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Issue Revisited: Who Can Sue The Surety For Bad Faith Under A Construction Bond?

March 1, 2000

This is one of a series of articles under the by line “Butler on Bad Faith” originally published in Mealey’s Litigation Report: Insurance Bad Faith, Vol. 18, #21, p. 25 (March 1, 2005). © Copyright Butler 2005.  

In this journal, in May 2000, the author discussed the then recent decision in Ginn Construction Co. v. Reliance Insurance Co., 51 F. Supp. 2d 1347 (S.D. Fla. 1999). He argued that, contrary to a suggestion in Ginn, an obligee under a general contractor’s performance bond ought not be allowed to sue the surety for bad faith. This article will look at some decisions handed down since. The trend is toward no bad faith liability by a surety to either an obligee or a principal under a surety bond.

In the Ginn case, the United States District Court for the Middle District of Florida granted summary judgment in favor of a surety, which had been sued for bad faith by its principal – the general contractor. The District Judge found that no such cause of action existed because the principal is not an “insured” under a surety bond. Then in Adictum, the Court theorized. “[I]f any party has a claim for ‘bad faith’ failure to settle under (the Florida bad faith statute) it would be the . . . obligee under the bond.” 51 F. Supp. 2d at 1352. It was this observation that prompted the earlier writings in this journal.

Since the Ginn decision, several other jurisdictions have addressed the issue. For example, Masterclean, Inc., et al v. Star Insurance Co., 556 S.E.2d 371 (S.C. 2001) came up on a certified question to the Supreme Court of South Carolina from the United States District Court for the District of South Carolina. In that case, The University of South Carolina needed asbestos removed from a building. The general contractor hired to do the job obtained a performance bond from Star Insurance Company.

The University terminated the general contractor for non-performance and made a claim on the bond. Star investigated and concluded that, indeed, the general contractor had defaulted. Star then entered negotiations on the claim with the University. Meanwhile, at additional cost, the University hired a replacement contractor to complete the asbestos removal.

After a state administrative proceeding, involving the University, Star and the general contractor, there was an award of $1,000,000 to the University. The parties negotiated a settlement in which Star paid $100,000 and the general contractor paid the rest.

The general contractor (the principal under the bond) sued Star for bad faith. It contended that, as soon as it determined the general contractor was in default, Star should have immediately remedied the default, completed the contract, or arranged for a replacement contractor as provided in the bond. The United States District Court certified the following question: “Can [the general contractor and its indemnitors] sue Star in tort for its bad faith refusal to pay under the performance bond?” The Supreme Court of South Carolina answered the question “in the negative.”

The South Carolina Supreme Court’s analysis was cogent and thorough. “Plaintiff asserts sureties are insurers and a performance bond is insurance. Such a determination would allow Plaintiff to sue in tort for Star’s bad faith refusal to pay insurance benefits on a first party claim under Nichols v. State Farm Mutual Automobile Ins. Co., 279 S.C. 336, 306 S.E.2d 616 (1983).” In support of that position, the general contractor made three arguments. The Court rejected all three.

First, the general contractor contended that, because sureties are regulated by the state insurance code, surety bonds are insurance. No, said the Supreme Court: “[A] bad faith tort action arises from the common law due to special characteristics of the insurance relationship, not simply because it is a regulated industry.”

Next, the general contractor contended surety bonds are insurance policies at common law. The Supreme Court rejected this, pointing to a lengthy passage in Appleman, Insurance Law and Practice. The passage noted that, unlike insurance, a corporate surety has recourse for indemnification against the principal. “If a compensated surety’s contracts were regarded as insurance for all purposes it is apparent that the surety would not have such right of recourse. . . .”

Finally, the general contractor asserted that “public policy” mandates a bond be treated as a policy. For this assertion, the general contractor offers three bases. All three were rejected by the Supreme Court. For one thing, there is no “strong public interest” in bonds, as there is in insurance policies, because public construction projects involve commercial entities. For another thing, an inequity in bargaining power – ordinarily present between an insured and an insurance company – is “largely absent in the surety context because the obligee, not the surety, usually dictates the bond requirements.” Finally, the fact that a surety has no risk of liability beyond the penal sum of the bond (and therefore may be tempted to delay or deny payment of a claim) “alone is insufficient to recognize a bad faith claim for sureties.”

Another court decision since the issue was last addressed in these pages, is Cincinnati Insurance Co. v. Centech Building Corp., 286 F. Supp.2d 669 (M.D.N.C. 2003). In the Centech case, the surety had been sued by the obligee. The United States District Court for the Middle District of North Carolina granted a summary judgment in favor of the surety. The District Court, relying on the Texas Supreme Court case of Great American Insurance Co. v. North Austin Municipal Utility District No. 1, 908 S.W.2d 415 (Tex. 1995) rejected all rationales proferred for allowing a bad faith cause of action by an obligee against a surety. Among other things, the District Court did not find the surety had “unequal bargaining power” or “exclusive control over the claim evaluation process.” Moreover, because of the “fundamental differences in insurance and suretyship . . . an obligee may not assert a bad faith cause of action against a surety . . . .”

One fairly recent decision against this trend is International Fidelity Insurance Co. v. Delmarva Systems Corp., an unpublished opinion found at 2001 WL 541469 (Del. Super.). In that case, the surety, International Fidelity Insurance Company (“IFIC”) issued a bid bond and a performance bond on a public school project.

The facts in Delmarva Systems do not bear repeating. Suffice it to say the case came before the Delaware trial court on a motion to dismiss. The surety urged dismissal on the various grounds discussed above (and previously in these pages). The Delaware trial court denied the motion to dismiss with the following observations.

While the Court believes that the inclusion of surety [sic] in the Delaware Insurance Code bears considerable weight to the end result, the Court also finds that it is not solely determinative of the issue.

A special relationship exists between a commercial surety and an obligee that is nearly identical to that involving an insurer and an insured. When an obligee requests that a principal obtain a commercial surety bond to guarantee the principal’s performance, the obligee is essentially insuring itself from the potentially catastrophic losses that would result in the event the principal defaults on its original obligation.

Although the relationships between the surety/obligee and the insurer/insured are not completely identical, the differences do not warrant the denial of tort damages in the breach of a surety bond.

(Emphasis added.) Unfortunately, the Delaware trial court did not articulate why “the differences” (a bond is a three party agreement in which the surety has obligations to both of the others, and a right of indemnity against the principal) were not significant enough to make a difference.

In any event, the better reasoned decisions, since the issue last was addressed in these pages, are moving away from liability by a surety against either a principal or obligee under a general contractors performance bond. This is good and right. Whether regulated under an insurance code or not, suretyship is not insurance. And, because a surety bond is not insurance, the concepts of “bad faith” and tort liability should not be more applicable to a bond than to any other contractual arrangement.