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THE RIGHTS AND OBLIGATIONS OF THE SURETY UNDER DUAL ...

By George Holmes,2014-07-09 03:38
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THE RIGHTS AND OBLIGATIONS OF THE SURETY UNDER DUAL ...

    American Bar Association

     Forum on the Construction Industry/TIPS Fidelity & Surety Law

    Committee

    Expecting The Unexpected: Anticipating and Managing

    Key Risks to Successful Projects

    The Rights and Obligations of the Surety

    Under Dual Obligee Bonds

    Martha L. Perkins

    Ernstrom & Dreste, LLP

    Washington, DC

    January 26, 2006

    The Waldorf-Astoria, New York, NY

    ? 2006 American Bar Association

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    The Rights and Obligations of the Surety

    Under Dual Obligee Bonds

    Martha L. Perkins, Esq.

    Ernstrom & Dreste, LLP

    1050 Connecticut Avenue, NW th10 Floor, Suite 1050

    Washington, DC 20036

    Telephone: 202-772-1127

    Facsimile: 202-772-3308

    mlp@ernstromdreste.com

     This paper was first presented as an unpublished paper at the annual

    meeting of the Surety Claims Institute, in Galloway, New Jersey, in June 2005.

    I. Introduction

     It is axiomatic that the liability of a surety on a bond arises from the bond language, the contractual obligations incorporated into the bond, and any applicable statutes. Subject to the limitations of the bond language, the surety agrees to indemnify the obligee in the event the bonded principal fails to perform its obligations to the obligee. The surety owes no obligation to the obligee unless the principal fails to perform. Thus, the surety‟s liability is secondary, and the obligee must establish the liability of the principal in order to seek recovery from the surety. The inclusion of a dual obligee under the bond should not change these, or any other, basic principles of suretyship.

     A dual obligee, or co-obligee, bond names as an additional obligee a lender or other party that is granted a direct right of action under the bond. The dual obligee bond provision or rider extends a surety‟s obligations under the bond to that interested third party. In the context of a performance bond, the additional obligee is usually a construction lender, although other entities having some interest in the completion of the 1project, such as title insurers, can also be dual obligees. And, while historically dual

    obligee riders have been issued to construction lenders, in recent years lenders involved in other complex commercial transactions have predicated execution of the loan agreement with the obligee on the additional security of being named as a dual obligee on a surety bond.

     On their face, dual obligee bonds, absent language to the contrary, do no more than add a party with standing to bring a bond claim, without extending the potential liability of the surety. Sureties do notand should not expectthat the risk will be

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    expanded. These bonds, however, often create more complex problems for the surety than was ever intended. While the principle of a dual obligee bond is quite simple, courts have at times created complex, unintended, and inconsistent obligations for sureties that 2have issued such bonds.

     This article addresses some of the common issues concerning dual obligee bonds: the effect of a savings clause, the extent of the surety‟s obligations under dual obligee

    bonds, the surety‟s defenses to coverage, the measure of damages recoverable by a dual obligee, and the surety‟s potential affirmative causes of action against a dual obligee that engages in misconduct.

    II. Dual Obligee Provisions

     An additional obligee might be named in the bond itself or, more commonly, will 3be added in a dual obligee rider. There is no common form of dual obligee rider. The

    relevant provision of a typical dual obligee performance bond reads as follows:

    NOW, THEREFORE, the condition of this obligation is such that, if

    Principal [contractor] shall well and truly perform all the undertakings,

    covenants, terms, conditions and agreements of said Contract on its part,

    and fully indemnify and save harmless Obligees [owner and lender] from

    all cost and damage which they may suffer by reason of failure so to do,

    then this obligation shall be null and void; otherwise it should remain in 4full force and effect.

    Without such a bond provision or rider adding the additional obligee to the bond, a third party, such as a construction lender, should not be permitted to recover under a contractor‟s performance bond.

     However, one court has opined that a bank, which was not named as a bond co-obligee, was permitted to assert a claim under the contractor‟s performance bond for money loaned to the contractor to carry out its work on the bonded project. In State v. Ed 5Cox and Son, the Supreme Court of South Dakota allowed recovery under the language of the bond, which obligated the surety to pay certain enumerated categories of claims and “all other just claims incurred by [contractor] in carrying out the provisions of said 6contract . . . .” The court found that this language “indicates an intention to include 7additional liability.” The court relied on the broad language of the bond to hold that the contractor‟s construction financing was within the scope of the bond and required the surety to pay the outstanding balance of the construction loan upon the contractor‟s 8default. By so holding, the court interpreted the performance bond as a financial 9guarantee bond in favor of the contractor‟s lender.

    III. Extent of the Surety’s Liability

     As stated above, addition of a dual obligee on a bond should not change the extent

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    of the surety‟s liability under the bond, absent express language to the contrary. Under basic suretyship principles, the surety has well-defined rights and obligations with regard to the principal contractor, obligee owner, and dual obligee lender. Indeed, by the insertion of a dual obligee rider, the surety does not intend to guarantee the financial obligations of the owner to the lender, nor to indemnify the lender, absent express language to that effect in the bond. In particular, it is noted that the obligation of a surety 10under a dual obligee bond is not that of a guarantor of the owner‟s note.

A. THE SAVINGS CLAUSE

     1. “Savings Clause” Provision

     A “savings clause,” or a condition precedent clause, should always be included in

    dual obligee bond or rider in order to properly circumscribe the surety‟s liability to the dual obligee. One example of a savings clause in a dual obligee rider is the following:

     The Surety shall not be liable under the Bond to the Primary

    Obligee, the Additional Obligee, or any of them, unless the Primary

    Obligee, the Additional Obligee, or any of them, shall make payments to

    the Principal (or in the case the Surety arranges for completion of the

    Contract, to the Surety) strictly in accordance with the terms of said

    Contract as to payments and shall perform all other obligations to be

    performed under said Contract at the time and in the manner therein set 11forth.

     Another example of a savings clause is the following:

     Notwithstanding anything contained herein to the contrary, there

    shall be no liability on the part of the Principal or Surety under this Bond

    to the Obligees, or either of them, unless the Obligees, or either of them,

    shall make payments to the Principal, or to the Surety in case it arranges

    for completion of the Contract upon default of the Principal, strictly in

    accordance with the terms of said Contract as to payments, and shall

    perform all the other obligations required to be performed under said 12Contract at the time and in the manner therein set forth.

     2. Purpose of the Savings Clause

     The purpose of the savings clause is to place both the obligee owner and the dual 13obligee lender in the same position and subject both to the same defenses. Both of the

    above-quoted savings clauses clearly and unambiguously relieve the surety from liability under the bond, to either and both of the obligees, if either of the obligees fails to make payments strictly in accordance with the terms of the bonded contract or fails to perform all other obligations under the bonded contract. Default by either the obligee or the dual obligee relieves the surety from performance obligations under the bond--to either of the

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    14 Accordingly, a lender must, among other things, fund the contractor in the obligees.

    event of the obligee borrower‟s default in order to preserve its rights under the dual obligee bond.

     A number of courts have properly recognized that a “savings clause” in a dual obligee bond or rider is a condition precedent to the assertion of a claim against a surety by an obligee owner or a dual obligee lender.

     A case that well illustrates the problems that ensue when a surety issues a dual obligee bond without a savings clause is Continental Bank & Trust Co. v. American 15Bonding Co. The dual obligee bank brought suit against the surety, seeking recovery on bonds guaranteeing the principal‟s completion of specified improvements on a land development project. The surety defended on the grounds that the dual obligee bank had wrongfully released the job funds. The court determined that the bank had no duty under the loan agreement, bond, or the construction agreements to pay the general contractor and that the unavailability of additional funds under the loan was caused by the actions of 16the owner of the development. The court observed that, even if the owner‟s actions

    could be construed as wrongful and, therefore, a breach of the construction agreements, such a default on the part of the owner “would not extinguish the surety‟s liability to” the 17bank. The court opined that the surety was liable to the bank under the dual obligee bond:

    [Bank and owner] had severable and distinct interests in the construction

    contracts, as did [bank and owner] in the bond agreements. Therefore,

    [bank‟s] right to enforce these agreements could not be defeated by the 18acts of its co-obligees.

     The bond in Continental Bank & Trust Company apparently contained no savings

    clause, and the bank was, therefore, able to disburse funds without consideration of the impact of its actions on the principal‟s obligations under the contract or the surety‟s 19obligations under the bond.

     3. Refusal to Give Effect to Savings Clause

     Not all courts will give proper effect to a savings clause. One case in particular 20that confounds is New Amsterdam Casualty Co. v. T.J. Bettes. The surety in this case

    issued an AIA A311 performance bond, which named the owner as obligee. The interim construction lender, Bettes, was named dual obligee in a rider, which contained a standard savings clause. The bonded construction contract contained the following language, which was incorporated by reference into the bond:

    “Owner agrees that the interest of the lender in such bonds shall be the

    amount of construction money which it shall have advanced, together with

    interest on each such advance from the time of the advance at the rate of 6

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    per cent per annum, which interest and claim of such lender on each such 21bond shall be prior to and superior to any interest and claim of owner.”

     One of the projects was abandoned by the principal contractor when it was only twenty-five or thirty percent complete, but a much greater percentage had been paid upon false payment certificates sworn to and submitted by the contractor. The lender, without knowledge of the fraud, had advanced loan funds as certified. The surety rightfully asserted its overpayment defense, which the court rejected:

    [S]urety takes the position that the rights of Bettes under the Plattsburgh

    dual obligee bonds must stand or fall with the rights of [owner], and that if

    [owner] knew of the falsity of the certificates filed by [contractor] then

    Bettes, an innocent party, cannot recover under the bond. We cannot

    agree with [surety‟s] contention in this regard. Assuming, Arguendo [sic],

    that [owner] knew of the falsity of the affidavits yet we cannot find any

    basis for charging Bettes with this knowledge. The position of Bettes as a

    co-obligee on the bond is defined by the well expressed terms of the bond 22itself . . . .

     Thus, the court refused to impute the knowledge of the obligee owner that the certificates were false to the dual obligee lender. By so refusing, the court completely ignored the express language of the savings clause and the protection that it was intended to afford the surety. The court ignored the dual obligee lender‟s duties to the surety. Indeed, the court stated the lender “stands in a similar position to the materialmen” in a 23payment bond case. This comparison does not withstand scrutiny as the rights of the dual obligee lender are predicated solely on the terms of the rider, limited by the savings clause. Nor does this result comport with the court‟s own pronouncement on the savings clause in the bond: “The bond also contains the endorsement to the effect that the surety

    shall not be liable to either of the obligees unless all contract obligations are performed 24by the obligees.”

     4. Savings Clause Inapplicable to Subcontractor and Supplier Claims

     Courts will not give effect to a savings clause in a dual obligee payment bond or a broadly drafted dual obligee performance bond to preclude a subcontractor or supplier‟s claim under such bond. The reasoning is that the savings clause is a condition precedent to a claim by either, or both, the obligee owner or dual obligee lender, but not to a claim by an unpaid subcontractor or supplier.

     25 In Aetna Insurance Co. v. Maryland Cast Stone Co., the surety issued a dual

    obligee payment bond to the owner and to the lender that had agreed to lend money to finance the construction contract. One of the express conditions of the bond was a savings clause that provided as follows:

     “The Principal and Surety shall be liable to the Obligees, or either

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    of them, unless the said Obligees, or either of them, make payment to the

    Principal or, in the event of Principal‟s abandonment of project or default,

    to the Surety, strictly in accordance with the terms of said construction

    contract as to payments, and perform all the other obligations to be

    performed under said construction contract at the time and in the manner 26 therein set forth.”

     When an unpaid supplier sued on the bond, the surety denied liability because no payments had been made to the principal contractor by either the obligee owner or the dual obligee lender under the terms of the bonded contract. The surety argued that the savings clause placed the supplier in the same position as and subject to the same defenses as the dual obligee lender. The Maryland Court of Appeals rejected the surety‟s argument, holding that the supplier‟s claim was unaffected by the savings clause. Significantly, however, the court indicated, in dicta, that the savings clause would have precluded a claim by the dual obligee:

     Aetna would have us hold that for it to be answerable to [supplier],

    there must first be proof that [owner] or the Bank made payments to

    [bonded contractor]. The simple answer to this contention is that such a

    payment may be a condition precedent to the assertion of a claim against

    Aetna by [owner] or the Bank, the Obligees of the bond, but it has nothing 27whatever to do with [supplier].

     28 Similarly, in Acoustics, Inc. v. Hanover Insurance Co., the court considered the

    effect of a savings clause in a dual obligee bond. The bond contained a savings clause that required that payment to the principal by the owner obligee and/or the dual obligee lender be made strictly in accordance with the terms of the contract. When an unpaid subcontractor sued the surety, the surety contended that the bond obligation was discharged because the owner failed to pay the principal contractor all sums due and owing. The court held that the subcontractor‟s claim was unaffected by the savings clause: “A careful reading of the [savings] provision indicates that it only pertains to the

    liability of the surety to the obligees. Since [subcontractor] is not an obligee, this 29provision does not in any way affect [subcontractor‟s] claims against [surety].” The

    court‟s comment indicates that, as the court in Maryland Cast Stone Co., it would have

    applied the savings clause to preclude recovery by the dual obligee lender.

     30 The court in Guin & Hunt, Inc. v. Hughes Supply, Inc. also rejected the surety‟s

    argument that subcontractor‟s rights were defeated under a dual obligee bond because the 31owner and the lender failed to comply with the bond conditions. The surety had issued

    a bond for the construction of a condominium project, naming the owner and lender as dual obligees. The bond contained, as noted by the court, the following “special

    condition”:

    “Surety shall not be liable under this bond, unless Owner or Lender shall

    make payment to Contractor strictly in accordance with the terms of the

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    contract as to payments and shall perform all other obligations to be

    performed by Owner under the contract at the time and in the manner 32therein set forth.”

     The court stated that the bond was not only a performance bond but also a payment bond because it required that the contractor “„keep the property and construction funds free and clear of any and all liens for labor or material furnished in connection with 33the contract . . . .‟” The surety asserted the affirmative defense that the unpaid subcontractor‟s rights under the bond were defeated because the principal contractor had not received payments from the owner or the lender of the construction proceeds. The court soundly rejected this argument, stating that payment to the subcontractor, under the terms of the subcontract, was not conditioned on the general contractor‟s receiving any

    payment from the owner or lender. While this argument might be true, the court observed, “between the surety and the prime obligees,” the subcontractor was a “third 34party donee obligee of the bond” with vested rights.

B. SCOPE OF BOND COVERAGE UNALTERED

     1. Dual Obligee Bond is NOT a Completion Bond

     Sometimes the dual obligee bond is mistaken for a completion bond. However, a surety‟s obligation to a dual obligee lender under a performance bond is not the same as the surety‟s obligations under completion bonds, issued with some regularity in the 1920s and 30s. During that time, lenders, seeking to protect their interest in their collateral, the completed project, obtained from sureties completion bonds. Completion bonds were guarantees of the successful completion of the improvements bonded by the surety, free 35from all liens, with virtually no restriction on the surety‟s liability to the lender.

     Under a completion bond, the surety guaranteed, in effect, the performance of both the owner and the contractor under the terms of the bonded contract. The surety guaranteed completion of the construction project without receiving reciprocal consideration from the dual obligee lender. Lenders favored such bonds because they shifted responsibility for financing completion of a project to the surety after contractor 36breach of the bonded contract caused a default under the loan agreement. If there were

    a default on the project, even by reason of the owner‟s failure to pay the contractor, the

    lender could compel the surety to complete the project.

     The Supreme Court has opined concerning the surety‟s obligations under completion bonds as follows:

    Plainly the obligation of the bond was one of guaranty and not indemnity,

    and could be fulfilled only by the erection of the buildings or payment of

    the penalty in case of default. It is no answer to say that the value of the

    property immediately after the default exceeded the sum of the mortgage

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    together with all prior liens. . . . Petitioner is entitled to be put in as good

    position in respect of its debt as it would have occupied if the buildings

    had been completed in accordance with the terms of the 37undertaking . . . .

This unrestricted liability resulted in large losses to surety companies and, at times, unjust 38enrichment of the lenders. For this reason, sureties seldom write completion bonds

    today.

     Like completion bonds, however, dual obligee riders are a response by the surety 39industry to requests/demands, in particular, from lenders for additional security. Dual

    obligee riders have been written with regularity by surety companies during the last forty 40years. On their face, dual obligee riders only increase the number of parties with standing to bring bond claims, without changing the nature of the bond obligation assumed by the surety.

     Resolving issues of surety liability under dual obligee bonds can be confusing, because, among other reasons, an obligee is added who is not in privity with the owner on the underlying contract, the contractor, or the surety. Thus, the lender, or other interested party, seeks a direct right of action against the surety, either by being named as a co-obligee in the bond or being added in a dual obligee rider. A “savings clause” is included in the dual obligee rider to prevent an enlargement of the surety‟s liability by requiring the dual obligee lender to assume the same duties untaken by the obligee owner under the construction contract and the bond. Some courts, however, have still confused the surety‟s obligations under dual obligee bonds with those obligations under completion bonds.

     41 Such an example is Lippert Brothers, Inc. v. National Union Fire Insurance Co.,

    wherein the court provided an odd rationale that confused the concepts of the dual obligee performance bond and a completion bond. A general contractor sued the surety on a subcontractor‟s performance and payment bond. The bank that financed the subcontractor was named as a co-obligee under the bond and intervened, claiming it had an agreement with the surety under which the surety guaranteed the performance of the contract. The bank argued that the surety urged the bank to loan money to the principal subcontractor so that it could undertake to perform the bonded contract. The court was impressed with the bank‟s assertion:

    [I]t was the intent, understanding and agreement of the [lender] and the

    defendant in making the [lender] a co-obligee on the payment and

    performance bond, that defendant would guarantee to the [lender], in view

    of loans to [principal subcontractor], that [principal subcontractor] itself

    would perform the subcontract and thereby entitle the [lender] to receive

    and apply the proceeds due [principal subcontractor] from the

    subcontract to the extent of its loans to [principal subcontractor] under

    and by virtue of the assignment of such subcontract proceeds from 42[principal subcontractor] to [lender].

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     The court acknowledged that a lender is not a typical beneficiary of a bond but noted that in the instant matter the bank had been named as a co-obligee in the bond. Having referenced the bond and the bank‟s status as a co-obligee therein, the court

    proceeded to enlarge the surety‟s obligations to the bank by reference to parol evidence to 43 In essence, the court judicially created a completion and modify the terms of the bond.

    repayment guarantee for the obligee lender‟s security interest in the contract, an obligation outside the scope of the bond.

     2. Dual Obligee Surety is NOT Guarantor of Owner’s Note to Lender

     a. Generally

     Absent express language to the contrary, a surety under a dual obligee bond is not a guarantor of the owner‟s note to the lender, although there are certainly cases to the contrary. The purpose of the dual obligee performance bond is to ensure that, if the contractor fails to perform its contract with the owner, the surety will undertake to perform or pay damages up to the penal sum of the bond. A loan guarantee, in contrast, is a form of security that is not included in the ambit of coverage under the bond. The lender may require various types of security for its loan: promissory note and mortgage or security deed from the owner or personal loan guarantees from the owner‟s principals, among other things. A construction loan guarantor pledges to the lender that the loan will be repaid, regardless of whether the project is ever built or has any value once 44completed. The dual obligee bond and the loan guaranty have different purposes and secure different performances.

     However, the lender has a different perspective and will usually assert that overly broad perspective against the surety to recover damages under the bond that were never intended to be covered. From the lender‟s perspective, if the contractor had completed the contract on time and for the agreed price, the owner‟s return on the project should have permitted repayment of the loan without any expense or loss to the lender. If the contractor‟s default causes the project to be unprofitable so that the owner cannot pay the loan and the lender incurs consequential damages, the lender is highly likely to seek recovery of such damages.

     However, notwithstanding the lender‟s improper expectations, the lender‟s interest in the project is the same as the owner‟s interest in the project. Therefore, if the

    lender forecloses on the loan to an owner, the lender merely steps into the owner‟s shoes, without increasing the surety‟s exposure. The dual obligee bond guarantees that the construction contract will be performed or that damages from breach of contract will be 45paidno more.

     b. Case Law: Dual Obligee Bond ? Guarantee of Note

     Over one hundred years old, the court in the venerable case of Weightman v.

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