverbial “hold harmless” obligation – the principal’s obligation to keep the surety from getting into its mess in the first place. When sureties see certain signs of a principal’s failure, such as outsize or multiple claims relative to the project or principal’s business, a surety can demand to be “put in funds” by a collateral demand in advance of anticipated losses for some amount correlating to those anticipated losses. If the principal does not do so willingly, sureties can and have sued for Quia Timet (apprehension of loss), an equitable and injunctive remedy to be granted collateral the surety can prove is reasonably necessary under the circumstances.

Conclusion

The goal of this article has been to discuss the inviolable rights of the surety in payment bond claims, and to a lesser extent affirmative claims, and investigations, while also exploring when the surety may choose not to involve itself in the principal’s handling of claims and potential claims. Nevertheless, for numerous reasons, the surety will often be better off resolving claims directly, rather than deferring to its principal, and when doing so, a cautious and thorough surety claims representative may substantially mitigate the surety’s risks and rely on the more predictable protections of its indemnity agreement.