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Annual survey of fidelity and surety law, 1993.

I. PUBLIC CONSTRUCTION BONDS

A. Miller Act Bonds

1. Jurisdictional Issues.

Waste water treatment plant not public work under Miller Act merely because funded by Farmers Home Administration.

General Electric Supply Co. v. United States Fidelity & Guaranty Co.(1) is a particularly good treatment of the issue that frequently arises as to whether a particular project is or is not a "construction, alteration or repair of any public building or public work of the United States," as required by the Miller Act.

A city in Kentucky contracted to make improvements to its waste water treatment plant, federal funding for which was provided through the Farmers Home Administration. After a good discussion of the authorities, the Sixth Circuit found that the purposes of the Miller Act were not served by extending the act to a situation in which the government was neither the owner of the property, the intended owner, nor even a party to the construction contract, notwithstanding that it was an obligee under the bond.

Repair of federally owned ships was public work, but jurisdiction depended on whether Miller Act bond actually issued.

In an unusual fact situation, a shipyard contracted to repair three ships belonging to the Department of Transportation and the United States Navy. A subcontractor filed suit only against the contractor and not the surety, alleging the existence of a performance bond and not a payment bond. The defendant shipyard contended that the contracts were not for "public works" and that the action should have been brought against the surety. An issue was also raised as to whether a bond was ever issued.

The federal district court in Owens v. Olympic Marine Services Inc.(2) wasted no time on the public works issue and found that in fact it was such. Likewise, the court held that the failure to join the surety was not a bar to a Miller Act claim. The court denied the motion to dismiss but stated that it would hear evidence on whether a bond existed. If no such bond existed, the action would be dismissed.

2. Procedural Issues

For relation back of 90-day notice, it is essential that there be underlying contract covering all items supplied by claimant.

In a somewhat suspicious set of circumstances, Double-R Construction Corp. performed work as a subcontractor on a construction project at a naval station. Robert DeFillippis Crane Service alleged that it furnished rental equipment to Double-R over a period of several years and for rentals of $1.6 million.

There was considerable evidence that one of the "R"s in Double-R was, in fact, Robert DeFillippis himself. He was not exactly forthcoming about his relationship with Double-R at meetings with the prime contractor and others. When Double R went broke, DeFillippis made a claim under the bond, notwithstanding that it never gave notices until more than a year after the so-called account had become delinquent.

In Robert DeFillippis Crane Service v. William L. Crowe Construction Co.,(3) the federal district court was unwilling to deny the DeFillippis claim in its entirety but stated that DeFillippis should have given 90 days' notice under the Miller Act as to each of a series of contracts, there being no underlying enforceable contract involving all the rentals. The court also indicated that it would hear evidence on the issue of whether DeFillippis was equitably estopped from recovery at all due to Robert DeFillippis's lack of candor.

Prime contractor may assert recoupment defense where materials supplied under subcontractor were defective. Setoff distinguished.

The jurist slated to become the newest member of the U.S. Supreme Court wrote an excellent opinion in United Structures of America v. G.R.G. Engineering,(4) giving surety lawyers some hope that at least one member of the High Court will have some insight into this area of the law.

A steel supplier to a bankrupt subcontractor sued under the Miller Act, and the general contractor defended that the steel was defective. The U.S. District Court for the District of Puerto Rico held that the Miller Act forbids the general contractor from taking such "off-setting" reductions, citing the Ninth Circuit's decision in Martin Steel Constructors v. Avanti Steel Constructors.(5)

While acknowledging that case, Judge Breyer for the First Circuit distinguished a set-off arising from a transaction extrinsic to plaintiff's cause of action from a recoupment related to the claim under consideration. He pointed out that the language of the Miller Act permits a supplier to recover not the full contract price, but the "sums justly due him." He went on to say: "Indeed, we do not see how the full contract price of goods supplied can possibly be 'justly due' a person who supplied defective goods."

B. State and Local Bonds

1. Procedural Issues

Forum selection clause enforced

A contract for a public project in Virginia was entered into with a Maryland contractor. The general contractor then subcontracted some of the work to a Michigan corporation. The surety was a Pennsylvania corporation. Action was brought on the payment bond in Georgia. The bond contained language stipulating that no claim could be commenced other than in a state court of competent jurisdiction in the county in which the project was situated or in a federal court in the district where the project was situated, "and not elsewhere."

It was clear to the Georgia Court of Appeals in Harry S. Peterson Co. v. National Union Fire Insurance Co.(6) that the state court had jurisdiction over these parties, although some issues were raised as to the validity of the service of process. In an opinion well worth reading, however, the court went on to enforce the forum selection clause after an extensive discussion of state and federal authorities.

Agreement to arbitration between general contractor and owner is binding on subcontractor in claim against general contractor.

In 3A Industries Inc. v. Turner Construction Co.(7) the general contractor was erecting an inmate housing project for a corrections center in Washington state. That contract included an arbitration clause. Turner subcontracted with 3A, but the subcontract did not specifically include an arbitration clause. Turner contended that the contract with the state was incorporated by reference in the subcontract.

The Washington Court of Appeals extensively discussed both state and federal authorities. It characterized the Washington bonding statute as a "Little Miller Act" and ultimately concluded that the arbitration clause was incorporated by reference and remanded the case to the lower court with directions to stay it pending arbitration.

Notice provision in contract not in conflict with statutory scheme.

In Pennington v. Apollo Piping Supply Co.(8) the bond under which recovery was sought required that a claimant, other than one having a direct contract with the general contractor, should give written notice within 90 days after work was performed or materials furnished. There was no such state statutory provision; the state bonding law merely required that an action be brought within one year.

Over a vigorous dissent, the South Dakota Supreme Court held that the notice provision in the bond did not shorten the limitations and was therefore enforceable.

2. Substantive Issues

Materials must be used or consumed on job and not merely delivered.

In a case of first impression, the federal district court in New Jersey had to resolve a controversy as to whether bond coverage extended to a supplier regardless of whether the materials were physically incorporated into the project. It concluded in Poly-flex v. Cape May County(9) that the statutory language referring to materials "used or consumed in, upon, for or about the construction" required that the materials be physically incorporated.

Subcontractor and subcontractor considered to be a single entity and not too remote to recover on bond.

In ordinary circumstances, the Kansas bonding law does not extend coverage to second-tier suppliers, but in Vanguard Products Corp. v. American States Insurance Co.,(10) the Kansas Court of Appeals held that there was a close corporate relationship between the first- and second- tier suppliers. One was named Consolidated Utilities Inc. and the other Consolidated Construction Inc. The court found that in fact they were a "single entity" and consequently not too remote to recover under the Kansas law.

Prime may assert recoupment defense where materials supplied to subcontractor were defective. Set-off distinguished.

Judge Breyer's decision in United Structures, discussed above (footnote 4), also considered a claim under Puerto Rico's Little Miller Act and applied the same reasoning employed in the Miller Act claim.

Damages under bid bond determined as of time of breach and not later.

A bidder on the contract for the construction of a school made an error in calculating the cost of roofing, which resulted in its refusal to proceed when its bid was accepted. The school district negotiated a contract with another bidder for $85,728 more than the low bid. The school district filed suit against the low bidder and its bonding company. When the work was completed by the second contractor, it appeared that considerably less excavation of rock was required, so that the eventual contract with the second bidder was for less than the amount bid by the first bidder.

The bonding company contended that its liability should be determined retrospectively rather than prospectively. But the Arkansas Supreme Court disagreed in Mountain Home School District No. 9 v. T.M.J Builders Inc.(11)

Attorney's fees and claims against surety.

Ayers Enterprises v. Exterior Designing Inc.(12) is a fairly straightforward case involving the law of Georgia and holding that the specific Georgia statute involving claims against sureties must be followed as to an award of attorney's fees, rather than a general statute having to do with claims under contracts. The claimant had failed to wait the 60-day period given by the statute before making its claim for attorney's fees.

Another case involving attorney's fees came from an intermediate appellate court in Texas and demonstrates graphically the problems of litigating there. In Aetna Casualty & Surety Co. v. Chapel Hill Independent School District(13) the surety brought an action in Texas to recover damages incurred when it completed a school construction project for its insolvent principal. The district counterclaimed for $57,000 owed by the defunct contractor. Remarkably, the contractor and the surety both admitted that the $57,000 was owed, but somehow the pleadings had never been amended to reflect that acknowledgment.

After commencing its opinion with a foreboding footnote calling attention to the fact that the surety used an attorney from Louisiana to assert its claims, the court went forward to allow the school district $101,000 in attorney's fees for prosecuting the $57,000 claim that was uncontested. No further comment seems necessary.

Claims against public project owners where bonds are defective.

While this subject is not clearly within the scope of this section of the annual survey, it is somewhat surprising that there were four cases in the second half of 1993 in which suppliers of labor and materials were frustrated in their efforts to be paid because the public owners had failed to pay bonds as required by statutes or the bonds were unenforceable for one reason or another.

In National Oil & Supply Co. v. Vaughts(14) the Missouri intermediate appellate court held that where county commissioners failed to obtain bonds, the officials would be personally liable. The same result, under somewhat different facts, was reached in another Missouri case a few weeks later, George Weis Co. v. Dwyer.(15)

The Supreme Court of Michigan had a somewhat more complicated analysis of the law in that state in Kammer Asphalt Paving Co. v. East China Township School,(16) in which the public owner had been aware for some time that its prime contractor was having difficulty in performing the contract. It continued to assure the suppliers that their rights were protected under a payment bond, notwithstanding that the surety on that bond did not exist. The court held that the supplier could assert a claim for negligence and unjust enrichment under Michigan law.

Finally, in a Georgia case the supreme court of that state refused to find liability where a surety became insolvent. Apparently a later statute, not applicable at the time of the transaction involved would dictate different results. DeKalb County v. J&A Pipeline Co.(17)

II. PRIVATE CONSTRUCTION BONDS

A. Liability of Surety

1. Extent of Liability

Payment bond claim allowed for material that was reasonably required but not used in performance of prime construction contract.

In Bethlehem Steel Corp. v. United States Fidelity & Guaranty Co.(18) summary judgment for Bethlehem Steel on its claim under a labor and material payment bond was affirmed by the New York Appellate Division by virtue of the "straightforward language of the bond" under which steel it supplied to a defaulting subcontractor was "material used or reasonably required for use in the performance of" the prime construction contract.

The court rejected the contentions of intervening defendants, presumably the surety's indemnitors who appealed, that the bond's payment obligation was not triggered because the steel was never used in the project, and that payment was not required because Bethlehem did not repossess the unused steel from the defaulting contractor. In rejecting the failure to mitigate damage defense, the court noted that there was no requirement or condition in the bond relating to a claimant's pursuit of other remedies, including repossession, against the surety's principal.

No recovery from surety for work performed by one not having direct contract with principal or subcontractor of principal.

In an interesting case, York Excavating Co. v. Employers' Insurance of Wausau,(19) York, an excavating contractor, filed suit on a payment bond, which was issued by an agent who had authority to do so. When York submitted a claim under the bond, the surety refused payment on the ground that no valid bond existed on that particular project. Later it appear that another bond in fact had been properly issued by the surety. The company pleaded the Pennsylvania statute of limitations, but the federal district court held that the surety was estopped from asserting that defense because of its earlier denial that a valid bond existed.

The surety also argued that York was not a proper claimant under the valid bond because York had furnished labor and materials under a different contract. York responded that the surety also was estopped from using that defense because it did not raise that issue when it first denied the claim. On this point, the court held that the failure to assert all potential defenses does not operate as a waiver. It went on to hold that the valid bond defined the claimant as one having a direct contact with the principal or with a subcontractor of the principal, and that York did not qualify under either category.

2. Coextensive Liability

Surety's liability is coextensive with liability of its principal, but whether payment bond covers damage award is question of law for trial court, not question of fact for jury.

In this wrongful termination of contract case, Aluma Glass Co. v. Bratton Corp.,(20) a second-tier subcontractor that was to furnish and install security glass received a jury verdict for its increased labor costs, material and equipment costs and unpaid contract retainage, plus an additional $200,000 for "loss of business value" caused by the impact of the wrongful termination of its contract. The jury determined that the general contractor and the first-tier subcontractor were liable for the damages but that their payment bond sureties were not.

Using de novo review on appeal, the 11th Circuit affirmed the jury's verdict entered in favor of the second-tier subcontractor against the general contractor and the first-tier subcontractor, reversed the judgement entered in favor of their sureties, and remanded the case for an award of prejudgment interest as part of the total amount of damages awarded to the second-tier subcontractor.

The court of appeals held that (1) the trial court plainly erred in not applying the general principle of suretyship that the liability of a surety is co-extensive with the liability of its principal, and (2) it is exclusively within the province of the trial court to determine as a matter of law whether the terms of a payment bond cover the damages found by the jury, notwithstanding the consent by trial counsel to the instruction and verdict form given to the jury on the issues of the surety's responsibility. The court also found that there was no basis for the trial court's conclusion that the jury verdict did not fix damages as of a specific date prior to the verdict, and it went on to hold, as a matter of Florida law, that prejudgment interest was part of the total amount of damages to be awarded.

B. Damages

Surety not liable for consequential damages caused by principal's default.

Marshall Contractors v. Peerless Insurance Co.(21) is a straightforward discussion of a surety's liability for consequential damages caused by its principal's default.

The plaintiff was a Rhode Island corporation working on a contract in Florida. It subcontracted some of the work to a Georgia corporation, which was bonded by Peerless. The subcontractor was declared in default, and the principal demanded that the bonding company complete the project. The bonding company failed to make satisfactory arrangements, and the principal completed the work itself and brought suit under its subcontractor's performance bond, seekign a wide variety of damages, including the cost of completion, increased overhead, delay expenses and "other consequential losses."

The federal district court in Rhode Island addressed the issue of consequential damages in deciding the plaintiff's motion for summary judgment and concluded that Rhode Island law applied since the subcontract itself so stated. The bond did not specifically provide for consequential damages, and the court held that it could not extend the scope of the bonding company's liability in those circumstances. It noted, however, that its decision did not relieve the bonding company from liability for consequential damages attributable to its own breach.

III. FIDELITY AND FINANCIAL INSTITUTION BONDS

A. Dishonesty

Acts of gross incompetence are not acts of dishonesty within meaning of bond.

In Progressive Casualty Insurance Co. v. First Bank(22) the surety sought a declaration that the acts of the insured's former president were not covered under a bankers blanket bond. The federal district court granted the surety's motion for summary judgment, holding that the bank could not recover under Insuring Agreement A for a loss caused by personal failings and business neglect.

An audit revealed that the bank's former president had taken an assignment of a $750,000 loan from a bank at which he had previously been employed and failed to record it on the insured's books. The insured then discovered other loans the former president had made without loan committee approval, including loans to personal friends on favorable terms. In some instances, he failed to take possession of stock pledged as security, misstated the value of collateral and, for no apparent banking reason, released collateral on extant loans.

The insured argued that one could infer that such conduct was motivated by secret gain, since the conduct was otherwise inexplicable. But the court held that the bond did not afford coverage because there was no evidence that the former president received a financial benefit or that he intended the bank to sustain the loss. The court also found that there was no evidence that he acted in collusion with any party to the transactions.

The court reasoned that evidence of dishonesty must be something more than bad judgment, negligence, mistake, carelessness or incompetence. The bond was not credit insurance, the court stated, and did not protect the insured from improvident or reckless extensions of credit.

Collusion between bank officer and borrowers may not be inferred based solely on reckless nature of loans, absent evidence that borrowers knew of or intended to promote the officer's scheme.

In Standard Chartered Bank v. Milus(23) the insured sought recovery under a financial institution bond for losses allegedly caused by Paul Milus, the bank's former executive vice president and chief credit officer. The insured claimed that Milus approved millions of dollars worth of under-collateralized loans to financially illiquid borrowers to prevent their prior loans from going into default and being written off the bank's books. His conduct allegedly was motivated by the imminent sale of the bank. Milus stood to gain personally from the sale because he owned shares of the bank, and had the loans been written off, the sale of the bank would have been in jeopardy.

The federal district court granted the insurer's motion to dismiss or alternative motion for summary judgment, finding no evidence that Milus had acted in collusion with the borrowers.

The parties agreed that the term "collusion" in Insuring Agreement A was synonymous with the term "conspiracy" in a criminal context. Relying on Direct Sales v. United States,(24) the bank argued that there was a "tacit agreement" between Milus and the borrowers since Milus approved the loans under such egregious circumstances that the borrowers must have known he was approving them for his own unauthorized purposes. The bank also contended that the borrowers encouraged the unauthorized loan approvals by providing Milus with substantially overvalued or worthless collateral, including valueless third and fourth mortgages on land and artwork.

The surety objected to the use of the "tacit agreement" theory, asserting that under governing Arizona law, the existence of a conspiracy requires evidence of an agreement between the parties to exchange benefits.

The court found it unnecessary to examine the extent to which Direct Sales constitutes Arizona law because it concluded that the facts of the case were insufficient to create an inference of tacit collusion. The court held that conspiracy or collusion cannot be inferred based solely on facts showing that loans were approved negligently or recklessly and that borrowers aided that conduct. The court reasoned that unlike the sales of morphine, which were involved in Direct Sales, loans are not inherently susceptible to abuse and consequently approval of a loan, even if negligent or reckless, would not put a borrower on notice of possible illegal activity.

Neither did pledging worthless collateral support an inference that the borrowers knew of or intended to promote Milus's scheme, the court continued, since there was no allegation that the borrowers engaged in an activity knowingly designed to encourage the unauthorized lending or that they pledged worthless collateral at Milus's behest.

The court also noted the absence of evidence that the borrowers were aware of the impending sale or of Milus's scheme to protect the value of his stock.

Manifest intent requirement does not permit coverage for reckless conduct, absent evidence of employee's subjective intent to cause loss.

In Oritani Savings & Loan Association v. Fidelity & Deposit Co.(25) the insured, after failing under Insuring Agreement B, sought recovery under Insuring Agreement A of a savings and loan blanket bond for losses resulting from telephone fraud.

On two occasions, persons telephoned Oritani's main office, identified themselves as employees of a branch office and requested that funds be wire transferred from a customer's account. Oritani discovered later that the identified account had insufficient funds to cover the transfers. Oritani conceded that the employee who wired the funds was not a knowing participant in the fraudulent scheme, but it nevertheless sought recovery under Insuring Agreement A for loss caused by his fraudulent and dishonest acts.

It argued that the manifest intent requirement of Insuring Agreement A was ambiguous and could be interpreted to extend coverage to loss caused by an employee's reckless conduct, where it is objectively foreseeable that loss would result from that conduct.

But the court was unpersuaded by the insured's argument and granted summary judgment to the surety. The court held that the definition of dishonesty in Insuring Agreement A was unambiguous and covered only actions taken by an employee with some degree of dishonest intent to cause a loss to the insured and to secure a benefit for himself or others. It declined to construe the definition to include acts undertaken by an employee with no dishonest motive or intent to cause a loss and secure personal gain.

Bond provisions requiring proof of manifest intent and $2,500 benefit are not inconsistent with South Dakota law.

In First Dakota National Bank v. St. Paul Fire & Marine Insurance Co.(26) a purchaser of a failed bank sought recovery under two bankers blanket bonds for losses sustained in connection with 14 separate transactions. The jury found in favor of the plaintiff on 12 of the claims, but the federal district court entered judgment as a matter of law in favor of the surety on four of those 12 claims. Both parties appealed.

The bank challenged the validity of bond provisions requiring the insured to prove that the employee acted with the manifest intent to cause a loss and, in the case of loan losses, to obtain a benefit of at least $2,500. South Dakota law controlled, and the district court held that the bonds were statutory bonds executed pursuant to Section 51-17-36 of South Dakota Laws Annotated, which did not require a showing of manifest intent or financial benefit.

But the Eighth Circuit held that the bonds were legally enforceable under South Dakota law, observing that the South Dakota director of banking and finance had approved St. Paul's bond form as written. The court also reasoned that the two additional bond requirements were not inconsistent with the underlying purpose of the statutory section.

Unrealized gain in value of stock is not financial benefit for purposes of bond coverage.

In the same case, the bank appealed from the summary judgment in favor of St. Paul in connection with a loan to a company in which the insured's president, William Deam, possessed an undisclosed equity interest. Deam purchased stock in a corporation, and the bank subsequently loaned the company $100,000. Several months later, Deam sold the stock for the same price at which he originally bought it, and the corporation defaulted on the loan.

The district court had concluded that the bank failed to prove that Deam had derived a benefit of at least $2,500 in connection with the transaction. On appeal, the bank argued that although Deam bought and sold the stock for $13,500, it had appreciated in value to more than $21,000, as reflected in a financial statement Deam had provided to the bank.

But the Eighth Circuit held that no reasonable jury could have found that Deam realized any financial benefit from his holding of the stock because he bought and sold the stock for the same price. Unrealized gain does not constitute a financial benefit for purposes of the bond, the court said.

Bank employee did not act fraudulently or dishonestly, and insured suffered no loss, in connection with sale of property to insured.

St. Paul contended in the same appeal that it was entitled to judgment as a matter of law in connection with another transaction as to which the insured suffered no loss due to employee dishonesty. The Eighth Circuit agreed and set aside the jury's $190,000 verdict entered in favor of the bank.

The bank was trustee for a trust the bank's president had established for his children. The trust owned approximately 80 percent of the stock in a corporation whose only asset was a building. The trust sold all of its interest in that corporation for about $190,000 to the bank.

The Eighth Circuit ruled that the $190,000 sale price of the corporate stock was roughly equivalent to the trust's 80 percent interest in the value of the building. It held that the insured consequently suffered no loss. Moreover, since the bank president was not a party to the transaction and abstained from voting on final approval of the purchase, no fraudulent or dishonest act was committed, the court ruled.

Ratification by board of directors requires full disclosure of material facts.

First Dakota also appealed in connection with a transaction involving payment of an unauthorized dividend. Deam had received board of directors authorization to pay a dividend to enable the bank's holding company to pay a "small bill." The board had authorized a dividend of approximately 44 cents a share, which would have resulted in a total payout of $4,700, but Deam caused the bank to pay a $470,000 dividend. As a bank shareholder, Deam benefited from the dividend.

An audit subsequently revealed that the total dividend payment was a hundred times the amount authorized by the board. Deam called another board meeting and informed the board that some "technical" or "minor" corrections had to be made in the board minutes, and the minutes were then "corrected" to state that the board approved a "dividend of 44.34 percent to all shareholders of record." There was no indication in the minutes of a dividend of $470,000.

St. Paul contended that by "clarifying" the minutes, the board had in fact approved payment of a $470,000 dividend. It added that the payment of the dividend could not be fraudulent or dishonest because the conduct was authorized or ratified by the board of directors.

The Eighth Circuit rejected this analysis and reinstated the jury's verdict in favor of the bank as to this transaction. First, the court held that legal ratification by a board of directors requires full disclosure of all material facts, and it concluded that Deam had kept the board in the dark and failed to provide full disclosure. Second, the court observed that the dividend payment resulted in negative retained earnings by the bank and violated state banking laws. The court held that fraudulent or illegal acts cannot be ratified.

Jury instruction "person is deemed to intend the natural consequences of his acts" creates an improper mandatory presumption, but surety was not prejudiced.

In the same appeal, St. Paul urged that it was prejudiced by a jury instruction stating that "a person is deemed to intend the natural consequences of his conduct." According to its argument, this instruction relieved the bank from its burden of proving manifest intent and created a mandatory presumption in favor of the insured.

The Eighth Circuit agreed that the instruction created an impermissible mandatory presumption, but it declined to reverse on this ground. Additional qualifying language in the instruction was stated in a non-mandatory fashion, it noted, and assured that St. Paul's due process rights were not violated. By its footnote 6, however, the court suggested that future intent instructions "should not include any 'deemed to intend' language or any 'law presumes' language, but instead should be couched in non-mandatory terms that clearly provide a jury with a choice of whether or not to make an inference."

St. Paul also contended the trial judge erred in instructing the jury regarding the terms "dishonest or fraudulent acts" and "discovery" and by failing to instruct the jury regarding the "director exclusion," the "two-year limitation" and the "termination provision," but all of these positions were rejected.

Guilty pleas are admissible in considering manifest intent.

In First National Bank of Louisville v. Lustig(27) the surety sought to exclude from evidence two pleas of guilty entered by the wrongdoer in a related criminal case. The federal district court held that the pleas were admissible.

The wrongdoer's initial plea of guilty in federal court was withdrawn after the judge found the plea agreement too lenient, and he then pleaded guilty to a superseding information. The sureties argued that the pleas were the product of a fraud on the court because the insured bank had improperly influenced the prosecutor to include in the superseding information language to facilitate recovery under the bond--that is, that the wrongdoer had acted willfully and knowingly, with the intent to injure and defraud the bank.

The court concluded that the pleas of guilty were admissible under the hearsay exception of Rule 803(22) of the Federal Rules of Evidence since they were used to prove facts essential to the wrongdoer's conviction of a crime punishable by more than one year in prison. The court ruled that the guilty pleas were not unreliable and were admissible in connection with the issue of whether the wrongdoer acted with manifest intent to cause the insured to sustain a loss. It rejected the sureties' argument that the insured's influence, if any, in modifying the language in the superseding indictment constituted a fraud on the court.

B. Forgery

Insuring Agreements B and D do not cover losses caused by bank's knowing acceptance of checks containing forged or unauthorized endorsements.

In Empire Bank v. Fidelity & Deposit Co. of Maryland(28) the insured sought recovery under Insuring Agreements B and D of a bankers blanket bond for losses sustained as a result of the conduct of two bank customers. The federal district court entered judgment in favor of the surety because losses were caused primarily by the bank's failure to comport with the bank's own internal policies and accepted banking practices.

A bank vice president instructed bank employees to cash checks made payable to a corporate customer, Campbell 66 Express, which were endorsed by the president of the corporation. The president requested either cash or cashier's checks made payable to him or Campbell 66. He also instructed the tellers to cash third-party checks submitted to the bank by the wife of the president of Campbell 66 without requiring her to add her endorsement.

The wife had directed the corporation's bookkeeper to draw checks on corporate funds deposited at another bank, forged the endorsements of the payees on the checks and then presented them to the insured for payment. On at least one occasion, an employee saw her sign the name of another person on the back of a check.

The court observed that bank policy prohibited the bank from cashing checks made payable to a corporation absent an appropriate corporate resolution and that there was no corporate resolution authorizing officers of Campbell 66 to cash corporate checks. Bank policy also required that all checks presented by a third party must be endorsed by the third party before any cash is paid. The wife had refused to endorse the third-party checks.

The court concluded that all losses incurred by the insured were caused by the intentional acts of an officer of the insured in instructing bank employees to violate prescribed procedures and reasonable commercial practices. The court held that bonding companies issuing bankers blanket bonds have a right to assume that an insured will follow the procedures of its own operations manual and operate in a commercially reasonable manner.

The court held in the alternative that the checks endorsed by Campbell 66's president were not covered by Insuring Agreements B or D because they were not forged and were not cashed as a result of false pretenses. The president was an authorized signator of the corporation, the court pointed out, so the checks were not forged, and the bank had presented no evidence that any representations by the president had induced it to cash the checks.

C. Insuring Agreement E

Fake city ordinance used to induce approval of loan was not a certificate of origin or title and was neither forged nor counterfeit.

In Federal Deposit Insurance Corp. v. Fidelity & Deposit Co. of Maryland(29) the FDIC, as receiver for the insured, sought recovery under Insuring Agreement E of a bankers blanket bond of various loan losses. One of the loans had been made to a borrower based in part on his representation that he had secured a cable television franchise from Gulfport, Louisiana. The city ordinance submitted by the borrower ostensibly approved the franchise, but the ordinance had been fabricated. It was not genuine, and the purported signatures of city officials on the document also were not genuine.

Section 2(e) of the bond excluded coverage for any loan loss, except when covered under Insuring Agreements A, D or E. The FDIC contended that coverage was afforded under Insuring Agreement E on two grounds. First was E(1)'s language covering losses "resulting directly from the insured having "extended credit or assumed liability, on the faith of, or otherwise acted upon, any original... certificate of origin or title ... which ... bears a signature ... of any ... person signing in any other capacity which is a forgery." Second was E(3)'s language covering losses resulting when the insured "extended credit or assumed liability on the faith of any [certificate of origin or title] which is counterfeit."

The court addressed (1) whether the "ordinance" was an original document bearing a forgery or whether it was a counterfeit, and (2) whether the "ordinance" was a certificate of origin or title. It concluded that the signatures on the document purporting to be those of several city officials were forgeries, as defined in the bond, but that the document was not an "original." The court reasoned that E(1) restricted coverage to documents that, apart from the forged signature, are otherwise genuine and actual documents. An entirely bogus document, the court stated, could not be an original.

The court concluded that the "ordinance" also was not a counterfeit. The term counterfeit was defined in the bond as "an imitation which is intended to deceive and be taken as an original." The court determined that this definition required that there be an original document that the alleged counterfeit document attempted to imitate. The borrower had tried to imitate a general form of a city ordinance, but since no actual city ordinance existed granting the cable franchise, the court concluded that the borrower's document did not imitate an original ordinance.

In the alternative, the court examined whether the fake ordinance was a certificate of origin or title within the meaning of Coverage E, and it concluded that it was not. As defined in the bond, a certificate of origin or title was "a document issued by a ... governmental agency evidencing ownership of the personal property and by which ownership is transferred." The explicit language of the ordinance itself indicated that the ordinance could not be used to effect a transfer of the franchise, the court pointed out.

D. Discovery

Insured's knowledge of improper conduct prior to execution of bond precludes recovery under Insuring Agreements B and D.

In the Empire Bank case (footnote 28), in which recovery was sought under Insuring Agreements B and D, the court observed that the course of conduct which was the subject of Empire's claim had preceded issuance of the bond, and it held that, inasmuch as Empire had actual knowledge of the improper conduct before the bond was issued, Empire was precluded from recovery.

Definition of "learn" in termination provision combines subjective and objective elements.

In First National Bank of Louisville v. Lustig(30) the federal district court addressed the standard to be applied in determining when the insured "learned" of an employee's dishonest acts for purposes of termination of coverage under Section 12 of a bankers blanket bond. The insured argued that the standard is a purely subjective "actual knowledge" standard. The sureties argued that it is a purely objective "should have known" standard.

The court held that the standard combines subjective and objective elements and that the termination clause applies when an insured has actual knowledge of facts that would cause a reasonable person in the insured's position to infer that an employee has committed dishonest or fraudulent acts. The definition of "discovery" in Section 4 of the bond is not determinative of the meaning of "learn" in Section 12, the court stated. However, it found that the majority of courts apply a "reason to know" standard to the Section 12 termination clause, which is the same standard described in Section 4. The court concluded that the "reason to know" standard lies somewhere between the purely objective standard of "should have known" and the purely subjective standard of "actual knowledge," resulting in a standard which requires awareness of underlying facts from which a reasonable person could make certain inferences about the facts in question.

The court declared that an insured may "learn" of an employee's dishonesty for purposes of terminating coverage through any agent acting within the scope of his or her authority on behalf of the insured, including the insured's attorneys. But mere suspicion of dishonesty without factual support from which a reasonable person would assume the existence of dishonest or fraudulent acts is insufficient to terminate coverage, the court stated, adding that the insured has no duty to investigate its suspicions to develop such factual support.

Insured's review of bank examination report critical of transactions involving officer's holdings is insufficient to constitute discovery, and knowledge of wrongdoers may not be imputed to insured.

In First Dakota (footnote 26), the surety also contended that the insured failed to file suit within 24 months after discovery of loss, as required by the bonds. It argued that the insured first discovered a covered loss in January 1986, when the bank's board met and discussed the results of a state bank examination report that "criticized" the bank for paying more than book value for four companies acquired by the bank and for overstating the assets of those companies on its financial statements. All of the companies had been owned by Deam, the bank's president.

Discovery, as defined in the bond, occurred "when the insured first became aware of facts which would cause a reasonable person to assume that a loss of a type covered by this bond has been or will be incurred."

The Eighth Circuit held that discovery of fraud or dishonesty occurs when the insured actually becomes aware of sufficient facts that would cause a reasonable person to conclude that an insured loss had occurred and that mere suspicion of loss is not sufficient. The court concluded that discovery did not occur in January 1986, as St. Paul contended, because the examiner's report was critical primarily of how the assets were being reflected on the bank's books and the examiner had testified that there had been no proof of dishonesty by bank officials at that time. Such facts, the court concluded, may have been the basis for suspicion, but they were not sufficient to cause a reasonable person to conclude that a covered loss had occurred.

Relying on First National Bank of Sikeston v. Transamerica Insurance Co.,(31) the surety argued alternatively that the knowledge of Deam and other officers of their own wrongful conduct should be imputed to the board. But the court turned down this argument, noting that in Sikeston the insured's officers not in collusion with the wrongdoer knew of his scheme, whereas here the insured's board did not know the true nature of Deam's fraudulent activities. The court also ruled that the knowledge of key officers cannot be imputed to a board of directors when the officers' interests are adverse to those of the bank.

E. Exclusions

Loan exclusion precludes recovery for loss resulting from repo and reverse repo transactions.

In Resolution Trust Corp. v. Aetna Casualty & Surety Co. of Illinois(32) the RTC filed suit to recover under a savings and loan blanket bond for losses sustained as a result of fraudulent repurchase and reverse repurchase agreements ("repo" and "reverse repo") entered into by a failed savings and loan. The federal district court held that the losses were sustained in connection with transactions in the nature of loans and were excluded from coverage pursuant to the loan loss exclusion.

The insured had entered into a series of repo and reverse repo transactions pursuant to which the other parties were supposed to maintain the securities in separate "safekeeping" accounts. Unknown to the insured, the other parties did not segregate the securities and instead used them to collateralize other repo transactions. These parties eventually went bankrupt, and the securities were treated as general assets of their bankruptcy estates, resulting in a loss to the insured.

Aetna contended that the losses were excluded from coverage pursuant to the loan loss exclusion because the repo and reverse repo transactions were either collateralized loans, "de facto" loans or "transactions in the nature of loans or extensions of credit." The RTC contended that the transactions were purchases and sales of securities and thus outside the scope of the loan loss exclusion.

The court determined that a repo transaction is a hybrid of a sales and a collateral loan transaction. Relying on First Federal Savings & Loan Association of Toledo v. Fidelity & Deposit Co. of Maryland,(33) the court identified seven factors to be considered in determining whether a repo transaction is a loan: (1) whether the seller could require the purchaser to re-sell; (2) whether the purchaser could require the seller to re-purchase; (3) whether a definite remedy was provided in the event of either party's default; (4) whether the seller agreed to interest at a stipulated rate; (5) whether the value of the securities equaled the amount of advances; (6) whether there was evidence of a debt; and (7) whether any collateral was pledged.

The court concluded, based on five characteristics, that the repo and reverse repo transactions at issue were best described as "transactions in the nature of loans." First, the agreements set forth specific maturity dates, settlement dates for repayment and rates of interest. Second, the interest rates were negotiated at a rate that had no relation to the interest rate of the underlying securities. Third, the securities were not sold for full market value as in standard purchases or sales. Fourth, the principal and interest payments and the underlying securities were to be paid to the original owner of the security during the term of the transactions. Fifth, in the event of a default, the insured was able to sell the underlying securities without notice and for the best price available, charging the loss to the other contracting party.

The RTC argued alternatively that the losses were excepted from the loan loss exclusion because they were covered by Insuring Agreement E. It maintained that Coverage E applied because the losses resulted directly from the insureds having in good faith acted on securities that were lost or stolen.

But the court disagreed. Insuring Agreement E does not cover all losses resulting from theft of securities, it stated, but only title defects resulting from thefts occurring prior to the insured's good faith reliance on the instrument. The court reasoned that Insuring Agreement E was not intended to cover losses stemming from the subsequent theft of the security. RTC also failed to establish that the insured had "actual possession" of the securities at the time of the loss, the court said, a condition precedent to coverage under Insuring Agreement E.

F. Termination

Purchase of 80 percent of stock and subsequent assumption of management is takeover for purposes of termination provision.

In First American National Bank v. Fidelity & Deposit Co. of Maryland(34) the insured's successor in interest filed a declaratory judgment action seeking a construction of the termination clauses in a bankers blanket bond and a related excess employee dishonesty bond. Coverage under the bonds terminated "immediately upon the taking over of the insured by another institution." The federal district court determined that coverage terminated when the plaintiff's predecessor purchased at a foreclosure sale 80 percent of the insured's stock and assumed management control. The Sixth Circuit affirmed.

Approximately 80 percent of the insured's stock had been owned by the insured's holding company. Midland Bank, the plaintiff's predecessor, loaned the holding company approximately $2.2 million. Security for the loan included the insured's stock. The holding company defaulted on the loan, and Midland Bank purchased 80 percent of the voting stock of the insured at public foreclosure sale. The insured's board of directors thereafter approved the transfer of stock and approved a merger agreement between the insured and Midland.

The Sixth Circuit rejected plaintiff's contention that the termination provisions of the bonds were conditioned on a change of title. Citing the Random House Dictionary, the court defined "takeover" as "the act of seizing, appropriating, and arrogating authority, control, management, etc." The court concluded that a takeover occurred when 80 percent of the insured's stock was purchased and the purchaser assumed management control of the insured. Thus, coverage terminated prior to discovery of the loss.

G. Subrogation and Recoveries

Surety not entitled to reduction in amount of bond liability based on estimated value of collateral security held by insured.

In Federal Deposit Insurance Corp. v. Fidelity & Deposit Co. of Maryland (footnote 29), a jury returned a $5.3 million verdict in favor of the FDIC in connection with loan losses incurred by the insured. The parties sought a determination of the proper allocation of collateral held by the FDIC in connection with the loans for which the jury found coverage under the bond.

F&D alleged that it was entitled to a reduction of the jury verdict based on the estimated value of the security, but the federal district court disagreed. Citing Sections 7(a) and (b) of the bankers blanket bond, it held that the insurer was entitled to the insured's rights of recovery by assignment or subrogation only after the insurer made payment under the bond. If, after payment, the insurer chose not to utilize those rights, the court said, then any recoveries made by the FDIC would be allocated pursuant to Section 7(c) of the bond.

Recovery of loan payments by insured must be allocated only to principal and not to interest.

In the same case, the parties also sought a determination of the proper allocation of loan payments made to the FDIC after the discovery of loss. The FDIC contended that such payments should be allocated first to interest due on the loans and then to principal. The insurer asserted that the payments should be allocated only to principal.

Section 7(c) of the bond provided that recoveries shall be applied first "to satisfy the insured's loss in excess of the amount paid under the bond," and then to the surety as reimbursement of amounts paid in settlement of the bond claim. The limit of liability under the bond was $4 million, and the jury returned a verdict of $5.3 million. The court concluded that the term "loss," as used in Section 7(c), referred to losses covered by the bond. Because interest payments were excluded from coverage by the potential income exclusion, the court held that interest was not a "loss" within the meaning of Section 7(c), and the loan payments received by the FDIC had to be applied only to principal.

Debt arising from employee's embezzlement or larceny is not dischargeable in bankruptcy, notwithstanding the absence of fiduciary relationship, and employee's execution of promissory note does not negate fraudulent nature of debt.

In In re O'Brien(35) the Arthritis Foundation was the insured under an employee dishonesty bond issued by Great American Insurance Co., and the dishonesty of its employee, William J. O'Brien, caused a loss. The surety obtained from the insured an assignment of its rights, and O'Brien executed a promissory note in favor of the surety in the amount of the loss. O'Brien entered a plea of guilty in a criminal case relating to the same conduct and later filed a petition in bankruptcy. The surety filed an adversary complaint seeking a finding that O'Brien's debt was not dischargeable in bankruptcy.

On cross-motions for summary judgment, the bankruptcy court found the evidence was uncontroverted that O'Brien's acts constituted larceny as defined by the Bankruptcy Code, 11 U.S.C. [sections] 523(a)(4). O'Brien argued that the debt nevertheless was dischargeable because he was not acting in a fiduciary capacity when he embezzled the insured's funds. The court concluded that when the basis for nondischargeability under Section 523(a)(4) is embezzlement or larceny, there is no requirement that the debtor acted in a fiduciary capacity.

The court also rejected O'Brien's argument that his execution of the promissory note negated any wrongdoing or created a novation. The court held that the acts that give rise to the underlying debt must be examined in determining whether a debt becomes nondischargeable, and it concluded that to permit a debtor to escape responsibility for larceny or embezzlement by signing a promissory note would undermine the intent of the Bankruptcy Code and provide a haven for criminals.

H. Rights of Third Parties

Third party has no standing to enforce bond providing indemnity coverage.

In Killingsworth v. United Mercantile Bank(36) the plaintiff brought an action against a bank and its bankers blanket bond insurers for losses resulting from the dishonesty of a bank employee. The plaintiff settled with the bank, and the trial court granted summary judgment in favor of the insurers, holding that the plaintiff could not state a cause of action under the terms of the bond or the Louisiana Direct Action Statute.

The Louisiana Court of Appeals affirmed, concluding that the bond expressly excluded any action by anyone other than the named insured and was not a policy of liability insurance. The bonds were indemnity contracts, and plaintiff was not a third-party beneficiary, the court declared.

The court also held that the plaintiff had no cause of action under Louisiana's "oblique action" statute (Louisiana Civil Code Article 2044) because he had settled with the bank, a necessary party.

I. Miscellaneous

Attorney's fees may be awarded only on showing that surety's refusal to pay was vexatious or without reasonable cause.

In the First Dakota case (footnote 26), the plaintiff sought recovery of attorneys' fees after the court had entered judgment in its favor under two bankers blanket bonds.

The Eighth Circuit noted that under Section 58-12-3 of South Dakota Laws Annotated attorney's fees may be awarded if an insurance company has refused to pay the full amount of the loss and such refusal is vexatious or without reasonable cause. In this case, the court stated, the surety was not liable for fees since it had relied on legitimate coverage defenses, the evidence was enormous, and the jury ultimately decided in its favor with respect to several transactions.

Prejudgment interest accrues from date surety refuses payment.

In the same case, St. Paul argued that the district court had erred in awarding prejudgment interest in connection with five of the covered transactions. The Eighth Circuit pointed out that Section 21-1-11 of South Dakota Laws Annotated makes prejudgment interest available to a prevailing party from the date on which damages are certain or capable of being made certain by calculation. The fact that a defendant disputes the value of the damage or that a jury returns a verdict that varies from the damages alleged does not preclude an award of prejudgment interest, the court stated. When damages are certain and a defendant refuses to pay the entire amount, it continued, prejudgment interest starts to accrue from the date of the defendant's refusal.

Prejudgment interest accrues from date of judicial demand.

In the FDIC v. F&D case (footnote 29), the FDIC sought prejudgment interest in connection with its claim. F&D argued that prejudgment interest accrued 60 days from the time it received a sworn proof of loss. The court held that under Louisiana law prejudgment interest begins to accrue from the date of judicial demand, regardless of whether the damages are unliquidated, disputed or unascertainable until payment.

Common law cause of action for bad faith claim handling was not unconstitutional but required showing that insurer was obligated to pay claim.

In First National Bank of Louisville v. Lustig(37) the insured under a bankers blanket bond asserted statutory and common law claims of bad faith against the sureties for their alleged improper handling of the bond claim. The sureties moved for summary judgment, arguing that they had a reasonable basis to dispute the claim.

The court determined that under Kentucky law a cause of action for bad faith refusal to pay a claim required a showing that the insurer was obligated to pay the claim under the policy. It denied the sureties' motion for summary judgment, finding that an issue of fact existed as to whether the sureties were obligated to pay.

The court also rejected the sureties' claim that recognition of the insured's common law bad faith claim was unconstitutional. They argued that the possible imposition of punitive damages punished them for exercising their contractual rights. The court held that the imposition of punitive damages through a Kentucky bad faith action did not infringe on constitutional right to access to the courts, not did the bad faith action constitute an ex post facto punishment since the Kentucky Supreme Court had recognized a common law cause of action for bad faith at the time the bank gave notice of the claim.

IV. SURETIES' REMEDIES

A. Indemnity

Recovery of attorney's fees and costs against indemnitors of more than three times amount paid to performance bond claimant not unreasonable under facts of case.

In Rappold v. Indiana Lumbermens Mutual Insurance Co.(38) the successor in interest to the performance bond obligee sought some $175,000 in damages for breach of contract against Indiana and its principal. Indiana filed a third-party claim over against its indemnitors and then settled with the plaintiff for $12,000. At the time of trial against the indemnitors, its total claim was $44,128.48.

In the trial court, Indiana was awarded the full amount of its claim. The indemnitors appealed, alleging that the indemnity agreement did not provide for the recovery of attorney's fees, and even if it did, the amount was unreasonable.

Affirming, the Virginia Supreme Court examined the indemnity language, which stated that Indiana was entitled to be saved harmless from every claim, demand, liability, loss, cost, charge, counsel fee, expense, suit, order, judgment and adjudication by reason of having executed the performance bond. From this the court concluded that language was broad enough to include counsel fees and expenses in maintaining this action.

Regarding the reasonableness of the attorney's fees and costs, the court noted that the fees and costs amounted to only 18.3 percent of the original claim and that the surety presented at the trial the testimony of an attorney who qualified as an expert, who verified the reasonableness and whose opinion was not challenged by the indemnitors.

Surety entitled to recover attorney's fees and costs against its principal and indemnitors in defense of claim brought by performance bond obligee, although its principal, in same action, recovered judgment against obligee and suit against surety was dismissed without surety having to pay obligee.

In American Employers Insurance Co. v. Horton,(39) after being terminated on a job for poor performance, Howard A. Horton, the painting subcontractor, sued the general contractor, Westcott, to recover the value of its work. Westcott, in turn, filed a counterclaim against Horton and its performance bond surety, American Employers.

The surety retained its own defense counsel, and the case eventually settled, with the general contractor paying the subcontractor $20,000 and dismissing the counterclaim against the surety.

When the surety attempted to recover back its attorney's fees and costs incurred in defending the counterclaim, Horton refused, contending that American Employers failed to investigate properly, and had it done so, it would have determined that the counterclaim was frivolous and would not have incurred the fees and costs.

The surety obtained a summary judgment against its indemnitor, and the Massachusetts Appeals Court, after reviewing the affidavits filed by the parties, affirmed the judgment, holding that the surety had acted in good faith and had investigated the merits of the claim on the bond.

The court quoted the following language from Hartford Accident and Indemnity Co. v. Millis Roofing and Sheet Metal Inc.: "Want of good faith involves more than bad judgment, negligence or insufficient zeal. It carries an implication of a dishonest purpose, conscious knowing of wrong, or a breach of duty through motive of self-interest or ill will."(40) The court concluded that the Horton affidavits fell far short of raising a triable issue of fact on the issue of good faith. For the most part, they were merely nonadmissible expressions of belief.

Surety entitled to recover from indemnitors notwithstanding its initial position, when sued by obligee, that bonds it issued were invalid.

In Acstar Insurance Co. v. American Mechanical Contractors Inc.(41) Acstar issued performance and payment bonds on behalf of American Mechanical to the general contractor, Harbert International Inc., on a project for the United States.

On receipt of the bonds, Harbert wrote to American Mechanical that the surety was not on its list of acceptable companies and therefore not acceptable without additional information. American Mechanical requested additional information from the surety, which provided the requested financial data and surprisingly requested the return of the bonds for cancellation because of Harbert's rejection.

American Mechanical did not ask for the return of the bond, and once Harbert received the financial data, it accepted the bonds and so advised the surety and paid the premium for the bonds. Acstar deposited the premium check and did not respond to either American Mechanical or Harbert until after Harbert defaulted American Mechanical for failure to prosecute the work in a timely manner or to make timely payments to suppliers of labor and material. When claim was made on the bonds, Acstar denied liability, claiming that the bonds were null and void. After Harbert sued, including a demand for punitive damages for bad faith, Acstar settled with Harbert for $680,000.

Acstar had cross-complained against its indemnitors at the time they answered the Harbert complaint. The indemnitors were successful in a motion for summary judgment against Acstar on the theory that the bonds were null and void and therefore the surety was precluded from pursuing any claim arising from the indemnity agreement.

Reversing, the Alabama Supreme Court held that the trial court failed to evaluate the evidence before it properly. The objective intent of Acstar in accepting the premium for the bonds validated them, the court concluded, notwithstanding the Acstar's original protestation and demand for the return of the bonds for cancellation, which was conveyed to its principal but not to the intended obligee. Since the bonds were valid, the indemnity agreement guaranteeing the obligations of the principal also was valid and enforceable against the indemnitors.

Surety entitled to recover attorney's fees against indemnitors incurred in defending action on performance bond and in defending against indemnitors' counterclaim, which included tort causes of action.

In Harvey v. United Pacific Insurance Co.(42) the surety provided a $25,000 performance bond on behalf of a drywall subcontractor, Kenneth H. Harvey. United Pacific had been sued in California on the bond, and, at the special insistence of Harvey not to pay the claim, had defended it. Thereafter Harvey failed to co-operate with United Pacific in the defense or in the eventual settlement.

When United Pacific brought an action against Harvey in Nevada to recover its loss in the California action, Harvey counterclaimed for bad faith, breach of fiduciary duty, breach of the implied covenant of good faith and fair dealing, unfair insurance practices, abuse of process, unfair trade practice, intentional infliction of emotional harm and conspiracy. After extensive discovery and a two-week jury trial, there was an award in favor of United Pacific for $137,654 in damages, and Harvey recovered nothing on his counterclaim.

On Harvey's appeal, the Nevada Supreme Court remanded to the trial judge for an evaluation of the attorney's fees awarded to determine if they were excessive. The trial judge held a hearing on reasonableness and then confirmed the award. In explaining the basis for his decision, the trial judge noted that the original indemnity suit against Harvey in Nevada was for $41,618.95, which included $16,618.95 in attorney's fees and costs incurred in defending the California action. The balance of the jury award, $96,759.79, was the attorney's fees and costs incurred in prosecuting the Nevada indemnity action. The trial judge then gave examples of the tactics used by Harvey's counsel that turned a simple collection case into difficult and complex litigation. The trial judge concluded his findings by stating that the counterclaims by Harvey had no merit but were interposed merely to defeat the indemnity claim.

Harvey appealed again, but this time the Nevada Supreme Court affirmed in 3-2 vote. The dissenting opinion questioned the legal basis for allowing United Pacific to recover tort defense fees and costs, finding nothing in the indemnity agreement allowing that. The majority, however, ruled that the indemnity agreement permitted the recovery by the surety of all expenses, including attorney's fees, incurred by reason of the execution of the bond.

B. Subrogation

Under Ohio law, Internal Revenue Service is entitled to "final progress payment" due contractor bonded by surety over conflicting claim of payment bond surety alleging equitable subrogation rights.

A surety and the Internal Revenue Service both sought payment from a cash collateral account in a contractor's Chapter 11 proceeding in In re Construction Alternatives Inc.(43) The bonded contractor completed its work on an asbestos removal project for a school district in Ohio. Two weeks after the contractor filed Chapter 11 bankruptcy, the school district determined the final amount due under the contract as the final progress payment, there being no retention agreement between the contractor and district.

Pursuant to a turnover order from the bankruptcy court, the district deposited the contract balance of $39,705 into a cash collateral account provided for by the order. Then both the surety and the IRS filed claims with the bankruptcy court.

The bankruptcy court held that the IRS, which had filed a levy on the school district for delinquent taxes owed by the contractor prior to the bankruptcy, had superior rights to the money over the surety, which had made payment bond claims. The federal district court affirmed, as did the Sixth Circuit.

The surety raised several arguments, one being that under Pearlman v. Relicance Insurance Co.(44) the surety had an equitable lien on the fund, superior to the tax lien. The Sixth Circuit disagreed, pointing out that Pearlman involved retained funds held back by the government to pay any unpaid suppliers or subcontractors, while in this case there were no "retained funds," the school district being only a stakeholder. So the surety had no subrogation rights from the school district.

The surety also contended that it was subrogated to the rights of the unpaid subcontractors it paid. Under Ohio law, subcontractors have the right to file a mechanic's lien against a state project, and on giving proper notice to the state entity, the school district would have been compelled to withhold money from the general contractor to satisfy the liens. However, none of the subcontractors paid by the surety filed the requisite mechanic's liens, so the court concluded that the surety received no subrogation rights from those project creditors.

Another theory posited by the surety was that the contractor held the fund as the surety's trustee under the general agreement of indemnity the contractor had executed. The court rejected this argument, saying that under Ohio law, a general agreement of indeminty does not create an express trust.

Finally, the surety argued that the general agreement of indemnity created a security interest under Section 6323(h) of the Ohio Revenue Code, but once again the surety was unsuccessful. The court pointed out that for the surety to obtain a security interest, it was required to perfect its security interest by filing a financing statement with the appropriate state office, which it had failed to do.

Surety may bring action against principal's joint venture partner for indemnity, where surety sued as principal's subrogee, not joint venture's subrogee.

In County of Monroe v. Raytheon Co.(45) John B. Pike and Son Inc. contracted with the County of Monroe, New York, for more than $15 million to build a resource recovery facility. Federal Insurance Co. issued the contract bonds on behalf of Pike. Later Pike and John P. Bell and Sons Inc. entered into a joint venture agreement to perform the work under the contract, as well as additional work on the project that Bell had contracted to do, agreeing that their obligations would be joint and several.

When the county defaulted Pike for non-performance, it sued Pike and the surety. By this time Pike had become insolvent, and the surety filed a third-party action against the joint venture and also Bell alone for indemnity. Bell moved to dismiss the third-party complaint on several grounds, including the theory that there was no contractual or implied right of indemnity available to the surety because the joint venture agreement included the surety's principal, which, as a co-venturer, was responsible to some degree for the wrongdoing, and the surety stood in the shoes of its principal.

The Supreme Court of Monroe County disagreed, noting that a partnership is regarded as a separate legal entity for pleading purposes under New York law. But the court left open whether the surety, seeking recovery as a subrogee of its principal, assumes its principal's contractual liabilities under the joint venture agreement in determining the respective shares of joint venture liabilities allocable to each joint venture. The court indicated that issue should be determined in a fourth-party action.

C. Bankruptcy

Debtor's submission of materially false financial statement did not make debt to surety non-dischargeable where surety failed to prove debtor offered bond application with reckless disregard as to its truth.

Ohio Casualty Insurance Co. issued an appeal bond to a Chapter 7 debtor in In re Smith.(46) The debtor subsequently lost the appeal and Ohio Casualty paid the judgment of $77,000. The surety then filed an adversary complaint seeking a determination that the obligation of the debtor to the surety was non-dischargeable.

The debtor had submitted with its bond application a net worth showing $1,618,141. The evidence produced at the trial indicated that the debtor's net worth, as of the date of the financial statement, was overstated by more than $1 million, which rendered the application materially false. The main issue in the case was whether the debtor presented the financial information to Ohio Casualty with reckless disregard as to its truth or falsity.

The major discrepancy in the financial statement was in the value of the debtor's oil and gas properties. The debtor had relied on an accountant to arrive at the value, and the accountant, in turn, computed the value by considering the valuations of two experts, plus the income information on the wells. There was no evidence that the accountant intentionally or fraudulently inflated the values.

The bankruptcy judge determined that the debtor was unsophisticated in the oil and gas business and had no way of knowing the figures were overstated. The court concluded that the debtor had a right to rely on his financial advisor, and doing so was not a reckless disregard of the truth. Therefore, the debt was dischargeable.

Surety not given proper notice of filing of bankruptcy by its principal when notice was sent to surety at its principal place of business, but not directed to a specific department as required by general indemnity agreement signed by debtor. Surety given additional time by bankruptcy court to file objections to dischargeability of debt.

Glenn A. Main III filed voluntary bankruptcy under Chapter 7 on July 29, 1988. National Union Fire Insurance Co. had issued the debtor a financial guarantee bond in consideration of the debtor's execution of a general indemnity agreement, which required all notices be sent to National Union at its New York office to the attention of the Division Manager, Comprehensive Financial Risk Division on the 21st floor.

The clerk of the bankruptcy court, based on information furnished by the debtor, sent the debtor's bankruptcy notice to National Union at the New York address, but did not further identify the specific floor or person to get the notice.

The deadline to file objections to the discharge of the debtor was November 7, 1988. National Union did nothing until May 7, 1989, when it filed a motion for an extension of time. The bankruptcy court granted National Union an extension, and the debtor appealed to the district court.

In In re Main(47) the district judge affirmed, concluding that Fifth Amendment due process principles required that the creditor be given the type of notice that the parties agreed on in the general indemnity agreement. The court noted that National Union was a large company, being a subsidiary of American International Group, a company with more than 30,000 employees. The burden was on the debtor to demonstrate that the surety had actual notice reasonably calculated to apprise it of the debtor's bankruptcy, and the debtor failed to meet that burden in this case.

However, in another National Union case involving the same issue, the surety ran into more difficulty in proving its point.

In National Union Fire Insurance Co. v. Broadhead(48) it issued a bond guaranteeing that Broadhead would pay certain promissory notes. In consideration, Broadhead executed an indemnity agreement which required written notice to the surety at New York office to the attention of the Special Programs Division. When Broadhead failed to make the required payment, the surety paid $53,740 on his behalf.

Broadhead filed for bankruptcy in Utah, listing National Union as an unsecured creditor but failing to indicate the Attention, Special Programs Division, as required by the indemnity agreement. The bankruptcy court issued an order discharging Broadhead from his debts on January 2, 1990, and on April 7, 1992, National Union, which denied any prior knowledge of the bankruptcy, filed suit against Broadhead in the U.S. District Court for the Southern District of New York to recover its loss. On November 12, 1992, the district court granted summary judgment in favor of National Union, finding its claim was not discharged because the surety was not given adequate notice of the bankruptcy.

Broadhead did not submit papers in opposition to the motion but later moved to vacate the judgment on the ground that his failure to object was owing to excusable neglect of his Utah counsel.

In the earlier and uncontested hearing, the district court had relied on In re Main (footnote 47) to grant the summary judgment. This time, after finding excusable neglect, the court considered other case law provided by Broadhead and concluded that the notice to National Union was sufficient to comply with the requirements of the Bankruptcy Code, pointing out there is no statutory requirement to identify a specific division of a corporation on a bankruptcy notice. Once a notice is delivered, it becomes the responsibility of the creditor to distribute the notice to the appropriate party within the organization, the court said.

There was due process as far as the statutory notice was concerned, the court concluded, vacating the judgment, but National Union was given a further opportunity to demonstrate that the failure to give the notice required by the indemnity agreement prejudiced it and that had it received the proper notice, it would have been in a much more favorable position regarding a possible non-dischargeable determination.

Debtor permitted to place subrogated surety in different classification from employees not paid by surety for workers' compensation benefits, giving those employees preferential position over surety in Chapter 11 reorganization.

In In re Chateaugay Corp.(49) Aetna Casualty & Surety Co. issued a self-insurer bond guaranteeing that its principal. LTV Steel Co., would pay workers' compensation claims. When LTV defaulted, Aetna paid more than $41 million in claims and then asserted its claim in this bankruptcy proceeding under its subrogation rights.

The debtor's plan called for full payment of workers' compensation benefits to employees, but not to any creditor whose claim was derived from an employee, such as Aetna. Aetna objected because under the plan it would receive a dividend of about 18 to 20 percent of its allowed claim.

The bankruptcy judge ruled in favor of the debtor. There was evidence of a valid business reason for the disparate treatment, he concluded, because by paying the employees' claims in full, their continued cooperation was assured, and this would lead to a successful reorganization. That inducement did not apply equally to Aetna, the court observed. It relied on Section 509(c) of the Bankruptcy Code, which specifically the subordination of a claim derived by way of subrogation to the claims of individual workers, until those workers' claims are paid in full.

D. Assignment

Surety that discharges obligation of principal then proceeds under assignment to contract balance held by obligee may not retain amount in excess of its costs and expenses.

In Howell Construction Inc. v. United Pacific Insurance Co.(50) Howell brought an action against its surety to recover the profit the surety realized in obtaining the contract funds from the federal government under an assignment.

Howell had been defaulted on the project, and United Pacific, as the performance bond surety, entered into a takeover agreement with the government. The cost to complete was $550,000, and the surety received more than $800,000 under the assignment.

Relying on Napier v. Duff,(51) the federal district court held that as a general rule under the governing Kentucky case and statutory law, a surety may not realize a profit at the expense of its principal. The court rejected United Pacific's argument that by virtue of the termination by the government, the principal's rights to the contract funds ended, and the surety was thereby permitted to enter into a new contract with the government, including the contract balance that had been earned by its principal.

After reviewing the indemnity agreement, which included a provision that he contract funds were to be held in trust for the payment of obligations incurred for labor, materials and services for which the surety would be liable under its bonds, the court determined that the surety's rights to the contract funds were qualified for the payment of obligations incurred by the surety. United Pacific held those funds as a fiduciary to satisfy its bond obligations only, the court said.

The court was also influenced by the fact that when Howell objected to the takeover agreement, the attorneys for the surety, in an effort to placate Howell, wrote two letters assuring Howell that the surety would not profit from the takeover agreement, but after deducting its reasonable expenses, would promptly reimburse Howell for the balance.

The court granted Howell's motion for partial summary judgment and ordered the surety to render an accounting of the net amount it claimed from the contract balance, with the remainder, if any, to be paid over to Howell, assuming no further dispute as to the amount required to reimburse the surety for its costs and expenses in completing the contract.

It appears that the surety subsequently determined that the plaintiff had settled with the government on its independent claim for wrongful termination. United Pacific filed a motion for reconsideration, but the court rejected its concern that Howell was "double-dipping," and it held that Howell's dispute with the government was of no legal consequence to Howell's dispute with the surety.

(1.)11 F.3d 577 (6th Cir. 1993).

(2.)827 F.Supp. 1232 (E.D. Va. 1993).

(3.)826 F.Supp. 647 (E.D. N.Y. 1993).

(4.)9 F.3d 996 (1st Cir. 1993).

(5.)750 F.2d 759 (9th Cir. 1984), cert. denied, 474 U.S. 817 (1985).

(6.)434 S.E.2d 778 (Ga.App. 1993).

(7.)869 P.2d 65 (Wash.App. 1993).

(8.)508 N.W.2d 376 (S.D. 1993).

(9.)832 F.Supp. 889 (D. N.J. 1993).

(10.)863 P.2d 991 (Kan.App. 1993).

(11.)858 S.W.2d 74 (Ark. 1993).

(12.)829 F.Supp. 1330 (N.D. Ga. 1993).

(13.)860 S.W.2d 667 (Tex. App. 1993).

(14.)856 S.W.2d 912 (Mo. App. 1993).

(15.)867 S.W.2d 520 (Mo. App. 1993).

(16.)504 N.W.2d 635 (Mich. 1993).

(17.)437 S.E.2d 327 (Ga. 1993).

(18.)598 N.Y.S.2d 873 (App.Div. 4th Dep't 1993).

(19.)834 F.Supp. 733 (M.D. Pa. 1993).

(20.)8 F.3d 756 (11th Cir. 1993).

(21.)827 F.Supp. 91 (D. R.I. 1993).

(22.)828 F.Supp. 473 (S.D.Tex. 1993).

(23.)826 F.Supp. 310 (D. Ariz. 1990).

(24.)319 U.S. 703 (1943). In Direct Sales, a pharmaceutical company that sold vast quantities of morphine to a doctor was accused of conspiracy to distribute narcotics. The Court inferred from the egregious nature of the conduct that a "tacit agreement" existed between the parties.

(25.)821 F.Supp. 286 (D. N.J. 1991), appealed on other grounds, 989 F.2d 635 (3d Cir. 1993) (insurer not liable under Insuring Agreement B). The decision of the Third Circuit was discussed in Part I of this survey, 61 DEF. COUNS. J. 116, 122 (1994).

(26.)2 F.3d 801 (8th Cir. 1993).

(27.)832 F.Supp. 1058 (E.D. La. 1993).

(28.)828 F.Supp. 675 (W.D. Mo. 1993).

(29.)827 F.Supp. 385 (M.D.La. 1993).

(30.)150 F.R.D. 548 (E.D. La. 1993).

(31.)514 F.2d 981 (8th Cir. 1975).

(32.)831 F.Supp. 610 (N.D. Ill. 1993).

(33.)895 F.2d 254, 260 (6th Cir. 1990).

(34.)5 F.3d 982 (6th Cir. 1993).

(35.)154 B.R. 480 (Bankr. W.D. Tenn. 1993).

(36.)623 So.2d 1384 (La.App. 1993).

(37.)827 F.Supp. 385 (E.D.La. 1993).

(38.)431 S.E.2d 302 (Va. 1993).

(39.)622 N.E.2d 283 (Mass.App. 1993).

(40.)418 N.E.2d 645 (Mass.App. 1981).

(41.)621 So.2d 1227 (Ala. 1993).

(42.)856 P.2d 240 (Nev. 1993).

(43.)2 F.3d 670 (6th Cir. 1993).

(44.)371 U.S. 132 (1962).

(45.)602 N.Y.S.2d 743 (Sup.Ct. Monroe Cty. 1991).

(46.)158 B.R. 847 (Bankr. N.D. Okla. 1993).

(47.)157 B.R. 786 (W.D. Pa. 1992).

(48.)155 B.R. 856 (S.D. N.Y. 1993).

(49.)155 B.R. 625 (Bankr. S.D. N.Y. 1993).

(50.)824 F.Supp. 105 (W.D. Ky. 1993).

(51.)136 S.W.2d 1083 (Ky. 1939).
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Title Annotation:part 2
Author:May, Ronald A.; Crane, David D.; Marmor, Randall I.; Leslie, Robert E.
Publication:Defense Counsel Journal
Date:Jul 1, 1994
Words:13717
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