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Birds of a Different Feather That Sometimes Flock Together
Most commercial liability insurance adjusters whose carrier insures construction contractors will at one time or another confront the issue of suretyship -- either in the context of initially allocating risks and damages between coverage under the policy and "coverage" under a performance bond or in the related context of subrogation. In order to better navigate the waters of these related but disparate vehicles of loss protection, it is important to first understand (1) the similarities and differences between insurance and suretyship, (2) how the rights and obligations of sureties and insurers affect each other, and (3) particular areas of concern, such as subrogation. We begin with the following overview.
Suretyship: What It Is
Like liability insurance, surety bonds provide protection against loss, but they do so in a fundamentally different way. Rather than protecting the insured against unknown or fortuitous risks and claimants, a surety protects a known risk and known parties pursuant to specific contractual terms. A surety bond is a tri-partite contractual agreement in which the surety guarantees to the obligee (owner or party receiving benefit of the bond) that the principal (the contractor/subcontractor or party undertaking the obligation ) will perform as promised. While there are many types of surety bonds, the most common are contract and commercial/financial surety bonds. Contract bonds are used to guarantee the performance of construction contracts; commercial and financial bonds are used to guarantee other types of transactions, including self-insured workers compensation programs and health coverage. They may also take the place of letters of credit in financial transactions. Contract bonds are more common and more highly regulated because they are often required in public works contracts. See, e.g., Tex. Gov't Code Ann. '' 2253.001-.079 (Vernon 2000 & Supp. 2005) (also known as the "McGregor Act"); 40 U.S.C. '' 270a-270f (also known as the "Miller Act"). Contract bonds can be further subdivided into three categories: (1) bid bonds, (2) performance bonds, and (3) payment bonds. Bid bonds provide initial financial assurance that the contractor's bid was made in good faith. The value of bid bonds is typically equal to 10% of the bid amount. Payment bonds guarantee that the contractor will pay certain subcontractors and suppliers; this guarantee is particularly important and required by statute in public works projects since no mechanic's lien attaches to public property. See Redland Ins. Co. v. Southwest Stainless, L.P., 181 S.W.3d 509, 511 (Tex. App.--Dallas 2005, no pet.). Performance bonds protect the owner from loss if the contractor/principal fails to perform in accordance with the contract. For that reason, they are also the bonds most likely to be encountered by commercial liability adjusters. Performance bonds usually allow the surety to either arrange completion of the work, make funds available to finish construction, or reimburse the obligee for damages arising out of the principal's default. Because the principal's default usually results in additional expenses due to delay, the amount of the bond may exceed the contract price and permit the obligee to recover damages up to a stipulated limit, called the penalty or penal sum of the bond.
To an even greater extent than insurance, suretyship is controlled by the language of the contract or bond. See Geters v. Eagle Ins. Co., 834 S.W.2d 49, 50 (Tex. 1992). Because the risk and obligation being guaranteed is agreed at the outset, Texas courts construe surety agreements under the rule of strictissimi juris ("of the strictest right or law") to refrain from extending a surety's obligation by implication beyond the terms of the agreement. Vastine v. Bank of Dallas, 808 S.W.2d 463, 464 (Tex. 1991). Any material alteration in or deviation from the underlying contract that is the subject of the bond releases the surety from liability. Id. This rule of strict construction favoring the surety has also been applied when ambiguity in the bond or contract is pled B in stark contrast to the contra proferentem rule that favors the insured in the insurance context. See Augusta Court Co-Owners' Ass'n v. Levin, Roth, & Kasner, P.C., 971 S.W.2d 119, 125 (Tex. App.--Houston [14th Dist.] 1998, pet. denied). Unlike insurance, surety agreements are also subject to the "statute of frauds," which requires that such agreements be in writing to be enforceable. Compare Tex. Bus. & Com. Code Ann. ' 26.01(b)(2) (Vernon 2002) with Employers Cas. Co. v. Winslow, 356 S.W.2d 160, 164 (Tex. Civ. App.--El Paso 1962, writ ref'd n.r.e.) (oral agreement to effect insurance is enforceable). As a result of these rules, "misrepresentation" is more often an affirmative defense of the surety than a cause of action brought by the party seeking performance or payment under the bond.
What It Isn't
Despite their similarities, the Texas Supreme Court has identified suretyships and insurance as different "species of economic enterprise." Dallas Fire Ins. Co. v. Texas Contractors Sur. & Cas. Agency, 156 S.W.3d 895, 896-97 (Tex. 2004). Thus, suretyships do not constitute the "business of insurance" and are therefore not subject to those portions of the Texas Insurance Code that regulate unfair insurance practices. Id.; Great Am. Ins. Co. v. North Austin Mun. Util Dist. No. 1, 908 S.W.2d 415, 424 (Tex. 1995). Suretyship companies are subject to the licensing requirements of the Insurance Code, however. See Insurance Co. of N. Am. v. Morris, 981 S.W.2d 667, 678 (Tex. 1998).
Similarly, the surety owes no common-law duty of "good faith and fair dealing" to either its principal or bond obligee, so the extra-contractual remedies of "bad faith" are not available in disputes with sureties. See Great Am. Ins. Co., 908 S.W.2d at 418 (Tex. 1995) (no duty of good faith to obligee); Associated Indem. Corp. v. CAT Contracting, Inc., 964 S.W.2d 276, 280 (Tex. 1998) (no duty of good faith to principal). The Texas Supreme Court declined to extend this extra-contractual duty as some other jurisdictions have done because (1) bond principals are generally sophisticated; and (2) the indemnity agreement that typically forms an integral part of the surety bond provides considerable protection for the principal by allowing the surety to seek indemnity only for amounts paid in "good faith." CAT Contracting, 964 S.W.2d at 281. "Good faith" in this context does not imply any duty to conduct a reasonable investigation; it merely requires the surety not to act maliciously or in willful ignorance of the facts. Id. at 284-85. In other words, "bad faith" in the surety context is a defense to the surety's indemnity action B but requires a showing tantamount to fraud. See Id.
In most instances, a surety also owes no fiduciary duty to the principal or bond obligee. CAT Contracting, Inc., 964 S.W.2d at 287. An exception may arise, however, if dealings between the surety and principal evidence a special relationship of "trust and confidence" that has developed through a course of dealing. Id. at 288. However, the relationship must exist separate and apart from the agreement made the basis of the suit. Id.
One question that has not been definitively answered by the Texas Supreme Court is the extent to which the business of suretyship is subject to the Consumer Protection-Deceptive Trade Practices Act. In CAT Contracting, the court specifically skirted the issue by agreeing with the court of appeals that there was no evidence of causation for the damages alleged. Id. at 287. In contrast, the court of appeals had expressly held that the principal in that case was a "consumer" for purposes of the DTPA. Associated Indem. Corp. v. CAT Contracting, Inc., 918 S.W.2d 580, 594-95 (Tex. App.--Corpus Christi 1996), aff'd in part, rev'd in part, 964 S.W.2d 276 (Tex. 1998) .
In our next edition we'll explore the interplay of the rights and obligations of sureties and insurance carriers - so stay tuned!
