Sureties do not issue bonds (e.g., payment or performance bonds) unless the principal and the principal’s personal guarantors execute a General Agreement of Indemnity (“Indemnity Agreement”). The Indemnity Agreement routinely requires that the principal / guarantors: (1) defend and indemnify the surety for all losses, liability, claims, attorney’s fees, and expenses that the surety may incur and (2) post collateral security into a reserve account set up by the surety to cover any claim on the bond; the surety may seek an injunction to compel such collateral if the principal / guarantors refuse. Yes, these are powerful provisions in favor of the surety if a claim is asserted against the principal’s bond (especially a performance bond claim) or if the surety, to offset liability or exposure, pays a claimant on behalf of the principal. The leverage lies with the surety with respect to the provisions in the Indemnity Agreement and the worst thing a bond principal can do when a claim is asserted against the bond is to outright refuse to work with and cooperate with the surety (based on the powerful provisions in the Indemnity Agreement).
The opinion in Developers Surety and Indemnity Co. v. Hansel Innovations, Inc., 2014 WL 2968138 (M.D.Fla. 2014), exemplifies what can happen if a bond principal refuses to cooperate with a surety even if the principal has potentially meritorious arguments. In this case, a surety issued a performance bond to a fire protection subcontractor. During the course of construction (and, arguably due to the general contractor’s nonpayment), the subcontractor experienced cash flow problems. The general contractor expressed concerns as to the subcontractor’s financial wherewithal to complete the contract work and made demand on the surety. The subcontractor requested financial assistance from its performance bond surety and the surety agreed to pay the subcontractor and its vendors in excess of $100,000 provided the subcontractor execute a separate financing and collateral agreement (as the surety expected to recoup its “loan”). Subsequently, the general contractor advised the surety and subcontractor of performance issues with the subcontractor’s work. The subcontractor, however, refused to complete its work and address the performance issues unless the surety continued to fund the subcontractor’s work, released the guarantors from personal liability, and pursued claims against the general contractor. Based on the subcontractor’s stance, the surety retained another subcontractor to complete the work and incurred additional costs. The surety filed a lawsuit to, among other rights afforded under the Indemnity Agreement, require the subcontractor and guarantors to post $200,000 in collateral security into a reserve account. The subcontractor and guarantor failed to post collateral upon demand.
The surety, as it customarily will do, moved for a preliminary injunction in accordance with the Indemnity Agreement for the court to order the subcontractor and guarantors to post collateral. One of the requirements for a court to order a preliminary injunction is for the surety to establish that it is substantially likely to succeed on the merits. This is not a challenging hurdle for a surety given the powerful provisions in the Indemnity Agreement. (Please see the following articles for more information on a surety’s right to demand collateral security and the requirements for a preliminary injunction in federal court: https://floridaconstru.wpengine.com/a-suretys-right-to-demand-collateral-security/ and https://floridaconstru.wpengine.com/a-suretys-right-to-demand-collateral-security/.)
The subcontractor argued that bad faith or unclean hands, evidenced by an improper motive, extinguished the surety’s substantial likelihood that it would succeed on its claim. The subcontractor argued this because it did not want to post collateral. In support of bad faith, the subcontractor contended that when the general contractor raised performance issues the subcontractor was 99% done with its work with the remaining work simply commissioning the fire sprinkler system and completing as-built drawings. It further argued that the general contractor placed it in a dire financial position because the general contractor did not pay it for over one year and did not pay it for change order work that was performed at the general contractor’s direction. (Not an uncommon subcontractor argument!) The subcontractor also stated that it only signed the financing and collateral agreement because the surety assured it that the surety would assist the subcontractor in collection efforts against the general contractor if the subcontractor signed the agreement and continued with the work. Then, the surety discontinued funding the subcontractor at the eleventh hour to help the subcontractor complete the work while contemporaneously failing to assist the subcontractor in collecting any money from the general contractor. The Magistrate, though, was not persuaded by the subcontractor’s bad faith argument taking the position that it cannot be bad faith for the subcontractor to be induced into completing its work on a project it was hired to complete.
The subcontractor may have very strong arguments that it was truly placed in a cash flow crunch because the general contractor refused to pay for contract work plus additional work. Thus, the subcontractor was forced to finance a job that it was never in a financial position to finance. Then, when it agreed to complete its work with the surety’s assistance, it did so with the understanding that the surety would assist the subcontractor in recovering monies that the subcontractor should have been paid all along for contract and change order work that would also be used to reimburse the surety. But, as shown in this case, truly establishing bad faith is very, very difficult and should not be sugarcoated with the sentiment that the provisions in the Indemnity Agreement do not have any teeth, because they do!
Keep in mind that a performance bond guarantees performance under a contract. Once a bond is furnished, it is rarely advisable to abandon a job or refuse to perform because it puts the surety in a compromising position where it will likely need to complete the subcontractor’s performance in order to mitigate its exposure and liability. Here, the subcontractor’s surety was willing to finance the subcontractor’s work until the subcontractor was virtually complete. All the subcontractor had to do was complete its work when it was 99% complete and work with and cooperate with the surety since the best course of action in the long run may have been for these entities to work together to recover monies that the general contractor owed the subcontractor and/or figure out how the subcontractor would reimburse the surety. However, based on what the surety may have construed as an obstinate position by the subcontractor, the surety incurred additional expenses and elected to pursue its options against the subcontractor and guarantors under the all mighty Indemnity Agreement.
Please contact David Adelstein at dadelstein@gmail.com or (954) 361-4720 if you have questions or would like more information regarding this article. You can follow David Adelstein on Twitter @DavidAdelstein1.