Valid Arbitration Agreements
The popularity of arbitration in construction cases escalated when the American Institute of Architects (AIA) members felt that arbitration was a less expensive and more efficient mode of dispute resolution and began including such form provisions in their documents. At common law, agreements to arbitrate were met with great hostility; and in many state courts, predispute arbitration agreements were considered void and against public policy because they took away a party’s ordinary right to litigate.
In an effort to put an end to such arguments, Congress enacted the Federal Arbitration Act (FAA), creating a policy preference in favor of arbitration. In short, the FAA makes a written agreement to arbitrate enforceable if the underlying contract “evidenc[es] a transaction involving [interstate] commerce.” Accordingly, if the facts and circumstances relating to performance of the contract are such that interstate commerce is involved, and assuming that a claimant satisfies any procedural steps or conditions relating thereto, predispute arbitration agreements are readily enforceable.
Threshold questions and presumption. Before compelling a party to arbitrate pursuant to the FAA, there are two threshold questions. First, is there an agreement to arbitrate? And, second, does the dispute at issue fall within the scope of that agreement?
Pursuant to the decision in Moses H. Cone Memorial Hospital v. Mercury Construction Corp., there is a strong presumption in favor of resolving disputes through arbitration in both state and federal courts.
Initial question. The presumption in favor of arbitration disappears when the existence of a valid arbitration agreement is disputed by the parties.
For example, in Century Indemnity v. Underwriters, Lloyd’s, London, the U.S. Court of Appeals for the Third Circuit found that the presumption in favor of arbitration does not apply to the initial question of whether there is a valid agreement to arbitrate. The court explicitly stated that it did not need to reach a definitive conclusion on the breadth of the presumption; rather, it needed to determine whether the parties had agreed to arbitrate. The court noted that ordinary state law principles govern the formation of contracts, not a presumption in favor of arbitration.
Similarly, in Sherer v. Green Tree Servicing LLC, the court stated that
[w]e apply the federal policy favoring arbitration when addressing ambiguities regarding whether a question falls within an arbitration agreement’s scope, but we do not apply this policy when determining whether a valid agreement [to arbitrate] exists.
Once an agreement between parties has been proven, “the federal policy favoring arbitration” requires that “any doubts concerning the scope of arbitrable issues should be resolved in favor of arbitration,” but this policy “does not extend to situations in which the identity of the parties who have agreed to arbitrate is unclear.” Therefore,
the federal policy favoring arbitration applies [only] to issues concerning the scope of an arbitration agreement entered into consensually by contracting parties; it does not serve to extend the reach of an arbitration provision to parties who never agreed to arbitrate in the first place.
Exception for incorporation by reference. Removing the presumption in favor of arbitration from the initial inquiry as to whether an agreement to arbitrate exists may seem like good news for those parties who were not signatories to the underlying contract but who instead are bound to the agreement under the “incorporation by reference” theory. Removing the presumption refocuses the matter on the issues of intent and actual consent of the parties. Notwithstanding, the majority of federal circuit courts have determined that arbitration agreements found in layered contracts or agreements structured in a column (i.e., a prime contract, a subcontract, and a performance bond) are to be enforced if the contract incorporates by reference the arbitration clause.
Incorporation by Reference Clauses
Most payment and performance bonds do not contain an arbitration provision. Instead, a surety’s duty to arbitrate often arises from language contained in an underlying contract, such as the contract between an owner and a contractor, or from language within a subcontract between a principal and an obligee. It is in these situations—where the surety bond contains language that the entire contract “is made a part” of the bond—that the arbitration provisions of the underlying contract may become “incorporated” into the bond.
Before going further, a distinction must be drawn between a surety being compelled to arbitrate a claim and simply being bound by an arbitration award in a proceeding where the surety did not participate. There is a split of authority as to whether a surety is required as a nonsignatory to participate in an arbitration pursuant to the contractual provisions incorporated by reference into the bond. Some courts view incorporation by reference clauses as the equivalent of having consent of the surety, thereby binding the surety to arbitrate if the bond incorporates by reference a contract containing an arbitration provision. Other courts view incorporation by reference clauses as binding only upon the actual parties of the contract. The surety in such situations most likely will be bound by the result of an arbitration between the principal and the obligee; however, it may be able to assert any personal surety defenses it may have if the principal loses an arbitration and the obligee sues the surety to enforce the award.
When a demand for arbitration is made upon a surety, the first step is to determine the law of the controlling jurisdiction. In most jurisdictions, if the payment or performance bond incorporates by reference the underlying contract (or subcontract) containing an arbitration agreement, the surety can be compelled to arbitrate; and, conversely, the surety can compel claims brought against it. The few jurisdictions that hold otherwise either distinguish the extent of the incorporation by reference clause or hold that an agreement to arbitrate cannot be extended by construction or implication.
A word of caution: Although the incorporation by reference doctrine is the most prevalent vehicle to extend arbitration to sureties, it is not the only such mechanism. For example, a surety who executes a takeover agreement that incorporates all of the rights and responsibilities of its bond principal as set forth in an underlying contract containing an arbitration clause may find itself assuming the obligation to arbitrate when there was no such prior obligation.
Current Developments in the Law: Federal Decisions
Arbitration follows incorporation by reference. The U.S. Court of Appeals for the First, Second, Third, Fourth, Fifth, Sixth, Seventh, Tenth, and Eleventh Circuits all have determined that the surety must arbitrate if the bond incorporates by reference a contract that requires arbitration.
For example, the First Circuit simply held that because the performance bond expressly incorporated by reference the terms of the subcontract, the parties who bound themselves to submit disputes arising under the performance bond obligated themselves to arbitrate.
Similarly, the Sixth Circuit held that a court could compel a surety to arbitrate where the arbitration clause was found in the prime contract because the performance bond specifically incorporated the terms of the subcontract, and the subcontract in turn incorporated the general contract’s obligations, including the general contract’s duty to arbitrate.The court of appeals explained that a party does not have to be a signatory to the contract containing the arbitration clause when the contract is specifically incorporated by reference in the surety bond. Moreover, the fact that the arbitration clause was restrictively phrased, referring only to the immediate parties, did not preclude the court from recognizing that there was such an incorporation.
The Eleventh Circuit, in U.S. Fidelity & Guaranty Co. v. West Point Construction, also found an express intent to arbitrate by the incorporation of a subcontract into a bond. In this case, the general contractor sought to compel a subcontractor’s surety to arbitrate a dispute pursuant to a performance bond that incorporated by reference a subcontract between the general contractor and a subcontractor. The Eleventh Circuit held that because the subcontract was referred to in and made part of the bond, disputes arising under the bond, including disputes concerning the adequacy of the subcontractor’s performance under the subcontract (a condition of the performance bond), were subject to the arbitration provisions of the subcontract.
Arbitration not mandated. The Eighth Circuit, however, has diverged from the majority of federal jurisdictions on this issue. In AgGrow Oils, LLC v. National Union Fire Insurance Co. of Pittsburgh, Pennsylvania, the court considered a dispute between the owner of a processing facility and the surety of a contractor hired by the owner to build the facility. The underlying construction contract between the plant owner and the contractor contained an arbitration clause, and the surety sought to compel arbitration, arguing that the language of the bond incorporated the obligation to arbitrate found in the underlying contract. However, the performance bond itself contained a clause providing for judicial settlement of disputes. The court of appeals found that the provision referencing judicial settlement created an ambiguity as to intent to incorporate the agreement to arbitrate. Applying North Dakota law, the court went on to analyze the incorporation clause’s main purpose and found that it was meant merely to clarify the construction company’s performance obligations that the surety undertook to guarantee, and nothing more. The clause, according to the Eighth Circuit, did not clearly reflect the intent of the owner and the surety to arbitrate their disputes under the bond.
In Liberty Mutual Insurance v. Mandaree Public School District No. 36,the U.S. District Court of North Dakotafollowed the Eighth Circuit in AgGrow Oils. In Mandaree,it was the bond obligee, as opposed to the surety, attempting to compel arbitration, but it made no difference to the outcome. As in AgGrow Oils, the court in Mandaree foundrelevant that the bond contained a provision contemplating that disputes would be resolved in court—again, a direct contradiction to the assertion that the parties intended to submit disagreements to arbitration. Furthermore, the underlying construction contract expressly limited the contractual relationship to the named parties. Because the bond language was the same as in AgGrow Oils and the construction contracts in both cases had nearly identical arbitration provisions referring only to the immediate parties, the Mandaree court found the case indistinguishable from AgGrow Oils.
In Ohio Casualty Insurance Co. v. City of Moberly, Missouri, the U.S. District Court for the Eastern District of Missouri did affirm the arbitration agreement, but it did so by distinguishing AgGrow Oils, noting that the key language in the bond in AgGrow Oils conflicted with the language in the underlying contract. In Moberly, because the performance bond was included within the definition of Contract Documents and the bond stated that the contract was “by reference made a part hereof as fully as if attached hereto or set forth herein,” the court found that the language of the bond did not conflict with the language of the contract; and, therefore, the “[s]urety [w]as bound by the arbitration agreement in the [c]ontract the same as it would be if there were an arbitration agreement in the [b]ond itself.”
In at least one case, the Eleventh Circuit veered from its usual pro-arbitration stance. In World Rentals & Sales v. Volvo Construction Equipment Rentals, albeit a case outside the surety context, the arbitration provisions of an underlying franchise agreement were expressly limited to the immediate contracting parties. Also, in an unusual provision, the arbitration clause in this case explicitly excluded corporate parents or affiliates. Under these circumstances, the Eleventh Circuit took a position similar to that of the Eighth Circuit and refused to compel arbitration despite general incorporation language.
The U.S. District Court for the District of Columbia likewise held that a surety was not obliged to arbitrate its dispute with an owner under an arbitration clause incorporated in a performance bond by reference. In Western Surety Co. v. U.S. Engineering Co., the court reasoned that because the subcontract mandated arbitration for “[a]ny controversy or claim of Contractor against Subcontractor or Subcontractor against Contractor,” only those two parties were bound by the arbitration agreement.
Thus, the Eighth Circuit does not appear to be as much of an outlier as first thought in allowing restrictively phrased arbitration clauses that refer to the immediate parties to preclude recognition by incorporation.
Lack of consensus on same facts. Four recent federal decisions involving the same parties reached differing conclusions. The cases all arose from an arbitration demand made by the general contractor, Carother’s Construction, Inc., against Developers Surety and Indemnity Company. Developers had issued payment and performance bonds on behalf of subcontractors Liberty Enterprises Specialty Contractor and Seven Hills Construction, LLC, in favor of Carothers. Following the default by both subcontractors, Carothers filed suit against Developers, arguing that the bonds incorporated by reference the mandatory arbitration provisions of the subcontracts. Applying South Carolina law, the U.S. District Court for the District of South Carolina held that a surety is bound by the arbitration agreement in the incorporated contract, reasoning that a bond is to be construed together with the agreement it incorporates in order to ascertain the parties’ intent. However, the U.S. District Court for the District of Kansas held that the arbitration agreement expressly applied only to disputes between the contractor and subcontractor and that Developers as surety was neither. The court further held that even though the bond incorporated the subcontract by reference, Developers did not agree to assume “any and all obligations” of the subcontractor. Most recently, in the U.S. District Court for the District of Connecticut on cross-motions for summary judgment, the court ruled in favor of the surety, finding that Developers is not bound by the arbitration provision and noting its disagreement with the conclusion reached by the District Court of South Carolina and its concurrence with the holding of the District Court of Kansas and the U.S. District Court for the Northern District of Georgia.
Current Developments in the Law: State Decisions
Arbitration follows incorporation by reference. State courts in Alaska, Arkansas, California, Connecticut, Florida, Kentucky, Massachusetts, Missouri, and Tennessee all have upheld reasoning similar to that of the federal majority, taking a broad approach to arbitration clauses and finding that all claims “arising out of, or related to” the contract are broad enough to cover not only those claims and disputes arising out of the contract but also all claims arising from the bond involving the surety.
In the Florida case of Henderson Investment Corp. v. International Fidelity Co., the surety made a demand to compel arbitration pursuant to the performance bond it issued, which referenced the contract between the principal and the owner. In turn, the owner filed a complaint against the surety following the default of the principal. International Fidelity then filed a motion to compel arbitration and to stay litigation. The court held that when a surety bond incorporates a construction contract (that has an arbitration clause), the surety obligates itself to participate and be bound by arbitration for disputes arising under the construction contract.
Despite the Eighth Circuit decision in AgGrow Oils, Missouri is another state taking the position of the majority in recognizing the strong federal policy in favor of arbitration and enforcing agreements to arbitrate contained in contracts that are incorporated by reference into bonds. However, the Missouri Supreme Court in Dunn Industrial Group, Inc. v. City of Sugar Creek distinguished the case before it from a typical incorporation by reference case because the guaranty agreement simply made reference to the underlying contract and did not specifically incorporate it by reference. Accordingly, the Missouri Supreme Court held that this language was not enough to show that Dunn as a guarantor consented to arbitrate, and it therefore refused to compel arbitration of the claims against Dunn as a guarantor.
The Kentucky Supreme Court held in Black Run Baptist Church v. Cumberland Surety Insurance Co. that where the performance bond specifically and clearly references the underlying construction contract between the principal and the owner, and the contract contains an arbitration clause, the surety is entitled to compel arbitration. In Black Run, the owner failed in an attempt to defeat the surety’s demand for arbitration by arguing that the performance bond was “insurance” and therefore excluded from arbitration by the Kentucky Arbitration Act.
Arbitration not mandated. The Supreme Court of Maryland has gone in its own direction by adopting a narrow definition of suretyship, focusing on the intent of the parties and thereby placing great emphasis on the consensual nature of a contract. Essentially, it holds that a typical arbitration provision is not “consented to” when a surety issues a bond that incorporates an underlying contract involving the principal. In Hartford Accident & Indemnity Co. v. Scarlett Harbor Associates Limited Partnership, the standard language in the bond written by Hartford was that the subcontract is by reference made a part thereof. Accordingly, the question was whether the surety could compel the obligee to arbitrate. The court ultimately held that the bond incorporation language did not require the obligee to submit to arbitration; further, it noted that the underlying contract did not require an arbitration provision to be in any bond provided to the owner and that the bond itself did not contain any such provision.
More recently, in the case of Schneider Electric Buildings Critical Systems, Inc. v. Western Surety Co., the Maryland Court of Special Appeals followed the court in Scarlett Harbor and held that the language in the surety’s performance bond incorporating the principal’s subcontract was not sufficient to bind the surety to the arbitration requirements of the subcontract. Both the circuit court and the court of special appeals held that regardless of whether the FAA or the Maryland Uniform Arbitration Act governed, the controversy was a matter of contract formation controlled by basic Maryland contract law principles. The surety’s undertaking to guarantee performance of the principal’s subcontract therefore only extended to the work to be performed by its principal, not to any other obligations or provisions of the underlying contract. Accordingly, the court held that the arbitration clause, as incorporated by reference into the bond, did not compel Western Surety to arbitrate its dispute with its principal.
Likewise, in Faith Technologies, Inc. v. Horizon Construction Group, a subcontract agreement included an arbitration clause, but the payment bond, issued on behalf of the general contractor, did not. The Superior Court of Pennsylvania reversed the trial court in part and affirmed it in part, giving effect to the arbitration clauses between the prime contractor and subcontractor but holding that the surety could not compel the subcontractor to arbitration because the payment bond neither included an arbitration clause nor included such provision by incorporation.
In New York and New Jersey, the state courts diverge from their respective federal Second and Third Circuits. For example, in the New York case of Fidelity & Deposit Co. of Maryland v. Parsons & Whittemore Contractors Corp., the court held that a performance bond issued by the surety to guarantee performance of a contract, which contained a broad arbitration clause, did not entitle the surety to stay arbitration of issues arising under that contract but did entitle the surety to stay arbitration of other disputes not subject to arbitration under the performance bond. More specifically, the court found that because the performance bond incorporated the underlying contract, the surety agreed to be bound by any award in arbitration against its principal arising out of a dispute between the principal and the owner. On the other hand, as to issues related to the terms and conditions of the performance bond, the surety did not agree to arbitrate those disputes, as evidenced by the lack of any arbitration agreement in the performance bond.
In Gloucester City Board of Education v. American Arbitration Ass’n, the New Jersey Superior Court considered a surety bond that incorporated the underlying contract by reference such that “[a]ny controversy or claim arising out of or related to” the underlying contract would be submitted to arbitration. The court, perhaps more succinctly than the court in Parsons & Whittemore, held thus:
[T]he dispute between [the surety] and the [owner] concerning the enforceability of the . . . performance bond does not constitute a “controversy or claim arising out of or related to” [the contractor’s] contract with the [owner] and thus is not arbitrable.
Arbitration Clauses in Related Contracts and Agreements
The surety also may find itself forced into arbitration because of other related agreements.
Clauses involving subcontractors. In the case of First Sealord Surety, Inc. v. TLT Construction Corp.,the surety brought suit in federal court against its principal, the general contractor, for fraud. The general contractor moved to compel arbitration by enforcing a clause included in the bond stating that any claim “involving subcontractor” may be subject to arbitration at TLT’s election. The court found that even though the alleged fraud arose from TLT’s conduct, the fraudulent conduct was related to the subcontractor’s existence, performance, scope of work, capacity, etc., and thus “involved [the] subcontractor.” The court therefore enforced the arbitration provision even though the subcontractor was not a necessary party to the fraud case. This is a clear example of the increasingly broad approach more recently taken by the majority of the courts favoring arbitration.
General agreement of indemnity. Something else to watch out for is whether the surety can be compelled, or rather forced, to arbitrate for claims concerning or arising out of its general agreement of indemnity (GAI). The bonds issued by the surety typically (and in some cases expressly) are referenced in the GAI. Thus, consistent with the broad approach to arbitration, courts view the GAI as related to the performance bond and the bonded contract.
Even though the issues that concern a GAI are different from those of bonds and bonded contracts and have nothing to do with who breached the construction contract or which party owes what to whom under the contract or bond, it is easy to see how a court could become confused and believe that all the facts and issues are so closely related that joinder of all parties and claims makes sense and that the case is subject to arbitration. In actuality, though, many rights, duties, and obligations of the parties are different, are not so easily lumped together, and should not be lumped together. Further, while the obligee may be able to compel both the principal and surety to arbitration with regard to claims under the construction contract, that arbitration proceeding does not give any rights to parties such as individual indemnitors, nor does it change the duties that such indemnitors owe to the surety.
The same is true when the owner, architect, general contractor, and/or subcontractors arbitrate claims between themselves. Many of the parties and claims that could be joined in such an arbitration have nothing to do with the GAI even though the result of an arbitration could be binding upon the surety—but that does not mean that individual indemnitors might not try forcing the surety to arbitrate disputes arising out of the GAI.
GAI case: Atlantis. The case of Hanover Insurance Co. v. Atlantis Drywall & Framing, LLC is one such case. In March 2011, Atlantis Drywall & Framing, LLC, entered into a subcontract agreement with Brice Building Company, LLC, for certain work to be performed at the University of Alabama. Following execution of the subcontract, Hanover issued bonds that incorporated the subcontract, naming Atlantis as the principal and Brice as the obligee. In fact, the bonds specifically referred to the subcontract as the document being incorporated by reference. Not surprisingly, the individual indemnitors were not parties to the subcontract or the bonds. Hanover ended up incurring losses on the payment and performance bonds and accordingly filed suit against Atlantis and all of the individual indemnitors in the U.S. District Court for the Northern District of Alabama. The indemnitors filed a motion to compel arbitration.
On appeal to the Eleventh Circuit, the indemnitors argued that the district court erred by failing to compel arbitration. The indemnitors argued that Hanover’s indemnity claims arose out of or were collateral to the provisions of the subcontract or breach thereof. They also argued that the indemnity agreement and Hanover’s claims as surety against them related to a single transaction and therefore were subject to arbitration. Hanover argued that a simple reading of the indemnity agreement showed that it did not contain an arbitration provision, nor did it incorporate any other document by reference.
On August 29, 2014, the Eleventh Circuit issued its opinion and vacated the ruling of the district court, remanding the case back with instructions to compel arbitration. In so doing, the Eleventh Circuit held that the bonds, indemnification agreement, and subcontract were part of a single transaction and “relate to the same subject matter.”
Hanover filed a petition for rehearing, which the Eleventh Circuit granted. On May 26, 2015, the Eleventh Circuit upon rehearing denied the indemnitors’ motion to compel arbitration, finding that regardless of whether the indemnity agreement, the bonds, and the subcontract were part of a single transaction containing an arbitration provision, the arbitration provision here did not permit the indemnitors to compel arbitration.
Even though the Eleventh Circuit in Atlantis ultimately denied the indemnitors an opportunity to arbitrate the surety’s indemnity claims, it is not out of the realm of possibility that indemnitors in the future again will try compelling courts to force a surety to arbitrate disputes over its GAI, especially if the class of nonsignatories that can be compelled to arbitrate continues to expand. Indemnity agreements with provisions that expressly prohibit arbitration of indemnity claims, however, would reduce such possibilities.
Conclusion
The scope and enforceability of arbitration provisions, as well as who is bound by them and to what extent, ultimately depend upon the law of the applicable jurisdiction. Careful analysis of the state or federal law and the contract documents at issue, including the bonds, is critical to the surety enforcing its rights either by pursuing arbitration itself or when confronted with a claim in arbitration.