Pan-American Surety Association Newsletter
"News@PASA 2/4 of 2005

The Surety's Right to Settle All Claims - Part II

By: William J. Taylor, Esquire
Philadelphia, Pennsylvania USA

In our last article we discussed the basis of the surety's right to settle claims, both direct claims against it and claims asserted against and by its principal. In this article we discuss the surety's right to indemnification after settling a claim, including the principal's defense that the surety failed to act in good faith and thus is not entitled to be indemnified.

I. The Surety's Right to Indemnification After Settling a Claim - The Obligation of Good Faith

The settlement, assignment, and attorney-in-fact clauses found in the typical indemnity agreement in the United States confer broad discretion upon the surety to settle bond claims, and numerous U.S. courts have upheld a surety's right and authority to settle all claims regarding a bonded project, even the principal's own affirmative claims. The question for the surety, then, is how to recover, by way of indemnity, for the losses and expenses incurred as a result of the claim and its settlement. If the principal objected to the settlement, the surety certainly should not expect the principal to gladly agree to a claim for indemnity. How the agreement of indemnity is interpreted will dictate how the surety can recover.

The typical indemnification clause found in the General Agreement of Indemnity in the United States delineates the surety's right to seek indemnity from its principal - a right which already exists under U.S. common law - as follows:

The Indemnitors shall exonerate, indemnify, and keep indemnified Surety from and against any and all liabilities, losses and expenses of whatsoever kind or nature . . . imposed upon, sustained, or incurred by Surety by reason of Surety having executed, provided or procured the Bond(s).

However, the surety's right to recover under the indemnity clause is limited to the surety's good faith actions under the settlement, assignment and/or attorney-in-fact clauses. It is uniformly recognized in the United States that the surety is only entitled to indemnification for those settlement payments made in good faith. The issue facing the settling surety, therefore, is whether its conduct constitutes good faith, the definition of which can vary from jurisdiction to jurisdiction. Moreover, the good faith requirement can be either express or implied.

A. Express Requirement of Good Faith

Some indemnity agreements expressly state that the indemnitors are liable for all payments made by the surety in good faith. An express good faith clause can be used affirmatively by the surety to support its claim for indemnity. For example, in one leading U.S. case, the indemnity agreement at issue provided that:

The liability of Indemnitors hereunder shall extend to and include all amounts paid by Surety in good faith under the belief that: (1) Surety was or might be liable therefore; (2) such payments were necessary or advisable to protect any of Surety's rights or to avoid or lessen Surety's liability or alleged liability .. .

The principal in that case argued that the surety should only be entitled to indemnity for those amounts it paid to settle claims for which the surety was actually liable under the bond, and not for those payments made, albeit in good faith, on the basis that the surety might be liable or made for the purpose of avoiding or lessening the surety's liability or alleged liability. Based on the good faith language outlined above, the court rejected the principal's argument and noted that "such good faith clauses, while harsh, are typical in surety agreements and have routinely been upheld." The court further recognized that:

[s]ureties enjoy such discretion to settle claims because of the important function they serve in the construction industry. The purpose of good faith clauses is to facilitate the handling of settlements by sureties and protect them from unnecessary and costly litigation. It is believed that 'the expense, delay, trouble, and risk of loss to the [surety] is a sufficient safeguard against an unwarranted payment.'

Of course, an express good faith provision in an indemnity agreement also clearly demonstrates that the principal is not required to indemnify a surety for payments made through fraud or lack of good faith. It is under this principle that indemnitors often seek to avoid reimbursing the surety, i.e., by alleging that a settlement was effectuated in bad faith or in the self-interest of the surety.

B. Implied Requirement of Good Faith

Just as many commercial contracts in the United States are often found to have an implied covenant of good faith and fair dealing, indemnity agreements executed in favor of sureties have also been interpreted as being infused with such an obligation, even when they do not contain the express good faith language described above. Some courts have found that a surety is "bound by its implied covenant of good faith to exercise its discretion in compromising the claim so that the reasonable expectations of all the parties would be effectuated." Another court found that an implied covenant of good faith was to be "superimposed on the entire surety contract." In that case, the court found that because the surety did not make settlement payments in good faith, the surety could not recover those amounts from its principal. The covenant of good faith found by the court "requires a surety seeking indemnification to show that its conduct was reasonable." In all these cases, the indemnity agreement did not contain express language regarding the surety's duty to act in good faith. Rather, the courts implied this duty as a matter of law.

C. The Meaning of "Good Faith"

While almost every jurisdiction in the United States recognizes some type of duty of good faith on the part of the surety, whether express or implied, there is no consensus about what that duty actually requires.

1. The harshest view - mere "negligence" or "unreasonableness" constitutes bad faith.

A minority of U.S. jurisdictions equate a surety's bad faith with conduct that is merely negligent or unreasonable. For example, one court held "that negligence and bad faith are synonymous in this context." In another case, the court began its analysis of the surety's indemnity claim by noting that "every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement." The surety, which took over and completed a bonded project in response to a performance bond claim, argued that it should not have been found to have acted with a lack of good faith "because it did not have an evil motive when incurring these expenses." The court disagreed, and stated that "the covenant of good faith can be breached for objectively unreasonable conduct, regardless of the actor's motive."

Fortunately, there are not many jurisdictions in the United States where mere negligence is equated with bad faith.

2. The other extreme - fraud must be shown to prove bad faith.

Other U.S. courts, again in the minority, go far in the opposite direction and require a showing of actual fraud in order for a surety's actions to constitute bad faith. In one such case, the court ruled in favor of the surety for indemnification for losses incurred in satisfying a performance bond claim. Despite finding that the principal did not actually breach the bonded contract and that a somewhat lesser amount than that expended by the surety would have been sufficient to complete the repairs to the principal's work, the court ruled that, in light of the express good faith provision contained in the indemnity agreement, the surety could be denied recovery only in the event of fraud. Specifically, the court noted that it was "confronted with the well-nigh inescapable conclusion that the parties to this bond (indemnity agreement) have lodged in the indemnitee a discretion limited only by the bounds of fraud."

In another case, a federal court case out of New York, the district court noted that the surety's right to settle claims and make payments was limited only by the surety's obligation to act in good faith, and that "[i]n the absence of an indication of fraud or collusion between [the surety] and the claimants" the surety was entitled to be indemnified pursuant to the terms of its indemnity agreement.

3. The majority view - unreasonable conduct and improper motive constitutes bad faith.

The majority approach in the United States as to what constitutes bad faith lies between the two extremes of mere negligence and actual fraud. A recent U.S. case discussing this majority approach defined bad faith as requiring an improper motive or dishonest purpose on the part of the surety, but was "careful to note, however, that we do not interpret this standard as requiring the improper motive to rise to the level of fraud." In choosing the ground between mere negligence or unreasonableness and actual fraud, the court sought to "preserve a proper balance between affording the surety the wide discretion to settle that it requires, while ensuring that the principal is protected against serious and willful transgression." The court further noted that "although we are not interpreting good faith to mean reasonableness . . . whether a surety's actions were reasonable properly may be considered when analyzing bad faith. Unreasonable conduct can be evidence of improper motive and is a proper consideration where parties are bound by a contract that gives unmitigated discretion to one party."

In that case there were several factors considered by the court in determining the existence of bad faith on the part of the surety. The court noted that there was evidence at trial that the surety failed to conduct a sufficient investigation, including a failure to abide by a bond provision requiring the surety to furnish a written response to the claimant within forty-five days of the surety's receipt of the claim, and to pay those portions of the claim that were undisputed. Moreover, there was evidence that the surety had conducted only a superficial review of the claim documentation. The court recognized that "the failure to investigate, standing alone and not accompanied by other evidence of an improper motive, is not enough to constitute bad faith," but that the failure to investigate "when accompanied by other evidence reflecting an improper motive, properly may be considered as evidence of the surety's bad faith." Such "other evidence" was found to exist in the self-interested settlement entered into by the surety that was designed to resolve the bad faith and unfair trade practices claims against it. The settlement was also effectuated without the knowledge or participation of the principal. While the court recognized that a self-interested settlement, alone, did not necessitate a finding of bad faith, in that case the evidence regarding the surety's investigation and the nature and circumstances of the settlement, taken together, formed the basis for the court's ultimate finding of bad faith on the part of the surety. The surety was denied indemnification.

Another U.S. court recently found that "a good faith standard that protects the surety for every mistake, no matter how egregious, that falls short of fraud is unwise." Rather, the court concluded "that a standard of reasonableness also should be implied in the good faith analysis of a surety's actions in determining whether it may recover against the principal." There, the surety was found to be entitled to indemnity from its principal for the surety's settlement of a payment bond claim, even though the claim against the surety most likely fell outside the scope of the bond's coverage. The court found, however, that despite the surety's repeated attempts to communicate with its principal regarding the claim, the principal failed to timely share the facts underlying the bond coverage defense until after the surety had settled the claim. The court was careful to note that "we do not substitute a reasonableness standard for the good faith standard; we simply have equated the two standards . . . [w]e hold that the good faith standard allows the surety a discretion limited by the bounds of reasonableness, rather than by the bounds of fraud." The court also emphasized that the "reasonableness requirement is meant only to filter the most egregious, careless, or inattentive conduct, short of fraud, of a surety; such as making a payment on a bond that the surety clearly knows or should know is not covered by the bond." The court further stated that such a reasonableness requirement "is not meant to foster reluctance on a surety's part to satisfy bond claims."

The court also reminded us that "[n]ot only does the surety have to act with reasonableness and good faith, the principal is bound by a reciprocal obligation of good faith and fair dealing." This obligation on the part of the principal includes the duty to timely cooperate in the investigation and processing of claims, as well as sharing information that may support defenses to the claims. The principal's failure to meet its obligations clearly contributed to the court's finding that the surety's investigation was "frustrated," and that the surety's payment "based on the information that was supplied to it by" the claimant was "reasonable" and in "good faith."

II. Conclusion

The General Agreement of Indemnity used in the United States gives the surety the authority to settle claims, and broad discretion in doing so. However, this discretion is not unlimited. If the surety acts with an improper motive and unreasonably while settling a claim, it runs the risk that it may not be able to recover on an indemnification claim against its principal.