Pan-American Surety Association Newsletter
"News@PASA 1/4 of 2005

The Surety's Right to Settle All Claims

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

We've seen it all the time - a sizeable claim asserted against a surety on a performance or payment bond, with all conditions precedent satisfied and voluminous documentation submitted by the claimant to back up the claim, but a principal who swears that the claim has no merit and in fact he is the one who has been damaged and has a sizeable counterclaim to assert. Unfortunately, the principal cannot back up his alleged defenses, and the counterclaim seems largely illusory. Throw in the claimant's threats of a bad faith claim (if one has not already been filed), coupled with the principal's vow that nothing should be paid to the claimant and he'll be dammed if he'll pay the surety back for anything that the surety spends. All this time more and more legal bills are adding up. Can a surety simply settle the entire matter with the claimant and be done with it? After settling, can the surety then pursue the principal for indemnification? The answer to both these questions, generally, is yes, but the surety must act wisely to be successful.

This article will discuss the basis of the surety's right to settle claims, both direct claims against it and claims asserted against and by its principal. In our next article we will 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.

I. The Basis of the Surety's Right to Settle Claims

Under the common law in the United States, a surety clearly has the right to settle claims by or against it, but has no right to settle its principal's own claims. The right to settle on behalf of the principal, including settling the principal's affirmative claims, is a contractual right arising out of the principal's agreement of indemnity. An indemnity agreement generally must have certain specific clauses to enable a surety to settle not only claims asserted against it but also claims asserted against its principal and affirmative claims asserted by its principal against the obligee. Further, if the indemnity agreement contains these key provisions the surety can make this settlement even over the strenuous objections of its principal, and still will be entitled to indemnification from the principal after settlement monies are paid.

A. The Settlement Clause

Most U.S. courts analyzing a surety's right to settle note three important provisions of a typical indemnity agreement that play key roles in the settlement process. The first is the Settlement Clause. The typical Settlement Clause in an indemnity agreement reads as follows:

The Surety shall have the right to adjust, settle or compromise any claim, demand, suit or judgment upon the Bonds, unless the Contractor and the Indemnitor shall request the Surety to litigate such claim or demand, or to defend such suit or to appeal from such judgment, and shall deposit with the Surety, at the time of such request, cash or collateral satisfactory to the Surety in kind and amount, to be used in paying any judgment or judgments rendered or that may be rendered, with interest, costs, expenses and attorney's fees, including those of the Surety.

This provision, in and of itself, usually is interpreted to give the surety only the right to settle and compromise claims against it, and not the right to settle the principal's own claims. This right of the surety to settle claims against it exists even if the principal objects to the surety's settlement. Some Settlement Clauses (including the sample set forth above) do give the principal the ability to prevent a surety from settling claims against it, but only if certain specified conditions are satisfied. For example, in the sample Settlement Clause set forth above a principal's ability to preclude the surety from settling pursuant to the authority granted under the Settlement Clause is conditioned upon a specific request by the principal that the surety litigate the claim and the deposit by the principal of satisfactory collateral. If the principal fails to post security and make a demand for litigation upon the surety, the surety is free to settle.

Even if the principal fails to demand that a claim be litigated, and fails to post collateral, the surety may have a problem seeking indemnification after a settlement is made if the principal can claim that it received no notice of the proposed settlement. For example, several years ago an appellate court in the United States held that a standard settlement clause in an indemnity agreement that gave the principal the right to deposit security and request that the surety litigate a claim "must be construed to require adequate notice" to the indemnitor. The court further noted that the language of the indemnity agreement's settlement clause was "in irreconcilable conflict" with the language of another clause in the agreement under which the indemnitor waived all notice of the execution of all bonds, all notice of default, and all notice of liability on the part of the surety and/or the indemnitors. The court held that this conflict rendered the indemnity agreement ambiguous, bringing into the play "the rule that the contract of a surety, for hire, is to be strictly construed against the surety." However, other courts in the United States have held that the indemnity agreement does not require the surety to consult with the principal prior to settling any claims, and the fact that a surety makes payments without giving notice to the principal is not evidence of bad faith. Further, if the indemnity agreement does not give the indemnitors the right to demand litigation and post collateral, the lack of notice of a settlement will certainly not impair the surety's indemnification rights

B. The Assignment Clause and the Attorney-in-Fact Clause

Clear authority for the surety to settle its principal's claims, including affirmative claims, is found in two other key provisions of the typical indemnity agreement - the Assignment Clause and the Attorney-in-Fact Clause. The Assignment Clause is generally a complex provision under which the principal assigns to the surety numerous rights, including usually all of its rights in each bonded contract, contingent upon certain events of default. A typical Assignment Clause may read as follows:

The Contractor, does hereby assign, transfer and set over to the Surety, as collateral, to secure the obligations in any and all of the paragraphs of this Agreement and any other indebtedness and liabilities of the Contractor to the Surety, whether heretofore or hereafter, incurred, the assignment in the case of each contract to become effective as of the date of the bond covering such contract . . . (a) All the rights of the Contractor in, and growing in any manner out of, all contracts referred to in the Bonds, or in, or growing in any manner out of the Bonds; (b) All the rights, title and interest of the Contractor in and to all machinery, equipment, plant, tools and materials which are now, or may hereafter be, about or upon the site or sites of any and all of the contractual work referred to in the Bonds or elsewhere, including materials purchased for or chargeable to any and all contracts referred to in the Bonds, materials which may be in process of construction, in storage elsewhere, or in transportation to any and all of said sites; (c) All the rights, title and interest of the Contractor in and to all subcontracts let or to be let in connection with any and all contracts referred to in the Bonds, and in and to all surety bonds supporting such subcontracts; (d) All actions, causes of actions, claims and demands whatsoever which the Contractor may have or acquire against any subcontractor, laborer or materialman or any person furnishing or agreeing to furnish or supply labor, material, supplies, machinery, tools or other equipment in connection with or on account of any and all contracts referred to in the Bonds; and against any surety or sureties of any subcontractor, laborer, or materialman; (e) Any and all percentages retained and any and all sums that may be due or hereafter become due on account of any and all contracts referred to in the Bonds and all other contracts whether bonded or not in which the Contractor has an interest.

Thus, the typical Assignment Clause conveys to the surety a wide array of the principal's rights, including all rights in or related to the bonded contracts. This would include, obviously, the principal's affirmative claims for extra work, delay, or disruption.

To effectuate the Assignment Clause, the typical indemnity agreement also has an Attorney-in-Fact Clause, which usually reads as follows:

The Contractor and Indemnitors hereby irrevocably nominate, constitute, appoint and designate the Surety as their attorney-in-fact, with the right, but not the obligation, to exercise all the rights of the Contractor and Indemnitors assigned, transferred and set over to the Surety in this Agreement, and in the name of the Contractor and Indemnitors to make, execute, and deliver any and all additional or other assignments, documents or papers deemed necessary and proper by the Surety in order to give full effect not only to the intent and meaning of the within assignments, but also to the full protection intended to be herein given to the Surety under all other provisions of this Agreement. The Contractor and Indemnitors hereby ratify and confirm all acts and actions taken and done by the Surety as such attorney-in-fact.

The courts in the United States have generally held that the Assignment Clause plus the Attorney in Fact Clause give the surety wide authority to settle claims, including affirmative claims of a principal. This authority to settle the principal's claims as well as the surety's claims is often the key to a successful resolution of a claim, as the obligee will often insist on a total resolution of the matter rather than a piecemeal settlement with individual parties.

Thus, these three provisions of a typical indemnity agreement - the Settlement Clause, the Assignment Clause, and the Attorney-in-Fact Clause, work together to give a surety the power to settle on its behalf and on behalf of its principal. Moreover, this authority includes the authority to settle affirmative claims that the principal may have against the obligee.

Notably, while the authority to settle under the Settlement Clause exists in and of itself, the Surety's authority under the Assignment Clause usually must be triggered by some event of default on the part of the principal. These events of default may include the failure to pay subcontractors or materialmen or the failure to provide collateral or other security to the surety upon demand when a claim arises. A typical clause may read as follows:

[assignment occurs] only in the event of (1) any abandonment, forfeiture or breach of any contracts referred to in the Bonds or of any breach of any said Bonds; or (2) of any breach of the provisions of any of the paragraphs of this Agreement; or (3) of a default in discharging such other indebtedness or liabilities when due; or (4) of any assignment by the Contractor for the benefit of creditors, or of the appointment, or of any application for the appointment, of a receiver or trustee for the Contractor whether insolvent or not; or (5) of any proceeding which deprives the Contractor of the use of any of the machinery, equipment, plant, tools or material referred to in Section (b) of this paragraph; or (6) of the Contractor's dying, absconding, disappearing, incompetency, being convicted of a felony, or imprisoned if the Contractor be an individual.

The prudent surety will make sure that the Assignment Clause of the indemnity agreement is triggered before attempting to settle with the obligee, especially because the Settlement Clause alone may not provide sufficient authority for the surety to settle its principal's affirmative claims.