LAW: THE CONTRACTOR'S SIDE: Common collide

What happens when surety bonds/arbitration clauses conflict?

Blog Entry September 11, 2014

Larry Caudle is a principal in Kraftson Caudle LLC, a law firm in McLean, Va., specializing in heavy-highway and transportation construction.

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Two fairly common occurrences in construction are surety bonds and arbitration clauses in prime contracts.
 

What happens when the two collide? In particular, what happens when a project owner whose contract contains an arbitration clause seeks to arbitrate with the prime contractor’s performance bond surety?
 

In Liberty Mutual Ins. Co. v. Mandaree Public School District #36, 503 F.3d 709 (8th Cir. 2007), the Mandaree Public School District and Tooz Construction Inc. entered into a contract for remodeling and expansion of a public school. The contract provided that disputes between the district and Tooz would be resolved by arbitration in accordance with the rules of the American Arbitration Association (AAA). Liberty Mutual Insurance Co. issued a performance bond to secure Tooz’s performance on the project. Although the bond incorporated the construction contract by reference, it specifically provided that “[a]ny proceeding, legal or equitable, under this Bond may be instituted in any court of competent jurisdiction [where] the work is located . . . within two years after the Surety . . . fails to perform its obligations under this Bond.”
 

When a dispute arose between Tooz and the district, Tooz initiated arbitration. The District counterclaimed and then notified Liberty Mutual that it was asserting a claim under the performance bond. It was the district’s intention to have Liberty Mutual added as a third party to the arbitration so that all issues could be resolved in one single proceeding. However, Liberty Mutual refused to join the arbitration and the arbitrator denied the district’s request to amend. Liberty Mutual later advised the AAA it would consent “to becoming part of the arbitration,” but subsequent actions by the district prompted Liberty Mutual to send the AAA a letter withdrawing its consent. The AAA claims manager advised, “We are not adding [Liberty Mutual] as a party because it withdrew its consent to participate.” That same day, Liberty Mutual filed a lawsuit seeking a declaratory judgment that the district’s unilateral actions discharged Liberty Mutual’s obligations under the bond. The district moved to stay the lawsuit and to compel Liberty Mutual “to arbitrate all of its claims against [the District] by joining in the pending arbitration.” The district court denied the motion, and the school district appealed.
 

On appeal, the district argued that because the bond incorporated a construction contract that obligated the district and Tooz to arbitrate their disputes under the contract, disputes under the bond were subject to arbitration as well. The appeals court, citing past similar decisions, noted that an incorporation provision in a bond does not reflect “a mutual intent to compel arbitration of all disputes between the surety and the obligee under the bond.” In past cases, the courts have cautioned that a contrary rule would permit a bond obligee to compel an unwilling surety to arbitrate defenses unique to the bond, “such as whether the obligee had impaired the surety’s position or released the principal obligor.” The court thus ruled for the surety and refused to compel the surety to arbitrate.
 

This decision implies that the district would have to arbitration its dispute with the prime contractor and then turn around and litigate the same factual issues in a separate court proceeding, thereby duplicating efforts and expenses as well as subjecting itself to possibly inconsistent rulings (i.e., it might win in one tribunal and lose in the other). This is not the case. In most states, all the claimant under the bond would have to do is place the surety on notice of the underlying arbitration and the surety would be bound by the result of the arbitration. Next, the claimant would simply take the arbitration ruling to the appropriate court, which would hear only those issues germane to the bond and surety defenses such as whether the claimant provided adequate notice of its claim under the bond, whether a claimant/owner overpaid the contractor/principal during construction, etc. No issues regarding the underlying dispute or whether the surety’s principal breached the underlying contractor and/or is indebted to the claimant would be re-litigated in the court proceeding involving the surety.
 

In any case involving a payment or performance bond where the underlying contract contains an arbitration provision, the claimant must follow all provisions of the bond regarding notice of claim and must inform the surety of the arbitration proceeding in order to bind the surety to the result of that arbitration. R&B

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