By: Ira M. Schulman, Partner, and Emily D. Anderson, Associate, Pepper Hamilton LLP
Payment bonds have been a staple of public construction projects since 1874, when the U.S. Congress first passed the Heard Act, which required that contractors obtain payment bonds for public projects to ensure that subcontractors and material suppliers have a way to recover their damages if an upstream contractor fails to pay for work performed and materials furnished on the project. The 1874 Heard Act has since been replaced by the 1935 Miller Act, and the concept has been expanded to construction projects funded by the states through state statutes known as “Little Miller Acts.” But the structure remains the same: On most public projects where the project’s cost exceeds $100,000, the prime contractor (the bond principal) is required to obtain a payment bond from a surety equal to the contract price to guarantee to subcontractors and material suppliers (the bond obligees) that the surety will pay for labor and materials under certain statutory or contractual conditions should the contractor fail to make payment.
A surety is jointly and severally liable with the contractor to the subcontractor, which means that the subcontractor may seek recovery against either the contractor or the surety or both, and the contractor and surety will be liable for the damages together. Put another way, in most states and in federal court, an unpaid subcontractor has the right to sue only the surety on the payment bond without joining the contractor because a contract of suretyship is a direct liability of the surety to the subcontractor.1 When the contractor fails to perform, the surety becomes directly responsible at once — it is unnecessary for the subcontractor to establish that the contractor failed to carry out its contract before the obligation of the surety becomes absolute.
The dynamics between the contractor and its surety are different when the contractor is not named as a party to the lawsuit. This article addresses the obligations and role that a contractor, who is the principal on a payment bond may have when a subcontractor chooses to sue the surety to seek recovery under a payment bond, but does not opt to sue the contractor as well.
Why Would a Claimant on a Payment Bond Sue Only the Surety?
Claimants often bring lawsuits solely against the surety and not against the contractor on the bond because the contractor, or a subcontractor with whom the claimant is in privity of contract, is insolvent or defunct. The prime contractor bond principal may also not be named as a party to the lawsuit when the payment bond guarantees payment to lower-tier subcontractors and suppliers who are not in privity of contract with the prime contractor, and thus the claimant does not have a direct claim for payment against the contractor. Other times, there may be a strategic reason to not involve the contractor that is the principal on the bond. For example, the subcontractor may want the lawsuit in federal court, but naming the contractor as a defendant would defeat diversity jurisdiction. The claimant may also gamble, rightly or wrongly, that the surety is less able to effectively establish defenses or counterclaims against the claimant without the contractor being a party to the lawsuit, or that the surety may pay the claim without consideration of the contractor’s defense against the claimant.
The Relationship Between the Nonparty Bond Principal and the Surety Named in the Lawsuit Creates a Close Litigation Dynamic Unique to Bond Claims
Regardless of the subcontractor’s reasoning for excluding the contractor from the suit, a contractor who is the principal on a payment bond is not off the hook for its obligations to pay its subcontractors and suppliers when a claimant chooses not to name the contractor as a party to the lawsuit. In fact, the contractor may have more at stake when a surety is sued on a payment bond. Thus, it is common for the contractor to accept a tender of the surety’s defense at the outset of the litigation to ensure that the claim is not settled prematurely without consideration for the contractor’s defenses or obligations.
A. Contractual Indemnification
While many sureties are also in the insurance business, suretyship is very different than insurance in that insurers generally take a calculated risk that the insurance premiums will exceed any loss, whereas a surety is unlikely to issue a bond unless it is reasonably certain that it will not sustain any loss. Accordingly, a surety generally will not extend surety credit unless the principal, the individual owners of the principal and, sometimes, the spouses of the individual owners of the principal enter into an indemnity agreement with the surety whereby the indemnitors agree to exonerate and indemnify the surety against any potential losses, costs or expenses, including attorney’s fees, it may sustain as a result of a claim on the payment bond and to prevent harm or loss to the surety.
B. Collateralization
When a contractor/principal has exceeded its bonding limit, many sureties will also require that the indemnification agreements include an obligation by the principal to collateralize the surety before it sustains a loss, either by depositing a sum into an account or posting personal or real property as security, or by agreeing to an onerous cash management plan.
C. Right to Settle
Many indemnification agreements also grant the surety an express right to settle payment bond claims, despite objections by the principal and other indemnitors or even if liability for the claim actually exists, for the sole purpose of avoiding the cost of litigation and without endangering or limiting the surety’s rights to indemnification.
D. Common Law Indemnification, Reimbursement and Exoneration
Even in the absence of an indemnification agreement, the surety still has common law indemnity, reimbursement and exoneration rights against the principal on the bond for the surety’s actual liability due to the principal’s not performing the bonded obligation (i.e., making payment for the labor and materials covered by the payment bond). However, in such a case, the surety generally cannot recover against the individual owners of the principal absent wrongdoing that warrants piercing the corporate veil.
In any event, the surety’s contractual, common law, or contractual and common law indemnification rights against the principal of the bond change the dynamic of the lawsuit dramatically. A nonparty bond principal (i.e., the contractor on the construction project) has a greater interest in the outcome of the litigation than the surety named as a party to the litigation because the principal, and often the owners of the principal if the principal is defunct or insolvent, will have to pay the judgment or settlement amount and the surety’s attorney’s fees.
E. The Surety’s Right to Assert the Principal’s Defenses and Counterclaims
Further compounding the unconventional stake of the nonparty bond principal in a lawsuit against its surety is the fact that the surety may invoke the defenses and assert counterclaims of the principal or any subcontractor that entered into a contract with the claimant. These defenses and counterclaims could include breach of contract, setoff, payment, release, settlement, waiver or failure of conditions precedent to payments (e.g., payment by the owner).
Depending on the jurisdiction and the applicable facts, when the contractor-principal’s defenses and counterclaims are asserted by the surety and fully adjudicated by a court or settled by the claimant and the surety, the contractor may be precluded later from bringing a separate action against the claimant for those same claims. Accordingly, it is often in the best interests of the contractor to accept the costs for the surety’s defense of the payment bond claim at the outset of the litigation to make sure that its defenses and counterclaims against the claimant are properly asserted.
What Role Should a Nonparty Contractor Take in a Lawsuit Against its Surety Given its Stake in the Outcome?
A. The Principal Has No Duty to the Claimant
When a claimant chooses not to sue the prime contractor who is the principal on a payment bond, the claimant is also foregoing the right to obtain party discovery from the contractor. In other words, the contractor is under no obligation to the claimant to produce documents or appear for depositions without the issuance of a subpoena. In fact, if the contractor is out of state, the procedure for obtaining and serving a subpoena can be onerous. So if the contractor’s testimony is necessary for the claimant to prove its case, naming the contractor as a party may be necessary.
Even in response to a subpoena, the production by the contractor is governed by any rules applicable to nonparties. For instance, local rules in New York mandate that the issuer of the nonparty subpoena is responsible for defraying the nonparty’s reasonable production expenses, such as costs incurred in connection with identifying, preserving, collecting and hosting e-discovery. As a contractor is technically a nonparty to the lawsuit, these would apply to the contractor’s production of documents, whereas it would not if the claimant had named the contractor as a party to the lawsuit.
B. The Principal’s Duty to the Surety to Cooperate
Although the contractor has no duty to the claimant to produce documents or appear for depositions without the issuance of a subpoena, most indemnification agreements require that the contractor cooperate with the surety in its claim investigation. In some state law, such as Texas, require parties involved in the construction project to produce certain documents, like the payment bond and the project contract.
Conclusion
A contractor’s vested interest in cooperating with the surety in an action involving a payment bond on which the contractor is the principal creates a tension with the contractor’s lack of obligation to voluntarily produce documents in the litigation. While it may be appealing to resist production of documents to the claimant, as a practical consideration and also due to the contractor’s obligations to the surety, in many instances, it is in the contractor’s best interest to produce documents material and necessary to defend against the claim on the payment bond because the surety is asserting the contractor’s defenses and counterclaims, and the contractor will be responsible for, at the very least, the surety’s actual liability.
1A minority of jurisdictions, such as Arizona, require that a lawsuit against a surety seeking to recover on a payment bond must also name the contractor as a defendant based on state rules of civil procedure.
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