Fidelity and Surety Law Committee

The Surety's Defenses To Unfavorable Provisions In A Bonded Contract

By: Caralisa Connell
Fidelity and Surety law Committee

Fidelity and Surety law Committee

Winter 2021 Newsletter

Introduction

The construction surety is no stranger to finding itself in unfavorable positions due to the actions of its principal. The surety’s involvement in most construction projects is delayed until some issue arises warranting notification to the surety—whether in the form of notice of default under a performance bond or a claim against a payment bond—as a direct result of the actions of its principal. The surety is rarely involved in negotiating or otherwise amending underlying construction contracts. Rather, the construction surety issues bonds on the underlying contract as negotiated and agreed to by its principal. The surety only occasionally has the opportunity during the underwriting process to review and analyze the principal’s contract with a project owner or higher-tiered contractor, and it is uncommon for the surety to put eyes on the principal’s subsequent subcontracts or purchase orders. Thus, bonded contracts may include provisions that are unfavorable to the surety.

Venue: Can the Bonded Contract Dictate the “Where”?

Contractual provisions in construction contracts that attempt to dictate where later disputes will be adjudicated have become increasingly popular across the industry. While these provisions may seem harmless at first glance, clauses related to venue have the potential of altering the parties’ rights, both substantively and procedurally, and could have a significant impact on the outcome of the dispute.

Venue provisions have long been a staple in construction contracts. The two primary types of venue provisions are with respect to (1) courts of jurisdiction and (2) arbitration provisions. It is no secret that the venue for certain actions may have a significant impact on the surety’s chances of success in defending claims under both performance bonds and payment bond.

Venue selection clauses (also known as “forum” selection clauses) come in different forms and fashions and may vary in specificity. For example, some contracts contain more generalized clauses that may state, “disputes related to the Contract shall be held in the place where the Project is located, unless another location is mutually agreed upon.” On the other hand, some contracts contain provisions that specifically set out a venue regardless of its relation to the project. These provisions may provide, for example, “Contractor submits to the venue and jurisdiction of federal and state courts within the Commonwealth of Kentucky.”

The surety’s rights and defenses with respect to a venue selection clause were analyzed recently in the case of Granite Re, Inc. v. Northern Lines Contracting, Inc, 2020 WL 4676290..[1] In Northern Lines, the surety filed a suit seeking declaratory judgment with respect to the rights of the project owner, the principal, and the surety with respect to three contracts: (1) the construction contract; (2) the performance bond; and (3) the indemnity agreement.[2] The construction contract provided that “[a]ny litigation concerning claims under the Contract shall be venued in the County District Court of the County where the project is located.”[3] The performance bond contained a venue selection clause which provided that “[a]ny proceeding, legal or equitable, under this Bond may be instituted in any court of competent jurisdiction in the location in which the work or part of the work is located . . . .”[4] The indemnity agreement did not contain a venue selection clause.[5]

The project owner filed a motion to dismiss for lack of subject matter jurisdiction or, in the alternative, for dismissal pursuant to the venue selection clause in the construction contract.[6] The United States District Court for the District of Minnesota first discussed subject matter jurisdiction and denied the project owner’s motion on that ground.[7] The court then discussed the venue selection clause.[8] The court laid out the underlying dispute as follows:

To resolve this motion, the Court must determine (1) whether [the surety] is bound by the construction contract’s forum-selection clause, given that it is not a party to the construction contract; (2) whether [the surety’s] claims fall within the scope of the forum-selection clause; (3) whether that forum-selection clause is valid; and (4) whether that forum-selection clause should be enforced in light of countervailing public-interest factors.[9]

The court then analyzed each of these considerations in turn. First, the court determined that the surety was bound by the terms of the venue selection clause in the construction contract.[10] In its analysis, the court stated:

The Court emphasizes that the performance bond incorporates the construction contract without limitation. The performance bond does not provide that only some of the terms of the construction contract are incorporated. Nor does the performance bond provide that the construction contract is incorporated by reference “except as otherwise provided” or “except insofar as it is inconsistent with this performance bond.” As a result, all of the terms of the construction contract – including the forum-selection clause – are binding on [the surety].[11]

However, given that the venue selection clause in the construction contract seemingly conflicted with the performance bond’s venue selection clause, the court then discussed how the two provisions interacted.[12] The court found that the two venue selection clauses did not conflict because the venue selection clause contained in the performance bond was a permissive venue selection clause, while the one contained in the construction contract was a mandatory venue selection clause.[13] After an analysis of case law, the court agreed with other courts that determined that lawsuits that are within the scope of the mandatory clause must be litigated in that forum, even if the permissive clause would otherwise permit them to be litigated in another forum.[14] Accordingly, the court found that the surety was bound by the construction contract’s venue selection clause.[15]

 This decision is particularly notable as the construction contract’s venue selection clause did not permit for disputes to be litigated in federal court. Thus, the court essentially found that the surety contractually waived its ability to have its dispute heard by a federal court despite the requirements of federal court jurisdiction otherwise being met.

Similarly, the surety must consider whether a bonded contract has an arbitration provision. Because there has been extensive case law analysis on the issue of whether sureties are bound by arbitration provisions in a bonded contract, this article will not discuss the incorporation of arbitration provisions in detail. However, it should be noted that there is a split of authority as to whether these provisions are ultimately binding on the surety and whether the surety waives any rights by choosing not to participate in an arbitration proceeding of which it was provided notice.[16]

 

Substantive Provisions: Can the Bonded Contract Dictate the “What”?

Sureties regularly delve into substantive provisions of bonded contracts (such as payment provisions, scope of work provisions, etc.) to determine whether the principal, and ultimately the surety, has defenses to claims made against the bond. What happens, however, when the bonded contract contains provisions that directly affect “surety” defenses such as penal sums, limitation periods, and performance options?

 One case discussing whether a bonded contract can alter the surety’s substantive performance options is Fidelity & Deposit Co. of Maryland v. Jefferson County Commission, 756 F. Supp. 2d 1329.[17] In this case, the surety issued an AIA A312 Performance Bond in relation to a public works project located in Alabama.[18] The obligee terminated the principal’s prime contract and asserted a claim against the performance bond.[19] However, the obligee rejected the surety’s efforts to utilize the principal to complete the job as permitted under the surety’s performance options enumerated in Section 4 of the performance bond.[20] The obligee made unilateral arrangements for completion, resulting in the surety’s filing of a declaratory judgment action.[21]

The United States District Court for the Northern District of Alabama started by looking at the terms of the performance bond.[22] In doing so, the court expressly found that Section 4 of the performance bond unambiguously provided four options for the surety to proceed.[23] Thus, the court held that the obligee’s rejection of the surety’s proposal to take over and complete pursuant to Section 4.2 of the bond constituted a breach of the performance bond, relieving the surety of its obligation under the bond.[24] However, in reaching this conclusion, the court was forced to address the obligee’s argument that because the bond incorporated the contract and the contract contained provisions allowing the obligee to unilaterally take action, the obligee had a right to proceed as it did.[25]

The court noted that “[a] generally accepted rule of contract law is that where a writing expressly refers to and sufficiently describes another document, that other document should be interpreted as part of the writing.”[26] Thus, the court agreed that the performance bond’s reference to the contract allowed for the terms of the contract to be interpreted along with the bond.[27] The court continued, however, to determine that the terms of the contract and the performance bond could be reconciled, since the contract stated that the obligee’s remedies were “subject to any prior rights of the surety.”[28]

In its analysis, the court cited to the case of Dooley & Mack Constructors, Inc. v. Developers Surety & Indemnity Co., 972 So. 2d 893, [29] but ultimately determined that the Dooley dissent was more persuasive.[30] In Dooley, a Florida state court held that a subcontract provision that was incorporated into the performance bond overrode an explicit notice requirement in the bond.[31] The Jefferson court cited to the Dooley dissent, which stated:

The majority . . . seizes upon an obscure provision of the subcontract agreement, not signed by the surety, to afford [the contractor] a remedy not contemplated either in the default provision of the subcontract or the bond . . . . The majority’s interpretation of the agreements in this case effectively converts the bond into an insurance policy.[32]

The Jefferson court continued its analysis stating:

As further explained by the Dooley dissent, the bond is necessarily the primary determinant of any dispute between the owner and the surety for two reasons. First, the contract for the work “usually precedes the issuance of the bond. Renegotiation of the contract or subcontract to assuage any or every concern of the surety at this stage is impractical.” Second,

[t]ypically the parties executing B141 [the official AIA architectural service agreements] may not have read, reviewed, or discussed A 201 [General Conditions of Contract] . . . . Incorporation by reference of other, unseen documents that substantially change the parties’ rights may be perceived as a dishonest or deceptive way to arrange for contractual terms that might not otherwise be acceptable to a party.

. . . Both of these explanations apply with equal force to the record before the court.[33]

 Accordingly, sureties should be on the lookout for bonded contracts that contain provisions that purport to substantively alter the surety’s rights under issued bonds. When faced with one of these unfavorable provisions, however, the surety can defend against the alteration of its rights by placing the focus on the bond as the ultimate determinant of any dispute and asserting similar policy arguments such as those in the Dooley dissent and Jefferson.

Final Thoughts and Conclusion

Sureties may find themselves facing unfavorable provisions in bonded contracts that, if found applicable to the surety, may increase the surety’s potential liability. However, the surety should not surrender if a court finds that it is bound by such unfavorable provisions. Rather, it should consider whether other provisions in the bonded contract can be used to its advantage. For example, if the surety is forced to participate in arbitration proceedings pursuant to a venue selection clause in the bonded contract, and the bonded contract also contains a prevailing party attorneys’ fees provision, the surety may argue that it is entitled to fees in the event it prevails. Ultimately, the surety is not without recourse against unfavorable provisions, but it should be aware of the way in which different jurisdictions handle contractual interpretation in relation to the bond’s incorporation of the terms of the bonded contract.

Caralisa Connell is an associate with Manier & Herod, PC in the Firm’s Nashville, Tennessee office.

[1] Granite Re, Inc. v. N. Lines Contracting, Inc., No. 19-CV-2832 (PJS/ECW), 2020 WL 4676290 (D. Minn. Aug. 12, 2020).

[2] Id. at 1.

[3] Id.

[4] Id.

[5] Id.

[6] Id. at 2.

[7] Id. at 2–3.

[8] Id. at 3.

[9] Id.

[10] Id. at 4.

[11] Id.

[12] Id. at 5.

[13] Id.

[14] Id. (“Lawsuits brought under the performance bond that do not concern claims under the construction contract may be filed—but do not have to be filed—in either the United States District Court for the District of Minnesota or the Faribault County District Court. And lawsuits brought under the performance bond that concern claims under the construction contract must be filed in the Faribault County District Court.”).

[15] Id. at 9.

[16] See William Schwartzkopf, Prac. Guide Constr. Cont. Sur. Claims §23.03 (3rd Ed. 2020).

[17] Fid. & Deposit Co. of Maryland v. Jefferson Cty. Comm'n, 756 F. Supp. 2d 1329 (N.D. Ala. 2010).

[18] Id. at 1330.

[19] Id. at 1334.

[20] Id.

[21] Id. at 1334–36.

[22] Id. at 1335.

[23] Id. at 1335–36.

[24] Id. at 1336.

[25] Id. at 1336–38.

[26] Id. at 1337.

[27] Id.

[28] Id. (“[A] close reading of the Construction Contract reveals that after a termination for cause, the rights of the owner, here the JCC, to ‘finish the Work by whatever reasonable method the Owner may deem expedient’ is ‘subject to any prior rights of the surety.’”).

[29] Dooley & Mack Constructors, Inc. v. Developers Sur. & Indem. Co., 972 So. 2d 893 (Fla. Dist. Ct. App. 2007).

[30] Fidelity & Deposit Co. of Maryland, 756 F. Supp. 2d at 1337–38; see Dooley and Mack Constructors, Inc., 972 So. 2d at 895–96.

[31] Dooley and Mack Constructors, Inc., 972 So. 2d at 894–95.

[32] Id. at 895–96 (emphasis added); see Fidelity & Deposit Co. of Maryland, 756 F. Supp. 2d at 1338.

[33] Fidelity & Deposit Co. of Maryland, 756 F. Supp. 2d at 1338 (emphasis added) (citing Dooley and Mack Constructors, Inc., 972 So. 2d at 895–96 (J. Shepard, dissenting)).

Caralisa Connell

Associate - Manier & Herod, PC

Caralisa Connell is an associate with Manier & Herod, PC in the Firm’s Nashville, Tennessee office.

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