Federal Circuit Court Decision Threatens Bonding Industry’s Solvency

December 2, 2014

Insurance LawGAI: The Surety Recoupment Mechanism

Insurance and suretyship play complimentary risk-transfer roles on a construction project. One key difference between them is how they remain solvent. Insurers look to premiums to fund their cost of business and are barred from suing their insureds. By contrast, sureties charge much lower premiums and look to the principal—the entity whose conduct is back-stopped by the bond and who therefore may well have caused the surety’s loss—to recoup payments made under the bond.

The primary vehicle for a surety’s recoupment action is the General Agreement of Indemnity (GAI), signed by the principal (as indemnitor) as a condition to receipt of bonding. Not surprisingly, the GAI establishes generous indemnification rights favoring the surety. Typically, the principal must reimburse all disbursements under the bond, made by the surety in good faith. This means that (1) the principal’s duty to indemnify exists independent of the principal’s ultimate liability to the obligee (the person protected by the bond) and (2) to defeat this duty the principal has the heavy burden of proving surety bad faith. Efficient and inexpensive enforcement of the GAI is a cornerstone to solvency of the construction bonding industry.

Standard Facts; Surprising Conclusion

In a case apparently of first impression nationwide, the Eleventh Circuit in Hanover Ins. Co. v. Atlantis Drywall & Framing, LLC, weakened a construction surety’s enforcement of the GAI against its principal. The facts are standard enough. On a construction project for the University of Alabama, the principal was a subcontractor and its surety (Hanover) obtained payment and performance bonds benefitting the general contractor. The subcontract contained a broad arbitration agreement governing disputes between the subcontractor and general contractor; while the GAI made no reference to arbitration.

Hanover made payments under the bonds, then sued the subcontractor in federal district court in Alabama for contractual indemnity. The principal moved to compel arbitration, arguing that the surety was bound by the subcontract’s arbitration provision.

The Eleventh Circuit in an unpublished decision granted the subcontractor’s motion to compel. Under Alabama law, a non-signatory to an arbitration agreement may be compelled to arbitrate its claim if (1) separate contracts constitute a single transaction and (2) the non-signatory’s claims are “intertwined with” and “related to” the contract containing the arbitration provision. As to the first element, the court pointed out that the parties were aware the three contracts—the subcontract, bonds, and GAI—were part and parcel of a single transaction: the bonds would not be issued until the indemnity agreement was signed, and the subcontractor could not perform its work until the bonds were issued. Each contract was dependent upon the other for the transaction to go forward. Strangely, the court was silent as to the second element: that Hanover’s claims against its principal were intertwined with or related to the subcontract.

The Atlantis Drywall decision is unsupported by Alabama law as the state cases it cites are readily distinguishable. More importantly, its ruling, if adopted nationwide, could complicate a surety’s enforcement of its indemnity rights.

Nationwide Implications

Sureties have long found courts receptive to enforcement of the GAI, thereby generating over the years a strong body of precedent in their favor. The U.S. Court of Appeals for the First Circuit, applying Rhode Island law, ruled that a broad indemnity agreement between a surety and its principals will be enforced unless the surety engaged in fraud or collusion with the claimant; moreover, this express agreement precludes consideration of the common law doctrine of good faith and fair dealing. The Connecticut Supreme Court placed upon the principal the burden of proving a surety payment to the claimant was outside the scope of the GAI. The Texas Supreme Court reasoned that, under a GAI’s “good faith” standard, a surety is not required to conduct a reasonable investigation; bad faith is defined as more than negligence, but must include willful misconduct or improper motive. The list goes on.

Sureties have routinely cited to this extensive body of case law to obtain pre-trial rulings from trial courts enforcing the GAI. However, it may be more expensive and time-consuming for the surety to obtain a favorable arbitration award. More importantly, arbitrators may feel less compelled than a court to follow the law. The arbitrator will likely be confronted not only with the surety’s indemnity claim but also the details of the dispute between the principal and the obligee. Even though the latter dispute is essentially unrelated to the propriety of the surety’s claim, it is likely the two disputes will mesh together in the arbitrator’s mind, so that a principal defense against the obligee will also become a principal defense against the surety. In addition, while an arbitrator should of course follow the law, the surety has no practical remedy should the arbitrator not do so.

In sum, sureties have found courts to be receptive to enforcement of the GAI. In ruling that Hanover must arbitrate its claim against the subcontractor’s principals, the Atlantis Drywall court has deprived sureties of a reliable and proven method for obtaining efficient enforcement of their indemnity rights against the principal. The Eleventh Circuit decision upsets a key underpinning of the suretyship relationship to both the principal and the obligee. It threatens to result ultimately in higher bond premiums to the detriment of the construction industry as a whole. In light of this decision, sureties are advised to add to their GAI language giving the surety the right to enforce its indemnity rights in any court of law having jurisdiction over the claim, regardless of any arbitration agreement between the principal and any other person or entity.