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May 19, 2000 | Publication| Contractors' Bonds: Who Can Sue The Surety For Bad Faith?
This is one of a series of articles under the by line "Butler on Bad Faith" originally published in Mealey's Litigation Report: Insurance Bad Faith, Vol. 14, #2, p. 39 (May 19, 2000). © Copyright Butler 2000.
In the case of a performance bond, the surety guarantees to the obligee that the principal will perform the work under a contract according to the plans and specifications therein. In the case of a payment bond, the surety guarantees that the principal will pay the obligees for labor, materials or equipment furnished in connection with the project. In either case, the surety binds itself financially if the principal does not perform or pay.
The whole topic of bad faith and contractors' bonds is large. I will not undertake it here. There are many fine and ambitious articles that have done so already.(1) Rather, this note is occasioned by a recent decision under Florida law, Ginn Construction Co. v. Reliance Insurance Co., 51 F. Supp. 2d 1347 (S.D. Fla. 1999), which deals with bad faith claims by principals under performance bonds. I will discuss that case and, in doing so, make some observations about the problems that flow from marrying bonds (which are not insurance) to concepts of bad faith liability under insurance contracts.
Ginn Construction Co. v. Reliance Insurance Co., 51 F. Supp. 2d 1347 (S.D. Fla. 1999), involved a performance bond. Ginn Construction Company, the principal, was the general contractor. The obligee was Palm Beach County. Reliance was the surety.
As a result of Ginn's alleged non­performance, there were alleged construction deficiencies. Ginn, seeing it would not be paid, sued the County in state court for anticipatory breach. The County notified Reliance that it planned to terminate Ginn if the deficiencies were not corrected by a certain date, and demanded that Reliance provide a completion contractor as it was obliged to do under the bond. Reliance did not do it.
The County kicked Ginn off the job and hired a completion contractor to finish the work. The County also counterclaimed in the state court action ­ which Reliance defended on behalf of Ginn. Three years later, Ginn settled with the County and its architect, which paid Ginn $425,000.
Ginn then sued Reliance in state court for "bad faith." Reliance removed the case to the United States District Court for the Southern District of Florida. Reliance filed a motion for summary judgment.
B. Who Is An Insured?
The issue on summary judgment was whether or not Ginn had standing to sue for bad faith under Florida law. The disposition of that issue turned on the answer to a question that goes to the heart of the problem of "good faith" in contractors' bonds? The question is ­ who is an "insured" under the bond? The problem is ­ a surety bond is not insurance. See, R. Mehr and E. Cammack, Principles of Insurance, P. 352, Fifth Ed. 1972; Pearlman v. Reliance Ins. Co., 371 U.S. 132, 140 n.19 (1962).
Contractors' bonds differ fundamentally in a number of ways from true insurance. First, unlike general liability and property insurance, a performance bond does not spread risk among a pool of insureds. Rather, it guarantees that a single entity (the principal) will do a certain thing (complete its contract or pay for labor and materials supplied by others). Thus, the principal holds in its hands the power to trigger ­ unintentionally or intentionally ­ coverage under the bond.
This gives rise to a second difference between contractors' bonds and genuine insurance. It is axiomatic in the law that an insurance carrier cannot be subrogated against its own insured.
No right of subrogation can arise in favor of the insurer against its own insured, since by definition subrogation arises only with respect to the rights of the insured against third persons to whom the insurer owes no duty.
16 Couch on Insurance § 61:136 (3d Ed. 1983). To do so would render insurance meaningless. However, this rule has no place in the case of a contractors' bond. When the principal does not perform, the surety must complete the project, pay the additional expense of getting it completed, or pay the subcontractors and materialmen as the case may be. The surety also must pick up losses resulting from delay in completion. The surety then is entitled to be indemnified by the principal. Indeed, it is standard practice for the principal to sign an indemnity agreement (often secured by collateral) as a condition of the issuance of the bond.
A third difference from true insurance is that losses are not expected in surety bonding. In most kinds of insurance, losses not only are expected but are assumed when determining the amount of premium to be charged. But the premium on a performance bond is not based on such underwriting considerations. Essentially, a bond premium is nothing more than a fee paid for use of the surety's name. Thus, the contractor is enabled to bid on jobs which require a bond. In this respect it is more like an open-ended letter of credit than an insurance policy.
All of this flows from the inescapable fact that the principal controls when and if the bond is triggered. As such, the contractors' bond does not partake of the fiduciarism and other public policy justifications for bad faith liability of true insurers. It is a different kind of instrument.
Notwithstanding the clear and significant differences between insurance and bonds, courts persistently have hitched sureties to the wagonload of good faith duties owed by insurers. It is understandable why.
For one thing, the law of many states lumps together suretyship and insurance. See, e.g., Transamerica Premier Ins. Co. v. Brighton School Dist. 27J, 940 P.2d 348, 353 (Colo. 1997)(Colorado includes sureties within its insurance code); Dodge v. Fidelity and Deposit Co., 778 P.2d 1240, 1241-42 (Ariz. 1989)(Arizona includes suretyship in its definition of insurance); Windowmaster Corp. v. Morse/Diesel, Inc., 722 F. Supp. 1532 (N.D. Ill. 1988)("Under Illinois law, contracts of compensated suretyship are deemed to be contracts of insurance."); Financial Indem. Co. v. Steele & Sons, Inc., 403 So. 2d 600, 602 (Fla. 4th DCA 1981)(applying Florida law). But see, Associated Indem. Corp. v. CAT Contracting, Inc., 964 S.W.2d 276, 282 (Tex. 1998).
For another thing, many of the same companies issue bonds as write insurance policies. Therefore "it must be a duck," as the saying goes.
Returning to the Ginn case, the pertinent issue on summary judgment was whether the principal was an "insured." It was a case of first impression. The question was framed because, under Florida law, there is no common law cause of action for first party bad faith. State Farm Mut. Auto. Ins. Co. v. LaForet, 658 So. 2d 55, 58-59 (Fla. 1995). Such claims exist only by statute and Ginn's alleged statutory basis was section 624.155(1)(b)1, Florida Statutes. That section creates civil liability of an insurance company for not "attempting in good faith to settle claims when, under all the circumstances, it could and should have done so, had it acted fairly and honestly toward its insured and with due regard for her or his interests." (Emphasis added).
The question, then, is to whom does a surety owe a duty. The Colorado Supreme Court addressed this issue in Brighton School District, 940 P.2d 348 (Colo. 1997). It compared the insurer/insured relationship to the surety/obligee relationship and concluded they were 'nearly identical,' stating 'when an obligee requests that a principal obtain a commercial surety bond to guarantee the principal's performance, the obligee is essentially insuring itself from the potentially catastrophic losses that would result in the event the principal defaults on its original obligation.' Id. at 352. Because the obligee looks to the surety for protection from calamity, the surety owes a duty of good faith to the obligee. Notably, in a suretyship, the principal does not look to the surety for protection. Quite the opposite is true; the surety looks to the principal for indemnification. [citations omitted]. The Fourth District Court of Appeal of California observed that 'it is not the duty of the surety to protect the principal as if the principal were the insured under an insurance policy. The surety's duty runs to the third party obligee.' Schmitt v. Insurance Co. of North America, 230 Cal. App. 3d 245, 281 Cal. Rptr. 261, 269 (Cal. Ct. App. 1991). Thus, as Reliance contends, if any party has a claim for bad faith failure to settle under section 624.155(1)(b)1, Florida Statutes, it would be the County, the obligee under the bond.
51 F. Supp. 2d at 1352. Accordingly, the court held "under the performance bond at issue, Ginn is not an 'insured' and therefore cannot sue Reliance for bad faith. . . . " Id. at 1353.
As discussed above, suretyship is not insurance at all. To this writer, it seems there is no more good reason to deem an obligee an "insured" than to bestow the same status on the seller in a commercial transaction secured by a letter of credit. When the seller requires the letter of credit "to guarantee the [buyer's payment], the [seller] is essentially insuring itself from the potentially catastrophic losses that would result in the event the [buyer] defaults on its original obligation." The only difference, it seems, is commercial banking is regulated under a different chapter of the code.
The result in Ginn is correct. The reasoning is not. The District Court decided rightly that a principal is not an "insured." But it arrived at that conclusion by assuming first that somebody has to be an insured under a surety bond. And because the obligee resembles an insured more than does the principal ("the obligee looks to the surety for protection from calamity") - the obligee must necessarily be the "insured." The flaw in this thinking is obvious. In truth, because a surety bond is not insurance, the concept of "bad faith" should not be more applicable than in any other contractual setting.
1. See, e.g., John J. Aromando, The Surety's Liability for "Bad Faith:" Claims for Extra-Contractual Damages by an Obligee Under the Payment Bond, 47 Me. L. Rev. 389 (1995); Bernard L. Balkin and Keith Whitten, Current Developments in Bad Faith Litigation Involving the Performance and Payment Bond Surety, 28 Tort and Ins. L. J. 611 (1993); B.C. Hart, Bad Faith Litigation Against Sureties, 24 Tort and Ins. L. J. 18 (1988).

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