Pan-American Surety Association Newsletter
"News@PASA 3/4 of 2004

Problems and Solutions For a Fronting Surety Part II: Indemnity Rights

By: William J. Taylor, Esquire
Brian P. Flaherty, Esquire

As we discussed in the last PASA newsletter, the use of "fronting" is becoming more and more common in the surety industry. It occurs when a surety issues a bond on its own paper for another surety's customer. The fronting surety's risk is then fully guaranteed by the first surety (known as the "backing" or "instructing" surety.) Fronting may be done as an accommodation or for a fee. Some in our industry believe that fronting is a simple, risk-free transaction with few potential hazards. However, there are several issues that need to be fully considered in a fronting situation, as the risks may be greater than initially anticipated. This article, which is the second in a series of articles that will address these issues, will deal with indemnity issues.

In the classic case of a surety issuing a bond for a principal, the surety has two types of remedies against its principal to recover its losses and expenses incurred on the bond: 1) those arising under common law for simple indemnity, or for any one of a number of more arcane legal rights such as quia timet and exoneration; and 2) those arising by contract pursuant to an indemnity agreement. Typically such agreements grant the surety rights against third parties other than just the principal, and those rights are broader and more effective that those available at common law.

However, in the case of a fronted bond, a third-party, the backing surety, is also involved in the relationship. Depending upon how the relationship is structured, the fronting surety may face the risk that its indemnity rights may be compromised, and it must protect itself against this risk. These rights became especially important if the fronting surety cannot recover on the guarantee obtained from the backing surety, which may occur, for example, if the backing surety becomes insolvent.

First, the fronting surety must determine if the principal is truly the principal of the fronting surety or of the backing surety. Since the fronting surety is issuing the bond (which usually clearly identifies the principal on its face) it seems sensible that the principal will be regarded as the principal of the fronting surety. Therefore, whatever common law rights which usually inure to the benefit of the fronting surety in its capacity as surety vis a vis the principal will inure to the fronting surety directly. However, this may not be entirely free from doubt. It is not inconceivable that the principal may argue that he truly is the principal of the backing surety and the backing surety alone, since it is the backing surety with whom he has a direct relationship. The remedy here is to clearly define on the bond itself the identity of the surety and the identity of the principal, i.e., "ABC Insurance Company, as surety, and XYZ Construction Company, as principal."

A larger problem, however, for a fronting surety is the ability to obtain from the principal contractual indemnity rights, which are far more valuable and easier to enforce than common law rights, and may extend to more solvent third parties. Typically, the backing surety will have an indemnity agreement with the principal on whose behalf it is procuring the fronted bond. But if the fronting surety does not obtain its own indemnity agreement from the principal, there are several questions that arise in connection with whether the fronting surety has any rights under the backing surety's indemnity agreement.

The first question is whether the backing surety will be considered to have indemnity rights against the principal and other indemnitors in regard to bonds issued not by itself but rather by the fronting surety. That is, does the indemnity agreement between the backing surety and the principal/indemnitor apply solely to bonds issued by the backing surety itself, or does it also apply to all bonds procured by the backing surety, even if it procures them by inducing another surety to issue them as a front? The authors are familiar with many form indemnity agreements which typically cover the surety for losses incurred on any bonds "procured" or "obtained" for the benefit of the principal and/or indemnitors. Thus, assuming that the backing surety incurs losses on such a bond, the fact that the backing surety did not actually issue the bond itself will not mean that the indemnity agreement's provisions do not apply. However, one should be careful to examine the indemnity agreement if one is going to rely upon it to insure that its terms specifically apply to bonds procured by the signatory surety as well as to bonds issued by it.

A second question is whether a loss in the nature of a payment of the reimbursement or guarantee obligation to the fronting surety by the backing surety qualifies as the kind of loss which is covered by the indemnity agreement. This obviously is of primary concern of the backing surety. Usually, a backing surety is regarded as a kind of reinsurer for the fronting surety, who has the direct primary liability to the obligee. The backing surety, to be sure, may be liable to reimburse the fronting surety for any losses the fronting surety incurs, but the backing surety is never directly liable to the obligee. Therefore, the indemnity agreement should be examined to insure that the definition of losses covered by it includes whatever reimbursement or guarantee obligations, however denominated, the backing surety owes to the fronting surety, and any losses incurred as a result of those obligations.

Finally, even assuming that the backing surety's indemnity agreement applies by its terms to the fronted loss in question, can the fronting surety take advantage of its terms? Absent specific language in the indemnity agreement, it may not be able to do so. For example, some indemnity agreements explicitly state that their terms inure to the benefit of any fronting surety who issues a bond at the instance of the backing surety for whose benefit the indemnity agreement was signed. Typical of such language is the following:

In the event the Surety procures the execution of the Bonds by other sureties, or executes the Bonds with co-sureties, or reinsures any portion of said Bonds with reinsuring sureties, then all the terms and conditions of this Agreement shall inure to the benefit of such other sureties, co-sureties and reinsuring sureties, as their interests may appear.

This would be an explicit provision that recognizes the fronting surety as a third-party beneficiary of the indemnity agreement, entitled to enforce its terms against any of the signatories. In the absence of such an explicit provision, however, it is questionable as to whether the fronting surety will be entitled to enforce the terms of the agreement directly against the principal. Generally speaking, the law regarding third-party beneficiaries requires that it be in the contemplation of all the parties that the third party beneficiary stand in that position. Without an explicit declaration as set forth above, a determination of whether that intent exists can turn into a fact-intensive dispute whose outcome cannot be predicted with certainty.

In summary, the best course for a fronting surety is to obtain an indemnity agreement directly from all of those persons to whom it would be traditionally looking for indemnity as a direct surety. Such an agreement should clearly and unambiguously delineate the surety's rights against the principal and other indemnitors. In the absence of such an agreement, the careful surety (both a fronting surety and a backing surety) should examine the terms of the indemnity agreement of the backing surety to insure:

(1) that it explicitly covers bonds issued by other persons at the instance of the backing surety, such as the fronting surety;

(2) that it explicitly covers losses incurred by the backing surety in the nature of the reimbursement it may be obligated to pay to the fronting surety in the event of a loss; and

(3) that it contains a provision explicitly recognizing the third-party beneficiary rights of a fronting surety so that a fronting surety may enforce the indemnity agreement directly against the principals.

Only by taking these steps can the fronting surety be assured of having rights of indemnity against a principal when it is fronting for another surety.