TWENTY SEVENTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS

TWENTY SEVENTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS CONFERENCE Charleston, South Carolina st nd APRIL 21 & 22, 2016 A SURETY'S RIGHT TO SETTLE CLAIMS OVER A PRINCIPAL'S OBJECTION PRESENTED BY: Amy M. Bernadas Krebs Farley, PLLC 400 Poydras St., Suite 2500 New Orleans, LA 70130 Leigh Anne Henican The Gray Casualty & Surety Company 3625 N. I-10 Service Road Metairie, Louisiana 70002

A Surety s Right to Settle Claims Over a Principal s Objection 27 th Annual Southern Surety & Fidelity Claims Conference Presenters: Amy M. Bernadas and Leigh Anne Henican I. Introduction Most General Agreements of Indemnity, or GAIs, expressly provide sureties the right to settle claims against the surety bond, with or without the principal s consent. The right to reach a conclusive settlement on behalf of the principal is essential for a surety seeking to avoid the costs of litigation and to mitigate its losses from the principal s default. Issues can arise, however, when the surety seeks indemnification for expenses after a settlement is obtained without the principal s approval. When deciding whether to settle a claim, the surety is burdened with the conflicting interests inherent in surety bonds and thus becomes vulnerable to claims of bad faith from the principal. This paper focuses on a surety s right to settle under the GAI and the often-asserted bad faith claim a surety must defend against in settling without the principal s consent, and provides measures to ensure recovery and protect against such a claim when acting without consent. Understanding the rights afforded under the GAI and taking precautionary good faith measures are essential to securing a surety s claim for indemnity. II. The Surety s Rights under the General Agreement of Indemnity to Settle Without the Principal s Consent Execution of the GAI is the beginning of the surety-principal relationship. Its objective, among other things, is to facilitate the handling of settlements by sureties and obviate unnecessary and costly litigation. 1 Each surety s GAI may differ slightly, but most GAIs contain the same general provisions that provide the source of a surety s 1 Fid. & Guar. Ins. Co. v. Constr. Advantage, Inc., No. 1:08cv460, 2010 U.S. Dist. LEXIS 17032, at *18-19 (W.D. N.C. Jan. 19, 2010) (citing Transamerica Ins. Co. v. Bloomfield, 401 F.2d 357, 362 (6th Cir. 1968)); Am. Mfrs. Mut. Ins. Co. v. Carothers Constr., Inc., No. 2:05-cv-00122, 2007 U.S. Dist. LEXIS 57746, at *15-16 (E.D. Cal. Aug. 8, 2007) ( Indemnity Agreements like those involved here are intended to facilitate the handling of settlement by sureties and obviate unnecessary and costly litigation. ). 2

rights and protections. These provisions include, but are not limited to: the Right-to- Settle Clause, the Takeover Clause, the Indemnity Clause, the Assignment/Attorney-in- Fact Clause, and the Collateral Security Clause. The Right-to-Settle Clause expressly grants sureties the right to settle claims made against a bond. A Right-to-Settle Clause may include the following language: The Surety shall have the exclusive right for itself and for the undersigned to decide and determine whether any claim, demand, suit or judgment shall, as the basis of liability, expediency or otherwise, be paid, settled, defended or appealed, and its determination shall be final, conclusive and binding upon the undersigned. Incorporation of similarly-worded provisions into the GAI provides the surety with wide discretion in settling claims. 2 Pursuant to this provision, a surety may agree to settle the obligee s claim, even over the protest of the principal. 3 That decision by the surety is conclusive and binds the principal to the settlement. Courts have consistently recognized that a surety may settle a claim regardless of whether the principal was actually liable under the claim or in default. 4 Moreover, a surety may settle a claim pursuant to the Right-to-Settle Clause even when motivated by the sole purpose of avoiding costs. 5 In effect, the Right-to-Settle Clause advances the general purpose of the GAI, that is to provide the surety an opportunity to mitigate the risk of loss and avoid the costs of litigation. 6 Courts have thus upheld the Right-to-Settle Clause and its 2 Liberty Mut. Ins. Co. v. Aventura Eng g & Const. Corp., 534 F. Supp. 2d 1290, 1306 (S.D. Fla. 2008). 3 See Transamerica Ins. Co. v. Avenell, 66 F.3d 715, 720 (5th Cir. 1995). 4 See, e.g., Amwest Sur. Ins. Co. v. Cardenas, No. 7:12-cv-00146-O, 2013 U.S. Dist. LEXIS 151335, at *27-29 (N.D. Tex. Oct. 22, 2013); Great Am. Ins. Co. v. McElwee Bros., No. 03-2793, 2007 U.S. Dist. LEXIS 19547 (E.D. La. Mar. 19, 2007); Comm. Union Ins. Co. v. Melikyan, 430 So. 2d 1217 (La. App. 1983). 5 See Aventura Eng g & Const. Co., 534 F. Supp. 2d at 1306. 6 See, e.g., Cardenas, 2013 U.S. Dist. LEXIS 151335, at *27-29 ( Courts have long recognized that a surety has an equitable right to reimbursement from the principal for amounts paid on an indemnity bond.... The indemnity agreement thus encourages settlement of claims, avoiding expensive, time-consuming litigation, generally without unfairness. ); Transamerica Ins. Co. v. Bloomfield, 401 F.2d 357, 363 (6th Cir. 1968) ( The purpose of [Right-to-Settle] clauses in indemnity agreements... is to facilitate the handling of settlements by sureties and obviate unnecessary and costly litigation.). 3

empowerment of the surety as consistent with public policy. 7 However, a court s ultimate decision to enforce the Right-to-Settle Clause often hinges on whether payment was made in good faith. See infra III for discussion of the surety s good faith obligations under the GAI. The Takeover Clause expressly grants sureties the right to take possession of and complete the bonded contract work. A Takeover Clause may state the following: In the event of default, the Surety at its sole discretion, is hereby authorized, but not required, to take possession of the work under any contract and, at the expense of the Indemnitors, complete the contract work, or cause same to be completed, or to consent to the completion thereof, or to take any other action which the Surety may deem appropriate to obtain the discharge of the Surety s obligations, as Surety for the Indemnitors, including but not limited to a monetary settlement with the obligee at the Indemnitors expense. Such a Takeover Clause provides the surety with wide discretion to select the appropriate manner and methods to complete the bonded project. The Clause only requires an event of default before the surety may take over the work. This precondition is often satisfied by a notice of default. However, before taking action under any Takeover Clause, the prudent surety should review the terms of the performance bond, which may contain additional prerequisites for takeover, prior to the surety s exercise of its takeover rights under the GAI. 8 The Right-to-Settle Clause and the Takeover Clause may appear to be selfevidently dispositive of a surety s ability to settle and resolve bond claims. Other provisions in the GAI, however, synergistically work with these Clauses in order to guarantee the surety s right to control the claim s disposition and ultimately recover for its related expenses. For example, the Indemnity Clause, as the primary provision of the GAI, generally provides that the principal agrees to hold the surety harmless and recognizes the surety s right to recovery. Most Indemnity Clauses will state that the 7 Hanover Ins. Co. v. Alpha Elec., Inc., No. 11-11055, 2011 U.S. Dist. LEXIS 133177, at *11 (E.D. Mich. Nov. 18, 2011) ( Provisions in indemnity agreements granting to the indemnitor the right to compromise and settle claims, and providing that vouchers and other evidence of payment shall be prima facie evidence of the propriety thereof, have been upheld as not against public policy and enforced by the courts. ) (citing Transamerica Ins. Co., 401 F.2d at 362-63). 8 See TORT & INS. PRAC., AM. BAR ASSOC., THE SURETY S INDEMNITY AGREEMENT: LAW AND PRACTICE 192-193 (Marilyn Klinger et al. eds., 2002). 4

surety is not required to prove the principal was in fact liable in order for the surety to be entitled to indemnification. See infra III for an example of language in an Indemnity Clause. The Assignment and Attorney-in-Fact Clause of the GAI may also be triggered by a surety s settlement of a claim. Pursuant to the Assignment and Attorney-in-Fact Clause, the surety becomes appointed as the principal s attorney-in-fact and is entitled to exercise all rights assigned to it. These rights also include allowing a surety to settle the principal s affirmative claims against the obligee. 9 Such provisions tend to resemble the following: The Indemnitors hereby irrevocably nominate, constitute, appoint and designate the Surety and its designees as their attorney-in-fact with the right, power, and authority, but not the obligation, to exercise all of the rights and powers that the Indemnitors assigned, transferred and set over to the Surety in this Agreement, and in the name of the Indemnitors, or any one or more of them, to make, endorse, execute, and deliver any and all additional or other instruments and writings, including, but not limited to, assignments, financing statements, documents, instruments, checks, drafts, deposits, ACH, and wire transfer directives and orders, change of address notices, liens and releases thereof, applications, certificates, draw requests, orders, releases and papers deemed necessary or desirable by the Surety in order to give full effect not only to the intent and meaning of the obligations assumed, and the agreements made, by Indemnitors hereunder, and the assignments and conveyances made herein, but also the full protection intended to be herein given to the Surety under all other provisions of this Agreement. The Indemnitors hereby ratify and confirm all acts and actions taken and done by the Company and its designees as such attorney-in-fact. A GAI s Collateral Security Clause may also influence a surety s right to settle a claim in good faith. Some GAI s contain a Collateral Security Clause to allow the principal an opportunity to request that the surety defend the obligee s claim rather than resort to a settlement agreement. Securing collateral grants the surety access to funds that are, in theory, sufficient to cover the expenses of litigation. A principal s failure to 9 Liberty Mut. Ins. Co. v. Aventura Eng g & Const. Corp., 534 F. Supp. 2d 1290, 1306 (S.D. Fla. 2008). 5

deposit collateral, however, may allow the surety to settle the claim and seek recovery of expenses. 10 A Collateral Security Clause may read as follows: If for any reason the Surety shall be required to or shall deem it necessary to set up a reserve in any amount to cover... a judgment, actual or contingent, with interest and costs, in any action instituted against the Principal and/or the Surety... the undersigned shall immediately, upon demand, deposit with the Surety funds in the amount of such reserve and any increase thereof, to be held by the Surety as collateral with the right to use such funds or any part thereof, at any time, in payment of compromise of any judgment, claim, liability, loss, damages, attorney s fees and disbursements and/or other expenses. While acting under the appropriate GAI provision, the Surety has the right to defend against, adjudicate and settle bond claims, regardless of any objection by the principal and without his specific consent. III. The Surety s Potential Liability for Bad Faith from the Principal After incurring losses (including costs and fees) to settle claims against the bond, the surety will seek to recover its losses from the indemnitors, pursuant to its indemnity rights under the GAI. The Indemnity Clause dictates the surety s ability to recover its loss. A common Indemnity Clause states: The Principals and Indemnitors 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: (1) By reason of having executed or procured the execution of the bonds; (2) By reason of the failure of the Principals or Indemnitors to perform or comply with the covenants and conditions of this Indemnity Agreement; or (3) In enforcing any of the covenants and conditions of this Indemnity 10 See Nguyen v. Lumbermens Mut. Cas. Co., 261 Ga. App. 553, 553-54 (Ga. App. 2003) (holding that, where the principal failed to request that the surety defend the claim and neglected to deposit collateral in order to secure the principal s right to litigation, the surety had acted reasonably and in good faith by settling the claim pursuant to the GAI. In that case, the GAI s Right-to-Settle Clause stated that the surety had the right to adjust, settle or compromise any claim unless the undersigned [principal] shall request [the surety] to litigate such claim or demand or defend such suit and shall deposit with [the surety] collateral satisfactory to it in kind and amount. ). 6

Agreement. Payment by reason of the aforesaid causes shall be made to the Surety by the Principals and Indemnitors as soon as liability exists or is asserted against the Surety, whether or not the Surety shall have made payment therefor. Such payment shall be equal to the amount of reserve set by the Surety. However, a surety s broad discretion to settle claims under the GAI is not without limits. A common defense to a surety s claim for indemnity is an allegation of bad faith. Certain jurisdictions impose a common law duty of good faith on the surety. 11 GAIs often directly impose a contractual duty of good faith on the surety. The following is a sample good faith provision in a GAI: In the event of any payment by the surety, the indemnitors and principals agree that in any accounting between the surety and principals or indemnitors, the surety shall be entitled to charge for any and all disbursements made by it in good faith in and about the matters herein contemplated by this [GAI] under the belief that it is, or was, or might be liable for the sums and amounts so disbursed or that it was necessary or expedient to make such disbursements, whether or not such liability, necessity or expediency existed. In both circumstances, the surety is entitled to indemnification only for payments that were made in good faith. The standard for good faith varies between jurisdictions, but generally requires some level of reasonable conduct on the part of the surety. An example standard for good faith in an indemnity agreement is honesty in fact in the conduct or transaction 11 Gray Ins. Co. v. Terry, No. 14-30917, 2015 U.S. App. LEXIS 4392 (5th Cir. Mar. 18, 2015) (holding that Louisiana law imposes a duty to perform contractual obligations in good faith); Travelers Cas. & Sur. Co. of Am. v. Highland P'ship, No. 10cv2503, 2012 U.S. Dist. LEXIS 167458, at *20-25 (S.D. Cal. Nov. 26, 2012) ( [T]he implied covenant of good faith and fair dealing applies to surety contracts. ); W. Sur. Co. v. WGG, Inc., No. 1:07-CV-1551, 2009 U.S. Dist. LEXIS 6220 (M.D. Penn. Jan. 29, 2009) ( The first issue before the Court is whether Pennsylvania law recognizes an implied contractual duty of good faith and fair dealing in the context of suretyship. The Court holds that it does. ); Am. Motorist Ins. Co. v. Southcrest Constr., No. 3:04-CV-2575-M, 2006 U.S. Dist. LEXIS 19933, at *11-12 (N.D. Tex. Apr. 17, 2006) ("[T]he primary difference between Illinois and Texas law regarding the interpretation of agreements of indemnity arising out of a surety relationship is the absence in Texas of a common law duty of good faith and fair dealing owed by the surety to its principal."). 7

concerned and the observance of reasonable commercial standards of fair dealing. 12 Conversely, bad faith requires more than mere negligence, lack of diligence, bad judgment or breach of contract. 13 Instead, bad faith generally involves some motive of interest, ill will or malice. 14 The surety is typically presumed to have acted in good faith in making payments. 15 When a settlement is made over the principal s objection, the primary defense to the surety s indemnity action will be the principal s claim of bad faith. Failure to comply with the provisions and expectations of the GAI may support a bad faith defense, but the most popular point of contention is whether the surety adequately performed an investigation of the claim. This responsibility is rarely expressed in the GAI. The duty to investigate and other extra-contractual expectations of the surety, including the surety s communication with the principal or compliance with the penal sum of the bond, can prove to be the demise of the surety s recovery of expenses. 12 Terry, 2015 U.S. App. LEXIS 4392; Hartford Fire Ins. Co. v. P & H Cattle Co., 451 F. Supp. 2d 1262, 1279 (D. Kan. 2006) ( [Under Kansas law,] a duty of good faith is implied in indemnification agreements, and that duty requires the surety to show that its conduct with regard to a bond claim was reasonable. ). 13 See Engbrock v. Fed. Ins. Co., 370 F.2d 784, 786 (5th Cir. 1967); Berkley Reg'l Ins. Co. v. Weir Bros., No. 13 Civ. 3227, 2013 U.S. Dist. LEXIS 160492, at *26-31 (S.D. N.Y. Nov. 5, 2013) ( New York courts have held that "proof that [the surety] failed to investigate the claim fully would not impugn the good faith of plaintiff in making the payment. Similarly, A decision to proceed with claims despite possible defenses... is not evidence of bad faith[,] even if [the indemnitors] were able to establish that [the surety] failed to proceed with claims despite possible defenses or failure to fully investigate, that in itself would not establish bad faith. [The indemnitors ] conclusory allegations of bad faith and unreasonableness are insufficient to avoid summary judgment. (internal citations omitted)); Highland P'ship, 2012 U.S. Dist. LEXIS 167458, at *20-25 ("A breach of the implied covenant of good faith and fair dealing involves something beyond breach of the contractual duty itself... and implies unfair dealing rather than mistaken judgment."). 14 See Engbrock, 370 F.2d at 786; Travelers Prop. & Cas. Ins. Co. v. Triton Marine Constr. Corp., 473 F. Supp. 2d 321, 330-331 (D. Conn. 2007) (citing PSE Consulting, Inc. v. Frank Mercede and Sons, Inc., 267 Conn. 279, 304-305, 310 (2004))( The Supreme Court [of Connecticut] concluded that bad faith requires an 'improper motive' or 'dishonest purpose' on the part of the surety. Applying that standard, the Court concluded that a surety's failure to conduct a sufficient investigation into the validity of a claim upon a payment bond, when accompanied by other evidence that reflects improper motive, may be considered evidence of bad faith. ). 15 See Garbutt v. Fairbanks Capital Corp., No. 03-1666, 2004 U.S. Dist. LEXIS 17138, at *5 (E.D. La. Aug. 27, 2004) (holding that fraud and lack of good faith are never presumed, but must be proven by a preponderance of the evidence). 8

For example, in PSE Consulting, Inc. v. Frank Mercede and Sons, Inc., 16 the Supreme Court of Connecticut considered the rights of a surety, pursuant to a GAI, to indemnification for payments made in settling a claim against a surety bond. The GAI included a Right-to-Settle Clause, but the Indemnity Clause did not impose an obligation of good faith on the surety. Instead, the principal defended that it was not liable under the GAI to indemnify the surety for the loss it incurred in settling bond claims because the surety breached the implied covenant of good faith and fair dealing. Specifically, the principal alleged that the surety failed to conduct a proper investigation of the claim upon the payment bond. The Supreme Court recognized that the surety was entitled to indemnification only for payments that were made in good faith. The Supreme Court found that the surety did indeed fail to conduct a sufficient investigation of the claim and also found evidence of improper motive by the surety, specifically that the surety settled a payment bond claim solely to protect its own self-interest. The Supreme Court noted that the failure to investigate alone was insufficient to establish bad faith. But, the failure to investigate combined with the improper motive was sufficient to show bad faith on behalf of the surety. The court held that the principal sufficiently proved the surety had breached its implied covenant of good faith and fair dealing in reaching a settlement and, therefore, the principal was not liable to indemnify the surety under the GAI. See also Auto-Owners Ins. Co. v. Southeast Floating Docks, Inc., 571 F.3d 1143 (11th Cir. 2009) (holding that the surety acted in bad faith in settling a performance bond claim by settling to avoid a bad faith claim asserted by the obligee, engaging in secret settlement negotiations with the obligee to purposefully exclude the principal, only conducting a rudimentary investigation of the obligee s claims and hiring an attorney who had a conflict of interest); Safeco Ins. Co. v. Siciliano, Inc., No. 06-3162, 2009 U.S. Dist. LEXIS 6364 (C.D. Ill. 2009) (denying surety s summary judgment motion against indemnitors, claiming breach of the indemnity agreement, by finding that indemnitors presented circumstantial evidence that the surety breached the implied duty of good faith because the surety convinced the principal to enter into a trust agreement and pre-sign default letters in exchange for financial assistance when the surety intended to cut off assistance and thereby effect defaults on the bonded projects, thereby acting unreasonably and in a matter inconsistent with the parties expectations at the time of contracting). IV. Surety s Steps to Avoid Liability for Bad Faith from the Principal & Ensure Recovery Under the GAI In order to avoid potential liability and ensure recovery, a surety must execute precautionary practices compliant with the expectations of good faith. First, the surety 16 267 Conn. 279 (Conn. 2004). 9

must recognize the rights and protections afforded by the GAI. The surety must also understand the terms and obligations asserted by the bond. This will help the surety ascertain the expectations of the principal and obligee, determine the scope of its obligation and reasonable expenses, and evaluate the extent of the principal s liability. Although actual liability of the principal is generally not required for indemnity, a surety would be well advised to perform an adequate investigation into whether a default occurred. The GAI may not include an express requirement for the surety to investigate. Yet, even in the absence of an expressed obligation, a principal will likely use a surety s failure to examine the extent of liability to support a defense of bad faith, as noted supra. Further, a surety should provide the principal with notice of the claim and invite the principal, first, to exonerate the surety. When working to reach a settlement agreement, with or without the principal s consent, a surety should also keep the principal informed of the negotiations and details of the settlement so as to avoid any appearance of impropriety. V. Conclusion The surety s rights to settle bond claims under the GAI are typically clear and unambiguous. However, in an effort to avoid costly litigation, the surety must balance its own interest with those of its principal, all the while protecting its rights and fulfilling its obligations under the bond and GAI. Communication with the principal during the settlement process is essential to this balance and often serves to protect the surety from any claim of bad faith. This communication, along with a clear understanding of the surety s contractual obligations, will assist the surety in securing its claim for indemnity. 10