TWENTY FIFTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS CONFERENCE New Orleans, Louisiana APRIL 10 TH & 11 TH, 2014

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1 TWENTY FIFTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS CONFERENCE New Orleans, Louisiana APRIL 10 TH & 11 TH, 2014 SURETY LOSS: METHODS FOR SEEKING REIMBURSEMENT PRESENTED BY: Jeffrey S. Price Manier & Herod 150 Fourth Avenue North, Suite 2200 Nashville, TN (615) Kathryn M. Truman Westfield Group

2 2014 SOUTHERN SURETY PROGRAM New Orleans, Louisiana Surety Loss: Methods for Seeking Reimbursement Presenters: Jeffrey S. Price, Manier & Herod Kathryn M. Truman, Westfield Group I. INTRODUCTION In exchange for a premium and the promise of indemnification, a surety will agree to be secondarily liable for an obligation of the primary obligor. In the commercial context, the nature of the obligation depends on the type and language of the bond issued. While many surety law papers focus on the surety s obligations to others, this paper will focus on how a surety recoups those losses and expenses incurred after performing bonded obligations. Although said many times, it is worth repeating here that surety bonds are not insurance. In fact, surety bonds are better likened to financial guaranties that provide protection against the risk that the beneficiaries under the bonds will suffer as a result of the principal s failure to perform some aspect of the bonded obligation. Most states have laws providing protections for the surety, including the surety s right to be held harmless from loss and to seek reimbursement from its principal. Most sureties also require their principals to procure an indemnity agreement, executed by related business entities and/or individuals with an interest in the principal s business. With these protections, sureties are theoretically not expected to incur a loss. It is generally only after the surety has incurred a loss that it seeks reimbursement from various sources via its common law and contractual rights. II. COMMON LAW REMEDIES Generally, a surety s common law remedies can be divided into three main categories: (1) the right of exoneration (i.e., protection from all losses associated with the principal s anticipated failure of performance); (2) the right of reimbursement or indemnity (i.e., repayment of those losses incurred as a result of the principal s failure of

3 performance); and (3) the right of equitable subrogation (i.e., the right to stand in the shoes of certain parties as a result of satisfying the principal s bonded obligations). 1. Right of Exoneration Upon a principal s breach of a bonded obligations and a surety s performance of the same, the surety is entitled to any relief from the principal that will properly protect its rights with respect to the principal s duty of performance. A comment to the Restatement (Third) of Suretyship and Guaranty 21 discusses the justification for this standard: The existence of the secondary obligation, typically having served as inducement to an action or forbearance by the obligee, is beneficial to the principal obligor. Where the principal obligor is charged with notice of the secondary obligation, the principal obligor has accepted this benefit of the secondary obligation. In such a case, there is an implied agreement between the principal obligor and the secondary obligor that the principal obligor will perform the underlying obligation so that the secondary obligor will not have to perform the secondary obligation. While, in most cases, performance by the secondary obligor will give rise to a right of reimbursement (see 22), realization of this right obviously involves expense and uncertainty. Accordingly, where the principal obligor is charged with notice of the secondary obligation, the secondary obligor is entitled to the principal s obligor s performance, not merely a cause of action for its failure to perform. In the context of construction surety bonds, the principal always has notice of the obligation undertaken by the surety. Accordingly, a principal is obligated to protect and ensure that the surety never actually sustains or incurs a loss under those bonds issued on its behalf. This obligation requires the principal to use its own funds not those of the surety to discharge bonded obligations and absolve the surety s liability. A surety s right of exoneration often manifests itself in practice by a surety making demand on its principal to satisfy a known bond claim. [E]xoneration allows a surety to insist that the principal satisfy any outstanding payment bond claims or remedy any alleged default. The principal is compelled to accept primary responsibility for its debt and discharge the obligation of the surety. Because the right of exoneration is invoked prior to the surety paying any bond claim, an issue that often arises is the degree of severity of a demand on a surety to warrant action by the principal. One court has held that, to invoke the right of exoneration, a surety must demonstrate that (i) the debt is presently due, (2) that liability ultimately rests with the principal, and, (3) absent equitable relief, the surety will be prejudiced because it will be forced to satisfy the principal s debt. If the principal resists its obligation of exoneration, the surety may find it necessary to resolve the bond claim before seeking enforcement of the right of

4 exoneration, thereby converting the claim into one of indemnification. Considering the time period in which a surety must generally respond to bond claims, the window of opportunity to seek exoneration from the principal is often very limited before the surety is ultimately forced to pay some portion of or all of the claim or face litigation. In the event the surety has an unlimited time to resolve the bond claim, the surety can petition a court for injunctive relief. In Borey v. National Union Fire Ins. Co. of Pittsburgh, Pennsylvania, two principals appealed a trial court order granting a preliminary injunction to enforce the surety s rights of exoneration and quia timet. The U.S. Court of Appeals for the Second Circuit vacated the trial court s order because the surety failed to establish that it would suffer irreparable harm (an element of recovery) from the loss of the rights of exoneration and quia timet. As discussed below, many sureties avoid this problem by having a collateral security provision in an indemnity agreement that specifically provides that the surety will suffer irreparable harm as a result of the principal s failure to exonerate and/or collateralize the surety. 2. Doctrine of Quia Timet The right of exoneration dovetails with the doctrine of quia timet, which, as an equitable remedy, allows the surety to demand the relief necessary to exonerate the surety. Quia timet is the right of a surety to demand that the principal place the surety in funds when there are reasonable grounds to believe that the surety will suffer a loss in the future because the principal is likely to default on its primary obligation[.] Although the doctrine commonly takes on the form of requiring the principal to collateralize the surety, quia timet relief can include protection of the principal s assets against dissipation, concealment or fraudulent transfer via injunctive relief compelling the principal to pay funds into the registry of the court, appointing a receiver for the principal or recovering assets that the principal wrongfully transferred to third parties. Although exoneration is closely related to quia timet, the two theories are not identical. As explained by U.S. Court of Appeals for the Second Circuit, quia timet is the remedy available to the surety before the principal s debt matures and it is likely that the principal will default on this obligation, whereas exoneration is the applicable remedy where the debt has matured and the principal has defaulted on this obligation. Similar to exoneration, a surety that seeks quia timet must general establish that (1) the debt will become due, (2) the principal will be liable for the debt, once due, and (3) absent equitable relief, the surety will suffer prejudice. A surety may seek to enforce quia timet by requesting injunctive relief from the court. 3. Right of Reimbursement Unlike the right of exoneration and the doctrine of quia timet, the right of reimbursement is triggered after the surety has incurred a loss in the performance of a bonded obligation. A surety s right to reimbursement is based on the theory that within the principal s request for a bond is the implication of the principal s promise to pay the surety for any such loss as a result of issuing the bond. However, the principal s

5 common law duty to reimburse the surety may not arise if the surety acts as a volunteer by performing or paying a claim under the bond without a legal obligation to do so. The surety s common law right of reimbursement is generally limited to the reasonable costs of performance and payment. While this calculation includes the actual amounts paid by the surety for labor and/or materials or performance of the bonded contract, it includes only those reasonable expenses incurred in relation thereto. According to The Restatement (Third) of Suretyship and Guaranty, the following would be included as part of the reasonable costs of performing bonded obligations: (1) the money paid to the bond claimant as a result of the principal s default; (2) the reasonable costs of performing non-monetary obligations; (3) the reasonable expenses incurred in investigating defenses to the bond claim(s); (4) the reasonable expenses incurring in asserting said defenses of the principal; and (5) any other incidental expenses reasonable incurred by the surety in connection with its performance of bonded obligations. One major downfall to the common law right of reimbursement is the surety s difficultly in using this doctrine to collect attorneys fees and expenses, meaning that a surety may not be truly made whole if relying solely on this cause of action against its principal. While those incidental fees associated with discharging the surety s bonded obligation, such as investigating, reviewing and/or defending a bond claim, may be recovered via a surety s claim for common law indemnity, those fees and expenses associated with actually seeking reimbursement are generally not recoverable under this theory. Many states have enacted statutes that codify the surety s common law right of indemnification or something similar thereto. 4. Doctrine of Equitable Subrogation A surety s right of equitable subrogation is particularly valuable to a surety because it affords a surety the recourse of recovering losses incurred while performing the obligations imposed by either a payment bond or a performance bond. The doctrine of equitable subrogation allows a surety to step into the shoes of the parties directly benefiting from the surety s obligation. Depending on the nature of the surety s obligation and the classification of the bond (i.e., payment bond or performance bond), the surety may be entitled to all the rights of the obligee, the principal and/or suppliers and subcontractors. The most important subrogation right held by the surety is an interest in unpaid contract funds earned by the principal but not yet distributed by the obligee to the principal. Pursuant to the bonded contract, the obligee has a right to use the contract balances to pay the principal, who in turn must pay laborers and materialmen for the performance of work on the bonded project. Should the surety become bound to perform these obligations, the surety gains the same entitlement to bonded contract balances. Often, the surety maintains a superior right to use the remaining contract funds to complete the bonded obligations and to reimburse the surety for losses incurred as a result of issuing the bonds.

6 The United States Supreme Court has recognized that a surety s right of equitable subrogation is well established, whether its bond be for performance or payment. Even without a contractual promise, a surety compelled to pay the debts of its principal is deemed entitled to reimbursement. Thus, a surety is entitled to the benefit of the bonded contract balances to the extent necessary to reimburse the surety for the losses resulting from paying the principal s debts. Although some courts have held that a surety is vested with the right of equitable subrogation after the principal has defaulted and the surety has made payments or performed on behalf of the principal, it is also accepted that the right may be triggered if the principal has defaulted and the surety s liability is imminent. The right to subrogation is created as of and relates back to the date of the issuance of the bond, whether the bond is for performance or payment. This distinction becomes of extraordinary importance to a surety when competing with a lien claimant for superior right to bonded contract balances. III. CONTRACTUAL INDEMNITY Where the common law fails a surety, perhaps the greatest multi-tool on the surety s belt the Indemnity Agreement will be a surety s primary basis of contractual recovery for its losses. In fairness, the Indemnity Agreement is borne out of the surety s common law rights of exoneration, indemnification, and subrogation, but it serves as a powerful supplement to and enhancement of these rights. Sureties generally require that the principal, the individual owners/members of the principal (and their spouses or other relatives), and any third party willing to assume the obligations of the principal (generally an affiliated company of the principal) to execute Indemnity Agreements in their favor. Although Indemnity Agreements are worded differently, it is generally held that [t]he contract of indemnity forms the law between the parties and must be interpreted according to its own terms and conditions. Compared with the common law, the surety often has an advantage under the Indemnity Agreement with respect to the triggering events for enforcement of its rights. Many Indemnity Agreement trigger the surety s rights upon the happening of an event of default, which may be either defined or generally discussed in the Indemnity Agreement. Other Indemnity Agreements do not require any conditions precedent or triggering events at all. Poignantly, the event of default under an Indemnity Agreement does not necessarily depend upon the principal being in default by the terms of the bonded contract. In fact, a default under the terms of the Indemnity Agreement can occur long before a principal is defaulted or terminated from a bonded contract. The broad triggering events for the exercise of rights under the Indemnity Agreement are an example of the tremendous value of an Indemnity Agreement over the rights available via subrogation and/or under the common law. The Indemnity Agreement also covers loss incurred based upon potential liability of the surety, not only actual liability. In fact, courts across the country have recognized

7 that the difference between the right to indemnity under the common law and the right to indemnity under a general indemnity agreement is that, [a]bsent a written indemnity agreement, the surety s common law indemnity rights exist only when there is actual liability...however, there will usually exist a written indemnity agreement between the parties, which will typically provide, among other things, that the surety need only show potential liability or that it believed in good faith that it was necessary or expedient to satisfy a claim to invoke its rights. 1. Indemnity Agreement Forms Sureties use a variety of Indemnity Agreement forms. Many contain the standard provisions: (i) an indemnification, exoneration and hold harmless provision, (ii) a collateral deposit provision, (iii) an assignment of certain equipment, assets, receivables and contract/subcontract rights of the indemnitors to the surety, (iv) a UCC- 1 provision that designates the Indemnity Agreement as a financing statement and allows a surety to perfect its security interest granted by the assignment, (v) a provision granting the surety power of attorney or attorney-in-fact for the indemnitors, (vi) a provision giving the surety the power to take possession of and complete the principal s bonded contracts and the option to finance the principal, (vii) a trust fund provision establishing that bonded contract funds must be held in trust by the principal for the payment of bonded obligations, (viii) a provision giving the surety the exclusive right to settle bond claims, and (ix) miscellaneous provisions regarding potential litigation between the surety and the indemnitors. All of these provisions are designed to minimize the surety s loss. Many of them are discussed in greater detail below. 2. Is Posting a Reserve a Loss? Before seeking reimbursement for its loss, a surety needs to determine exactly what that loss entails. While the surety generally has a reasonable estimate of its final loss, the surety may be faced with a situation where its actual loss numbers are fluctuating as both claims and contract funds are received and processed. Should the surety be forced to act promptly to enforce its rights in a fluctuating loss scenario, particularly under an Indemnity Agreement, the surety may assert that its reserve establishes a loss for the surety. Many Indemnity Agreements expressly provide for the obligation to reimburse a surety in the amount of any established reserve. For instance, an illustrative provision in one Indemnity Agreement provides: The Contractor and Indemnitors jointly and severally shall exonerate, indemnify, and keep indemnified the Surety from and against any and all liability for losses and/or expenses of whatsoever kind or nature (including, but not limited to, interest, court costs and counsel fees) and from and against any and all such losses and/or expenses which the Surety may sustain and incur.

8 Payment by reason of the aforesaid causes shall be made to the Surety by the Contractor and Indemnitors as soon as liability exists or is asserted against the Surety, whether or not the Surety shall have made any payment therefore. Such payment shall be equal to the amount of the reserve set by the Surety or equal to such amounts as the Surety, [in] its sole judgment, deems sufficient to protect it from loss or potential loss. The forgoing language may be used by a surety to combat the fluctuating loss issue when seeking contractual indemnification. One court recently held that, even absent such language in an Indemnity Agreement, the amount of the surety s reserve should be properly used to calculate the surety s loss. In The Hanover Insurance Company v. Jolley Building, the surety needed to obtain a quick default judgment against the indemnitors after learning that a creditor was foreclosing on their personal residence. Because the surety was in the process of completing the bonded projects pursuant to its performance obligations, it was unable to provide a final, actual loss number for default judgment purposes. However, the surety had established a reserve based on the anticipated completion costs for the bonded project. Even though the Indemnity Agreement at issue did not expressly provide that establishment of a reserve equates to a loss, the surety nonetheless argued that its claims against the indemnitors were nonetheless for a sum certain under Fed. R. Civ. P. 55(b)(1) because a reserve that had been established. The U.S. District Court for the Eastern District of Tennessee granted the surety default judgment against the indemnitors for the amount of the reserve, plus the surety s incurred fees and expenses. The court held: Plaintiff has paid $2,658, from the Reserve to third-parties in relation to the completion of the Bonded Contracts and the resolution of the Bond claims. Because the remaining funds in the Reserve are set aside and separately accounted for relative to future costs to complete the Bonded Contracts and resolve the Bond claims, the current amount of the Reserve ($2,929,991.00) reflects further, additional losses and expenses incurred by Plaintiff for which the Defendants are liable under the terms of the Indemnity Agreement. Accordingly, this court confirmed that the act of setting aside and separately accounting for future costs was additional loss and expense to the surety for which the indemnitors were liable. 3. Right to Deposit of Collateral One of the surety s strongest options to minimize (and avoid) its losses by virtue of the rights purveyed in the Indemnity Agreement is the right to demand and obtain collateral from the indemnitors. This remedy, properly couched as a demand for specific performance, may, depending on the language of the Indemnity Agreement, be sought by the surety before it ever makes a payment under a bond. The clause is a

9 logistical and contractual adaptation of the common law right of exoneration and quia timet. As discussed below, courts have not met claims for specific performance of contractual collateral deposit provisions with as much resistance as they have with exoneration and quia timet claims. In fact, sureties have found significant success enforcing the collateral deposit provision of the Indemnity Agreement via preliminary injunction and/or specific performance. As discussed above, the surety s rights, including the right to demand collateral, are often triggered under the Indemnity Agreement upon an event of default. This is a divergence from the traditional notions of common law exoneration, as the surety has the liberty to determine the triggering event. The surety determines the triggering event when negotiating the execution of the Indemnity Agreement. Typical triggering events for surety to make collateral deposit demand include (but are not limited to): the setting of reserves; the receipt of a claim/demand made; the actually incurring of liability; and request by principal to litigate claim. The obligation to post collateral typically arises at the time a reserve is set by the surety, or even in some cases, the Indemnity Agreement provides [the surety] with the right to be collateralized when, in it its sole judgment, it determines that potential liability exists. The courts have consistently held the collateral deposit obligation to be valid and have upheld the surety s right to recovery from indemnitors who failed to post collateral. The following is an example of a collateral deposit provision that may typically be found within an Indemnity Agreement: Payment by reason of aforesaid causes shall be made to the Surety by the Undersigned, upon demand by the Surety, as soon as liability exists or is asserted against the Surety, whether or not the Surety shall have made any payment therefor. The amount of such payment to the Surety by the Undersigned shall be determined by the Surety and the Surety s demand for payment hereunder may, at the Surety s option, be in addition to and not in lieu of or substitution for any other collateral that may have been previously deposited with Surety by or on behalf of the Undersigned The Surety s demand shall be sufficient if sent by registered or certified mail, by facsimile transmission, or by personal service to the Undersigned at the addresses stated herein, or at the addresses of the Undersigned last known to the Surety, regardless of whether such demand is actually received. The Undersigned acknowledge that the failure of the Undersigned to deposit with the Surety, immediately upon demand, the sum demanded by the Surety as payment shall cause irreparable harm to the Surety for which the Surety has no adequate remedy at law. The Undersigned agree that the Surety shall be entitled to injunctive relief for specific performance of any or all of the obligations of the Undersigned under this Agreement including the obligation to pay

10 the Surety the sum demanded and hereby waive any claims or defenses to the contrary. Under this provision, the obligation of the indemnitors to deposit collateral security is triggered (i) upon demand by the surety (ii) as soon as liability exists or is asserted against the surety. Notably, this provision requires the indemnitors to agree that its breach will cause the surety irreparable harm for which there is no adequate remedy at law and that the surety is entitled to injunctive relief in relation thereto. Depending on language of Indemnity Agreement, the demand for collateral may occur only in regard to actual or threatened loss, or more generally, at the sole determination of the surety that the deposit is necessary to secure Surety s guaranty. However, if the surety makes demand that collateral be deposited, it will likely have to demonstrate a rational basis for the nature and approximate amount of collateral demanded. For example, in Great American Ins. Co. v. General Contractors & Const. Management, Inc., the Indemnity Agreement provided that the indemnitors were obligated to exonerate the surety against liability as soon as liability existed or was asserted against the surety (whether or not surety has made any payment related to such liability). The court held that the surety had the right to demand and receive collateral from the principal because the surety had a rational basis for its fear that it will suffer a loss based on the claim that had been made against the surety. In any event, the ability to demand collateral to exonerate any actual or potential losses provides the surety with a very strong basis to mitigate its losses. Aside from the literal minimization of loss that the posting of collateral can provide to a surety, having a court order the specific performance of a deposit of collateral also signals to the indemnitors that the Indemnity Agreement will be enforced, encouraging cooperation (particularly from third-party and individual indemnitors). Numerous courts have upheld collateral deposit provisions within Indemnity Agreement by, inter alia, granting the surety a preliminary injunction and/or specific performance even when the principal or indemnitors assert defenses to the underlying bond claims and/or their indemnity obligations. Unlike the common law counterparts exoneration and quia timet, courts throughout the United States have also held that sureties lack an adequate remedy at law relative to the breach of a collateral security provision. For instance, in International Fidelity Insurance Co. v. Solutions to Every Problem, Inc., the obligee terminated a principal s right to prosecute work on a bonded contract and called upon the surety under its performance bond. The principal thought the termination was wrongful and asserted claims against the obligee. The surety paid losses and expenses under the bonds issued on behalf of the principal and anticipated incurring additional losses. In the lawsuit at issue, the surety sued the principal and the indemnitors and filed a motion for preliminary injunction seeking to enforce a deposit of collateral provision in the indemnity agreement. The principal and indemnitors argued that the surety s claims should be stayed until completion of the principal s litigation with the obligee. The court denied the request for a stay and, moreover, granted the surety s motion for preliminary injunction. Even though the indemnitors allegedly had a valid

11 basis to dispute liability to the obligee under the performance bond, the district court nonetheless granted a preliminary injunction in favor of the surety that compelled the indemnitors to deposit cash collateral with the surety. Moreover, although the court recognized that the surety did not act in bad faith with respect to the performance bond claim, the district court stated that it was cognizant that other courts have found that an asserted defense of lack of good faith does not defeat a surety s right to preliminary injunction for specific performance of the collateralization obligation. In Frontier Ins. Co in Rehabilitation v. M.C. Management, Inc., the surety sought to recover the losses and expenses it had already incurred and sought to specifically enforce the indemnitors obligation to deposit collateral with the surety upon demand. The U.S. District Court for the Western District of Kentucky explained its decision to award specific performance of the collateral security provision as follows: As part of its remedy, [the surety] requests that the Court enforce the collateral security provision, which requires the indemnitors, upon [the surety s] demand, to deposit a sum of money as collateral security equal to the reserve [the surety] has set aside to satisfy the bond claims. Requiring indemnitors to post collateral to cover an indemnitee s potential liability is the type of specific relief that courts may require. Specific performance ensures the creditor maintains the security position for which it bargained. This seems to be a reasonable view and no Kentucky or Sixth Circuit case law suggests a contrary result. Similarly, in Great Am. Ins. Co. v. SRS, Inc., the U.S. District Court for the Middle District of Tennessee held that the indemnitors must deposit collateral security to protect the surety where the agreement of indemnity (1) obligate[d] the Indemnitors to indemnify and hold harmless [the surety] against actual and potential liability, (2) specifically provides that [the surety] is entitled to specific performance and that the Indemnitors waived any claims or defenses to the contrary, and (3) stated that [the surety] lacks an adequate remedy at law relative to the Indemnitors failure to deposit collateral security. The district court considered an identical provision to that set forth as the example above. 4. Right to Attorneys Fees and Other Costs Many Indemnity Agreements specifically define Loss to include fees and costs incurred by the surety as a result of having issued surety bonds on behalf of the principal or enforcing the conditions of the Indemnity Agreement and/or provide for indemnification for the same. Some Indemnity Agreements provide that the fact and amount of the surety s payments, whether to bond claimants or to counsel, are prima facie evidence of the indemnitors liability and the extent thereof. Courts should use this provision to accept an affidavit or similar document of the surety s payments or

12 attorneys fees and expenses as prima facie evidence of the indemnitors liability, absent evidence of bad faith. In M-Pax, Inc. v. Dependable Ins. Co., Inc., the Georgia Court of Appeals held that the indemnitors were liable for the principal s attorneys fees incurred while defending the obligee s lawsuit because the indemnity agreement at issue provided that a voucher or evidence of such payment shall be prima facie evidence of such payment shall be prima facie evidence of the propriety thereof and of the indemnitor s liability therefor to the company. The court found that, after the surety presented prima facie evidence of payment, the indemnitors failed by cross-examination or otherwise to challenge the propriety or reasonableness of these payments. Although they chose not to in the M-Pax case, indemnitors may present evidence to challenge the reasonableness of and/or their liability for the fees and expenses. For instance, in Travelers Cas. & Sur. Co. of America v. Grace & Naeem Uddin, Inc., the U.S. District Court for the Southern District of Florida considered the indemnity provision allowing reimbursement for fees and expenses in conjunction with the claim settlement provision of the indemnity agreement that entitled the surety to reimbursement for all payments made by it under the belief it was necessary or expedient to make such payments. The court held that, even where the indemnity agreement does not expressly state so, the concept of reasonableness must be applied to any claim for indemnification of attorney fees. The court provided the rationale that [l]imiting fees and expenses to those which are reasonable ensures that the party is not entitled to recover all costs and expenses regardless of the amount or the purpose. The court clarified that this was not simply a good faith standard and held that the reasonableness of the fees and expenses was a question for the jury. The principal may attempt to reduce its liability for attorneys fees its surety may otherwise incur as a result of a lawsuit filed by claimant against both the principal and the surety by requesting that the surety tender its defense to the principal. Likewise, a surety may demand that its defense be tendered to the principal. However, a surety should consider whether the conflicting interests of the principal and the surety (e.g., different defenses or the surety s right to reimbursement) require it to retain its own legal counsel to protect its interests. If the surety declines the tender of defense arrangement, it should demand that its principal post collateral security sufficient to protect the surety. This issue arose in Central Towers Apartments, Inc. v. Martin. The Central Towers Apartments court set forth the standards in Tennessee for determining liability under an indemnity agreement when a surety hired separate counsel to defense a claim instead of comply with the principal s request that its counsel be allowed to defend the surety. The Tennessee Court of Appeals generally held that the Indemnity Agreement s provision mandating reimbursement of fees and expenses would render the principal liable for those litigation costs incurred by the indemnified surety in the defense of a suit brought by the owner obligee against the contractor and surety[.] However, the court further held hat that, when the surety exercises such right to hire separate legal

13 counsel from its principal, the liability of the principal for the attorneys fees and expenses depends on whether, under all of the facts of the case, it was reasonably necessary for the surety to so act in its own defense, and whether the surety acted in good faith towards the principal. The following factors were deemed relevant to this analysis: the amount of risk to which the surety was exposed; whether the principal was solvent; whether the surety has called on the principal to deposit with it funds to cover the potential liability; whether the principal on demand by the surety to deposit with it the amount of the claim has refused to do so; whether the principal was notified of the action and given opportunity to defend for itself and the surety; whether the principal hired the attorney for both himself and the surety; whether the principal notified the surety of the hiring of the attorney; the competency of the attorney hired by the principal; the diligence displayed by the principal and his attorney in the defense; whether there is a conflict of interest between the parties; the attitude and cooperativeness of the surety; and the amount charged and diligence of the attorney hired by the surety. After applying these factors, the court held that the surety did not act in good faith and under a reasonable necessity in hiring separate counsel so as to warrant charging the principal for its fees and expenses. The court stated: On the issue of good faith and reasonable necessity of action we further find that a solvent contractor did engage competent attorneys to represent the surety's interest, and notified the surety to this effect. There is no showing but that these attorneys were actively defending the suit and would have continued to do so. The contractor s financial ability to satisfy any judgment in the lawsuit is most pointedly established by the failure of the surety to demand a deposit by the contractor under the provisions of Paragraph Sixteen of the indemnity agreement. There was no conflict of interest between the contractor and the surety. The primary takeaway from the Central Towers case is the surety s need to demand collateral security if it chooses to deny a principal s request to assume defense of the surety. 5. Right to Settle The right to compromise or right to settle provision of an Indemnity Agreement can be crucial because it permits the surety to discharge its principal s obligations before suit or before incurring significant and unnecessary expenses, without endangering its indemnification rights. It also protects the surety from several of the

14 most common defenses asserted to an indemnity claim that the surety settled a claim voluntarily, unreasonably, and/or in bad faith, thereby forfeiting its right to indemnification. Alternatively, if a surety does not settle a claim for fear of impairing its indemnity rights, it may find itself defending a bad faith action instigated by a bond claimant. In the spirit of avoiding this Catch-22, the right to settle provision allows the surety to use its reasonable and prudent judgment when investigating and resolving bond claims. Right to settle provisions may follow this example: The Surety may pay or compromise any claim, demand, suit, judgment or expense arising out of any Bond or Bonds and any such payment or compromise shall be binding upon the Undersigned and included as a liability, loss or expense covered by this Indemnity Agreement, provided that the same was made by the Surety in the reasonable belief that it was liable for the amount disbursed, or that such payment or compromise was reasonable under all circumstances. Right-to-settle clauses are generally enforced according to their terms. With respect to the forgoing provision, a surety will be entitled to reimbursement for any loss incurred as a result of settling a bond claim so long as it had a reasonable belief that (1) it was liable for the amount disbursed or (2) such payment or compromise was reasonable under all circumstances. With such provisions, a surety typically has wide discretion in settling claims made upon a bond, even if the principal is not liable for the underlying claim. After all, the occasion where a surety would settle an underlying bond claim without, for instance, having a reasonable belief that it was liable for the amount disbursed, is rare. In contrast, common law equity generally implies a right to indemnification in favor of a surety only when the surety pays a debt for which its principal is legally obligated to pay. However, resort to implied indemnity principles is improper when an express indemnification contract exists; when there is such an express contract, a surety is entitled to stand upon the letter of the contract. The surety s discretion to make settlement payments, however, does have to comport with general standards of good faith. In Liberty Mutual Ins. Co. v. Aventura Eng g & Constr. Co., the court unambiguously found that the right to settle provision, read with the assignment and attorney-in-fact provisions, gave the surety the right, at its option and sole discretion, to settle or compromise any claim or demand upon any bond.the Aventura Engineering court also held that it is a well settled principle that a surety may settle claims regardless of whether liability for the claim actually existed, and for the sole purposes of avoiding the cost of litigation. In the same spirit as the Aventura holding, the U.S. District Court for the District of Pennsylvania stated that [s]ureties enjoy such discretion to settle claims because of the important function they serve in the construction

15 industry. The purpose of good faith clauses is to facilitate the handling of settlements by sureties and protect them from unnecessary and costly litigation. Courts interpreting right to settle provisions in Indemnity Agreements routinely conclude that, upon a finding that a surety has made a payment to a claimant upon a bond, the burden of proof shifts to the indemnitors to prove that the surety had not made the payment in good faith. However, notwithstanding this sentiment and the Aventura Engineering court s deference to the Indemnity Agreement, some courts will impose a limitation on the exercise of the surety s discretion and fold the analysis into a good faith discussion. For example, when reviewing the provision granting the surety the exclusive right or sole discretion to settle claims, the court in City of Portland, et al. v. George D. Ward & Associates held that the surety was bound to exercise its discretionary rights so that the reasonable expectations of all parties would be effected. It rejected the surety s argument that its sole discretion to settle is limited only by the surety s duty not to act for dishonest purposes or improper motives and held that parties to an Indemnity Agreement reasonably expect that compromise and payment will be made only after reasonable investigation of the claims, counterclaims and defenses asserted in the underlying action. Sureties can conclude, however, that the duty of good faith in settling claims is synonymous with good investigation. Other cases have also found that a showing of bad faith will be required to overcome an indemnity obligation of a principal. For example, in Associated Indemnity Corp. v. CAT Contracting, Inc., the court found no common law duty of good faith to the principal by virtue of the bond, but found there was a contractual duty of good faith under the Indemnity Agreement. Employers Insurance of Wausau v. Able Green, Inc., acknowledged that the surety had an obligation to act in good faith, but concluded that the surety must be deliberately malfeasant in order for there to be any lack of good faith. And, in Reliance Insurance Co. v. Romine, the court held that the only material issue in the case was whether the surety exhibited bad faith or abuse of discretion in paying claimants whether the payments were erroneous or excessive was immaterial with regard to the question of good or bad faith. i. Prime Facie or Conclusive Evidence Provision A prima facie clause in an Indemnity Agreement often provide that payment vouchers or other evidence of payment of claims shall be prima facie evidence of the propriety of the payment of such claims. Often read in conjunction with or included in the same paragraph as the right to settle provision, the prima facie provision serves largely to shift the surety s burden of proving that a given payment was made in good faith back to the indemnitors to show that a payment was made in bad faith. Courts have generally upheld these provisions based on the concept that [t]he purpose of [prima facie evidence] clauses...is to facilitate the handling of settlements by sureties and obviate unnecessary and costly litigation. Consequently, in a case where the surety included a right to settle provision in its Indemnity Agreement, but did not provide that the payment of monies by the surety was prima facie evidence of a good

16 faith payment, the court placed the burden upon the surety to prove the reasonableness of its disbursements under the bond, rather than requiring the indemnitors to plead and prove unreasonableness or lack of good faith. ii. Collateral Deposit in Right to Settle Provision Collateral deposit provisions were previously discussed as stand alone inserts in an Indemnity Agreement. However, these provisions may also or only be included within a right to settle paragraph of the Indemnity Agreement. When a right to settle provision includes the requirement of the deposit of collateral before a surety is obligated to litigate a claim, the majority of courts will uphold the provision and give no relief to the indemnitors who fail to deposit collateral upon demand. This is another example of the tremendous advantages an Indemnity Agreement provides to a surety in mitigating its losses. Without the clean, straightforward terms of the Indemnity Agreement, the surety would have to rely on its common law right of exoneration, available only to a surety after the principal s debt has become due. The N. Am. Specialty Ins. Co. v. Montco Constr. Co., Inc. court found that a principal s breach of Indemnity Agreement by failing to post collateral or otherwise exonerate the indemnity surety activated the attorney-in-fact and assignment clauses of the Indemnity Agreement and gave the surety the right to settle the principal s pending lawsuit against the owner/obligee. In another case, USA f/u/o Trustees of Electrical Workers Local Pension Fund v. D Bar D Enterprises, Inc., a surety was granted judgment on its claims under an Indemnity Agreement notwithstanding the fact that there may have been possible defenses to the underlying claim paid by the surety. Although the surety notified the indemnitors of the claim and the settlement negotiations, the indemnitors failed to post collateral or otherwise instruct the surety to litigate the claim, thereby failing to preserve any objection to settlement. Similarly, in Transamerica Ins. Co. v. Avenell, the U.S. Court of Appeals for the Fifth Circuit held that indemnitors wishing to prevent a surety from settling a claim must deposit collateral and request litigation. The court specifically stated that a failure to deposit collateral left the surety with no obligation to hear, much less honor the indemnitors protests of the claim. In Liberty Mutual Ins. Co. v. Aventura Engineering, the U.S. District Court for the Southern District of Florida specifically held that the Indemnity Agreement s right to settle provision, which included a collateral deposit demand language, gave the surety the right, at its option and sole discretion, to settle or compromise any claim or demand upon any bond. According to the court, if the principal wanted to protect its claims against the owner of the bonds, the Indemnity Agreement set forth a mechanism that allows it to do so (i.e., the principal must first ask [the surety] to deny the claim, and, at the same time, it must provide [the surety] with collateral that exonerates and indemnifies it against any potential loss ). Therefore, cases requiring the surety to

17 demonstrate good faith or liability in its settlements with bond claimants in order to recover under its Indemnity Agreement should be foreclosed where the surety had the ability to demand collateral and the indemnitors failed to place the surety in collateral. 6. Trust Funds & Discharge of Debt in Bankruptcy In addition to establishing the surety s right to be indemnified and collateralized, the Indemnity Agreement can further define the rights and remedies, as well as the obligations and duties, of both the indemnitors and the surety. The interests of the surety are best protected by the inclusion of language establishing a trust obligating the indemnitors to hold bonded contract funds in trust for the benefit of the surety and its bonded obligations, including payment to subcontractors, materialmen and suppliers furnishing labor and/or materials to the bonded project. By including such a provision within the Indemnity Agreement, the surety may be able to claim a right to contract funds already received by the principal, funds that will be received by the principal in the future, and payments in the hands of others. i. Creation of a Trust in an Indemnity Agreement Generally, the validity of a trust is determined by state substantive law. When a surety drafts a provision in the Indemnity Agreement obligating the indemnitors to hold the bonded contract funds in trust, the validity of the provision will usually be upheld if all elements of a valid trust are included within the language of the provision. [T]he starting point in each [case] is an examination of state law and whether the facts in such case evidence the existence of an enforceable trust under the laws of that particular state. Numerous courts have found an express trust within the contents of an Indemnity Agreement. For instance, the U.S. Bankruptcy Court for the Western District of Kentucky found the following language in an Indemnity Agreement satisfactory to establish a trust: Where any Bond is executed in connection with a contract, the Contractor and the Indemnitors covenant and agree to hold all money or other proceeds of such contract, whether received as payment or as loans, as a trust for the benefit of laborers, materialmen, suppliers, subcontractors and the Surety and to use such money or other proceeds for the purpose of performing the contract and discharging the obligation of the Bond beneficiaries, and for no other purpose, until the Bond and the Surety s losses, costs, expenses and attorney s fees are completely discharged. Furthermore, the U.S. Court of Appeals for the Sixth Circuit held that a trust provision that fails to expressly require that trust funds be held in a separate account is not a determining factor in holding whether a valid trust is formed. Instead, the U.S. Court of Appeals for the Sixth Circuit views holding trust funds in a separate account as a basic fiduciary obligation that is owed by the trustee, just as all other obligations written into a trust agreement impart duties on the trustee.

18 The Indemnity Agreement in In re Herndon was found to contain an express trust. The applicable provision stated: It is expressly understood and declared that all monies due and to become due under any contract or contracts covered by the Bonds are trust funds, whether in the possession of the Contractor or Indemnitors or otherwise, for the benefit of and for payment of all such obligations in connection with any such contract or contracts for which the Surety would be liable under any of said Bonds, which said trust also inures to the benefit of the Surety for any liability or loss it may have or sustain under any said Bonds, and this Agreement and declaration shall also constitute notice of such trust. The court simply stated that an express trust within an Indemnity Agreement effectively creates a trust relationship among the parties. The holding in this case almost creates a presumption for trust validity within an Indemnity Agreement if such provision has trust language. As such, the indemnitor, as trustee, owed a fiduciary duty arising from the trust instrument. The manner and conduct of the parties attempting to implement a trust within an Indemnity Agreement may be equally as important as the language of the trust provision itself. To provide the best protection, a surety should seek assurance that the funds disbursed are used for the express purpose of the trust, that the funds are segregated or readily identifiable, and clear notice is given to the depository institution of the trust account s purpose. ii. Express Trusts & Bankruptcy The Indemnity Agreement s trust fund provision becomes particularly important if the principal files for bankruptcy. Possibly the biggest challenge to a surety s efforts to protect its right to bonded contract funds arises in the context of insolvency proceedings. Sureties quite commonly find themselves sitting in the middle of the principal s bankruptcy, all the while fighting secured creditors and the debtor for contract balances. The surety s best approach to pull the bonded contract funds out of the hands of creditors or the estate is staking a claim to the funds through the surety s right of equitable subrogation. But what if the principal has yet to default and the surety has yet to perform under its bonds? The surety s right of subrogation may not be available. Even if this right is available, the surety can use another tool to make a claim on the bonded contract funds. In recognition of the importance of the relationships and obligations created by a trust, the Bankruptcy Code addresses trusts and provides for special treatment of such relationships. In order for such a trust provision to provide any enforceable rights, that trust and the circumstances surrounding its enforcement must be valid under the applicable state law. Even after establishing the validity of a trust, the surety must ensure that it has