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Annual survey of fidelity and surety law, 1996.

I. PUBLIC CONSTRUCTION BONDS

A. Bonds Under Federal Law

1. Jurisdictional

Housing project financed by HUD not public building or work under Miller Act.

The project in this case was an apartment building complex for elderly people financed through a loan made by the U.S. Department of Housing and Urban Development. Among other things, the contract between the builder and the owner provided that HUD reserved the right to become the owner of the property in the event of default, that it had the exclusive right to interpret the contract and approve changes, and that it retained the right of access to the construction site. So it was argued that the project was a "public building or a public work of the United States," as required by the Miller Act.

In a well-reasoned opinion, the Court of Appeals of Maryland held that since the government neither owned the land nor was a contracting party, the mere use of federal funds for financing the project did not bring it within the scope of the Miller Act. Advin Electric v. Reliance Surety CO.(1)

Federal Small Business Act provides no basis for federal jurisdiction of claim invoking federal contract.

In Crandall v. Ball, Ball & Brosamer,(2) the plaintiffs made a rather far-fetched claim that the Federal Small Business Act created a private right of action for individuals whose rights under the act were alleged to have been abused.

Work on a U.S. Bureau of Reclamation project was subcontracted in part to a woman-owned business. Numerous claims were made in a Miller Act suit that eventually was settled. The minority-owned business then filed a separate action claiming that the amounts it was due were not adequately compensated in the Miller Act case. It argued that the Small Business Act implied a cause of action for the class it protected.

The Ninth Circuit disagreed, giving short shrift to these arguments.

Federal regulations relating to Indian Housing Authority supply jurisdiction under federal Law.

The plaintiff was more successful in a Ninth Circuit case, Del Hur Inc. v. National Union Fire Insurance Co.,(3) in which the bond was issued pursuant to federal regulations under the Indian Housing Authority.

The local housing authority, which was the contractor, required in its bid specifications that all bidders provide a performance and payment bond. The regulations had no such requirement but merely provided that the contractor should "provide adequate assurance of performance and payment acceptable to HUD." The surety argued that the jurisdictional provisions of 28 U.S.C. [sections] 1352 require that the action be on "a bond executed under any law of the United States" and that "executed under" meant "required by."

The Ninth Circuit made the common sense decision that the bond was executed under the regulations, notwithstanding that the regulations allowed alternate forms of assurance.

2. Substantive

Amount paid by general contractor to subcontractor was not avoidable preference under Bankruptcy Act.

This case involved the supplier to a subcontractor that had filed suit against the sub, the prime, and the prime's surety. A consent judgment under the Miller Act was entered, and at the same time the parties entered into a stipulation by which the prime would pay the full amount due the supplier and offset payment against the sub's remaining balance on its contract. Some months later the sub went into a Chapter 11 proceeding, and the trustee there filed an adversary proceeding to recover the amount paid as a preference under the Bankruptcy Code. The bankruptcy judge originally ruled that the payment indeed was a preference, and the supplier appealed.

The U.S. District for the Eastern District of Michigan found that the prime contractor had an independent obligation to pay the supplier and that this was not a preference that could be set aside by the bankruptcy estate of the subcontractor. The opinion bears careful study. Gold v. Alban Tractor Co.(4)

B. State and Local Bonds

1. Procedural

Where bond incorporates contract, action on bond for latent defects is not barred by five-year statute of limitations on written contracts.

Southwest Florida Retirement Center v. Federal Insurance Co.[5] comes from a district intermediate appellate court in Florida, and it involved an action for latent defects. The contracts for the project in question were executed in 1981 and 1983. All construction was completed no later than 1984. In 1993, a severe storm caused water damage to the buildings constructed under the contract, and the owner claimed that latent defects in the construction were the cause of the damage. Florida has a five-year statute of limitations on written contracts.

In a rambling and somewhat incoherent opinion, the Florida court reversed the trial court's finding that the action was barred, primarily on the grounds that the contract included warranties and that the bond incorporated the contract provisions. There is an excellent dissenting opinion, which points out that the decision is in direct conflict with another from a Florida appellate court.(6)

Sureties are not automatically entitled to statutory notice and limitations protection simply because bond is for public work.

A painting subcontractor brought a claim against the general contractor and its surety, Fidelity and Deposit Company of Maryland, for excess work performed at a Memphis public housing project. The surety defended that the claim was brought beyond the six-month limit of Section 12-4-206 of the Tennessee Code and that the sub failed to provide the surety notice under Section 12-2-204. The surety won a directed verdict, and the Tennessee Court of Appeals affirmed, characterizing the bond as statutory under Tennessee's public works legislation.

On further appeal, however, in Koch v. Construction Technology Inc.,(7) the Supreme Court of Tennessee reversed the dismissal of the surety from the action. Noting the rather ordinary bond language, stating that the surety's obligation will be void "if the principal ... shall promptly pay all just claims for damages or injury to property and for all work done," the court read the provision to "pay all just claims for damages or injury to the property" as exceeding the minimum requirement of Section 12-4-201 of the Tennessee Code, which requires the surety to "pay for all labor and materials" alone. "If the principal and surety extend rights above and beyond those contained in the statutes, the bond is characterized as a common-law bond and is enforceable as written."

As a common law bond, it was not subject to the notice provision and limitations period for bringing an action under Tennessee's statutory scheme. Companies bonding in Tennessee should note the state supreme court's observation that the bond in question made no explicit reference to the state statutes, nor did it contain any express notice requirement or time limit to bring an action. These might be included in future bonds to ensure the protection afforded by the Tennessee Code.

2. Substantive

Whether claimant was subcontractor or joint venturer could not be resolved under motion for summary judgment.

A complicated factual situation arose in BRB Contractors Inc. v. Akkerman Equipment Inc.(8) All related to the lease of a tunnel boring machine.

The general contractor entered into a subcontract with American Tunneling Inc. to perform the tunnel work on the project. American Tunneling entered into an agreement with another entity, which appears to have been a joint venture. The U.S. District Court for Kansas found that it could not conclude whether this entity was a joint venture or a supplier, and it denied a motion for summary judgment, holding the issue subject to later trial.

Privity not required in payment bond action.

In the Del Hur case (footnote 3), having accepted jurisdiction of the case, the court rejected the surety's argument that privity of contract was required in order for a supplier to a subcontractor to prevail against the general contractor's surety. The bond itself provided for coverage to all persons supplying materials in the prosecution of the work under the contract and that they would have a direct right of action on the bond in the event of nonpayment. The decision seems eminently correct.

II. PRIVATE CONSTRUCTION BONDS

A. Mechanic's Liens

Material supplier allowed to sue surety directly on property bond releasing properly filed Georgia lien.

In H.P. Hendricks Contracting Inc. v. Blake & Pendelton Inc.(9) the Georgia Court of Appeals ruled that a general contractor/ principal was not an indispensable party to suit against the surety by a material supplier on a lien transfer bond.

Hendricks served as general contractor for the Griffin Corp. in the construction of a laboratory. One of its subcontractors, Radney Plumbing, ordered materials from Blake. After shipment, Blake was not paid. Blake contacted Radney, Hendricks and the owner seeking payment, and ultimately it filed a timely lien on the property. The subcontractor then filed for bankruptcy, and the owner paid Hendricks more than $4 million for its work on the job. Hendricks then issued a property bond to release the lien, which listed "Hendricks Contracting Company, a Georgia corporation" as principal and "Howard H. Hendricks" as surety.

At trial, the surety maintained that the supplier's claim was precluded by its failure to sue the principal directly. The court disagreed. Since the supplier satisfied the Georgia statutory prerequisites for the filing of its lien, the subcontractor's intervening bankruptcy relieved the supplier of the necessity to comply with the Georgia statute, which requires claimants to file actions against the contractor or subcontractor. The court noted that the property bond posted by the general contractor and surety served as a substitute for the lien and provided the necessary "contractual link" between the supplier and the surety, Howard H. Hendricks, individually.

Moreover, the court went on, the general contractor and surety by their execution of the property bond intended to release the lien. The court held that because a materialman may sue the principal and surety jointly or, at his option, either the principal and surety alone, the corporate contractor was not an indispensable party to the bond action. The verdict against the surety was affirmed.

B. Limitations

One-year limitation clause in AIA labor and material bond may contemplate later of either general contractor's or subcontractor's work.

In Eagle Fire Protection Corp. v. First Indemnity of America Insurance Co.(10) the general contractor agreed to renovate a building under a three-phase plan. It executed a labor and material bond with First Indemnity as surety. The claimant, a fire system subcontractor, performed work during the second phase of the project. The owner terminated the general contractor during the second phase, and the general contractor subsequently filed for bankruptcy protection. The labor and material bond was written on a standard AIA form containing a limitation clause requiring suit within one year "following the date on which [the general contractor] ceased work on [the] contract." The claimant did not file suit within one year of the subcontractor/ claimant's work.

The Supreme Court of New Jersey held that the bond incorporated the underlying contract, and as such, even though the general contractor had removed its own personnel and equipment, the presence of other subcontractors hired by the general contractor constituted work by the general contractor within the original scope of the general's contract. As a consequence, the subcontractor's claim against the bond was timely.

Five-year limitations period in Florida for surety bond actions does not begin to run until discovery of latent defects, when bond incorporates the construction contract.

In the Southwest Florida Retirement Center case,(11) the owner and contractor entered into an agreement for the construction of a retirement center to be built in two phases. The surety issued payment and performance bonds for each phase of the construction. The first phase was completed in 1982, and the second in 1984. Ten years later, the owner discovered latent defects resulting from the contractor's breach of an express warranty.

In its action against the surety, the owner alleged breach of the bond contracts, based on the surety's failure to cure the general contractor's warranty violations. The surety moved for a judgment on the pleadings, alleging that the owner's claim was time-barred by the five-year Florida statute of limitations applicable to actions based on contract.

The Florida Second District Court of Appeal found that by incorporating the construction contract into the bond, the contracts became co-extensive, and the limitation period for an action against the surety did not begin to run until the discovery of the latent defects constituting the breach of warranty.

B. Damages

Sub's liability to prime for its loss is limited to prime's loss to owner and does not include prime's obligation to indemnify prime's surety for its payments to owner.

A case that should be read is C.L. Maddox Inc. v. Benham Group Inc.,(12) in which a general contractor brought a breach of contract action against two subcontractors responsible for engineering and computer work.

The general contractor alleged that it suffered more than $2 million in damages because of the resulting bidding and engineering errors caused by the two subcontractors. The general contractor also sought to introduce at trial evidence that it was liable to the owner for approximately $1.5 million in damages resulting from owner-incurred costs for repair or replacement of defective equipment designed and supplied under the contract.

The trial court disallowed evidence of specific damages suffered by the general contractor in replacing the equipment because the general contractor's performance surety paid the owner approximately $2.8 million for equipment replacement costs. Although the general contractor was required to indemnify the surety, the trial court would not permit the general to introduce any testimony regarding the bond, considering the evidence too prejudicial. Along the same lines, the court also reduced the verdicts against each subcontractor by the amount of owner-incurred remedial costs. The court noted that the general contractor introduced no evidence during trial that he himself was damaged by the costs to the owner to replace and modify certain equipment. The subcontractors appealed the damages award, and the general contractor cross-appealed.

The Eighth Circuit affirmed, holding that the general contractor did not demonstrate proof of actual damages, as required under Missouri law, for a party to recover for breach of contract. Since there was no evidence that the general contractor actually reimbursed the owner for owner-expended sums, the general contractor had suffered no concrete damages at the time of trial. The court noted that if the owner had sued the contractor, then the contractor could have successfully sought its costs against the owner and been absolved from liability. However, under these facts, the court held that until payment was made, the general contractor's damages were merely speculative and thus not recoverable.

The contractor argued that had it been allowed to introduce evidence of the performance bond, it could have shown that

The annual survey of fidelity and surety law is a project of the IADC Fidelity and Surety Committee and is published in two parts. This is Part II of the 1996 survey. Part I appeared in the January issue of Defense Counsel Journal, page 121.

The sections of the survey were prepared as follows:

"Public Construction Bonds, " by IADC member Ronald A. May of the Little Rock firm of Wright, Lindsey & Jennings.

"Private Construction Bonds," by IADC member R. Earl Welbaum of the Miami (Coral Gables) firm of Welbaum, Guernsey, Hingston, Greenleaf & Grego.

"Fidelity and Financial Institution Bonds," by IADC member Randall I. Marmor of the Chicago firm of Clausen, Miller P.C.

"Sureties' Remedies" and "Miscellaneous," by IADC member Roger P. Sauer of the Roseland, New Jersey, firm of Friedman & Siegelbaum.

The survey material is edited by IADC Charles W. Linder Jr., of the Indianapolis firm of Linder & Hollowell, who wishes to acknowledge the assistance of Mark Greenwell, Michael Yates and Cole S. Kain.

While the preparers' principal work is identified by category, one or more contributor may appear in another's category or in "Miscellaneous. the surety had paid $2.8 million to the owner for costs of repair and that the general contractor was contractually liable to reimburse the surety. The court held that even if the disallowance of the evidence was error, the error was harmless.

The contractor also argued that since it was the indemnitor for the surety, it was subrogated to all rights of the surety, including the right to recover against the subcontractors for repair costs. The court countered that because subrogation does not occur until the party seeking it has paid the underlying claim, the contractor could be subrogated only to the surety's right to recover for repair costs if it had already paid the surety. Being that the general contractor had offered no evidence that it had actually reimbursed the surety, the general contractor would still not have been able to demonstrate that it suffered concrete damages. Consequently, the district court's bar of any performance bond evidence, if error, was harmless and the reduction of the damages award was proper.

C. Jurisdiction

Concurrent jurisdiction for mechanic's lien actions does not apply to suit on lien transfer bond.

In Current Control Inc. v. Bankers Insurance Co.(13) an electrical contractor filed a lien for labor and materials provided for a private residence. The lien was then transferred to a surety bond provided by Bankers Insurance Co. The lien action was filed in county court, a court possessing concurrent jurisdiction with another under the Florida law. Bankers moved to dismiss the action on the ground that the county court lacked subject matter jurisdiction. On denial of that motion, it sought and obtained a writ of prohibition from the circuit court on the same ground.

The lienor argued that under Florida law a lien foreclosure action is an action in equity subject to the jurisdiction of both the county and circuit courts depending on the amount in controversy. Since the amount of the lien was within the statutory monetary limit of the county court, the action was properly filed there.

The Florida Court of Appeal held that since the lien claim was transferred to a surety bond pursuant to a Florida statute, jurisdiction for bond actions was restricted to circuit court only, and the case was dismissed. While the court noted that this demonstrated inconsistent behavior on behalf of the legislature, nevertheless, the county court will lose jurisdiction if, in fact, the lien is transferred to a surety bond.

This holding, of course, could have dire consequences for a lienor filing in the lower court, if the limitations period applicable to lien foreclosure actions has already expired.

D. Liability of Surety

"Pay when paid" clause in subcontract does not protect surety from liability to claimant for undisputed amounts due for work under payment bond.

A case that does a good job of tutoring on the judicially attractiveness and unattractiveness of pay when paid arguments is Brown & Kerr Inc. v. St. Paul Fire and Marine Insurance Co.(14)

There Bucon Inc. entered into a multimillion dollar design-build contract with a limited partnership for construction services. St. Paul issued a labor and material payment bond for the project in the amount of $15,735,000, with Bucon as principal. Bucon, as general contractor, subcontracted with plaintiff, Brown & Kerr (BKI), for roofing materials. The subcontract contained a "pay when paid" clause.

As of the date of trial, Bucon owed $86,879.30 to BKI, but Bucon likewise had not yet received payment from the owner for work performed. BKI forwarded the manufacturer's and its own warranty for the roofing system to the general contractor and the owner. The manufacturer stated in its warranty that it would incur no obligation until both the manufacturer and BKI had been paid in full. BKI then sent notice of non-payment to both Bucon and the surety. With no payment forthcoming, BKI filed a one- count complaint on the bond seeking the balance of its subcontract. Since it still had not received payment, BKI suspended both roofing warranties.

On BKI's motion for summary judgment, the surety asserted that since it possessed the general contractor's defenses to the subcontract, St. Paul could avail itself of the "pay when paid" clause of the subcontract. There was no dispute as to the quality of BKI's work or that the money was owed. The only issue was whether St. Paul, as surety, could invoke two different provisions of the subcontract as defenses to payment under the bond -- first, the "pay when paid" clause and, second, the subcontractor and manufacturer warranties.

St. Paul argued that the liability of the surety was co-extensive with that of the principal and, as a result, the surety should not be held liable until payment by the principal was due. The U.S. District Court for the Northern District of Illinois held for the subcontractor/claimant, stating that the bond and the subcontract were separate agreements and that he underlying purpose of a bond -- to assure payment to subcontractors -- would be defeated if the surety were to maintain this defense. The bond neither incorporated the payment terms of the subcontract nor did it condition payment to BKI on the owner's making final payment to Bucon.

The court also disagreed with the surety's assertion that the "pay when paid" clause was a valid condition precedent to Bucon's performance under the contract. Rather, the court stated that the clause constituted a timing provision requiring the contractor to pay the subcontractor within a reasonable time. Even if the "pay when paid" clause were applied to the payment bond, it would not serve as a valid condition precedent to payment because this construction would work to forfeit the subcontractor's right under the subcontract and the bond.

St. Paul then argued that a material issue of fact existed as to whether BKI complied with the provision of the subcontracts requiring it to provide all reasonable guarantees and/or warranties related to its work. The court again disagreed, noting that BKI initially tendered warranties from both the manufacturer and itself and these warranties were suspended only after Bucon and St. Paul refused to make final payment. Accordingly, the court held, St. Paul could not invoke its own principal's failure to perform under the subcontract as a defense to payment under the bond.

E. Principal and/or Lender v. Surety

Surety successfully asserted recoupment defense against principal's claim in bankruptcy.

Newbery Corp. v. Fireman's Fund Insurance Co.(15) presents an interesting situation for a surety facing its principal's bankruptcy.

Newbery, a large electrical subcontractor, obtained performance and payment bonds from Fireman's Fund for a variety of projects. Newbery had executed a general indemnity agreement, and later abandoned all of its projects bonded by Fireman's and defaulted. The contractor then entered into an agreement with its primary lender whereby the bonded projects were transferred to the surety and the surety was allowed to use its principal's equipment to complete the project. In return, the surety promised to pay rent for equipment use to the primary lender holding a security interest on the principal's equipment. This agreement specifically incorporated by reference the general indemnity agreement between the principal and surety.

The surety hired a completing contractor and finished the principal's subcontracts. Pursuant to the later agreement, the contractor used the principal's equipment, but the surety failed to pay for the rental.

To make matters more complicated, a week after the agreement, the principal filed for Chapter 11 bankruptcy reorganization in Arizona and simultaneously filed a multi-million dollar lender liability suit against the primary lender. In order to resolve that suit, the principal and the lender entered into an a settlement agreement whereby the principal released the lender from the claim, and the lender in turn advanced $1.25 million to the principal. This loan was non-recourse to be repaid only from certain pooled assets that were to be distributed to the contractor and the lender in accordance with an agreed sharing formula. These assets included the claim to equipment rentals owed by the surety to the lender under the earlier agreement, which was specifically assigned as a "pooled asset." The lender also released its security interest in Newbery's equipment, and Newbery granted the lender a new security interest in the pooled assets. This assignment of the equipment rental right was recorded in Arizona, the site of the bankruptcy.

After the surety's failure to pay the rentals, the principal filed an action against the surety and the completing contractor in quantum meruit. The completing contractor was dismissed, and the surety moved for summary judgment, asserting the defenses of recoupment and set-off. After various procedural steps, the jury determined that more than $17,000 in rents had accrued. However, because the surety was entitled to recoupment under the general indemnity agreement, the district court ordered that the principal and the lender take nothing, and it entered judgment in favor of surety.

On appeal, the principal and the lender argued that recoupment should not have been applied because it conflicted with the bankruptcy principle of "ratable distribution of assets among creditors." The Ninth Circuit rejected this argument, stating that although limits are placed on set-offs by the Bankruptcy Code, 11 U.S.C. [sections] 553, these limits do not apply to recoupment claims -- that is, recoupment claims are not subject to the automatic stay. Unlike setoff, which can be applied from one creditor against another for a variety of transactions, a recoupment claim arises from the same transaction as the debtor's claim and is essentially a defense to the debtor's claim against the creditor.

The court rested its decision on a recent Supreme Court ruling that permitted a bankruptcy defendant to meet a debtor's claim with a recoupment defense arising from the same transaction, holding that this procedure should not be construed as a preference.(16) Put Simply, since the principal was contractually obligated to indemnify the surety for all losses incurred as a result of principal's bond default, and the debtor's claim against the surety for equipment rents arose from the same transaction, the incorporation of the parties' general indemnity agreement into their equipment rental agreement resulted in one contract from which both sets of claims arose.

The lender and the principal then argued three points: (1) recoupment was available only in cases involving overpayments on the part of the party seeking to recoup; (2) the surety acted in bad faith; and (3) the surety's claim for recoupment did not arise from the "same transaction." All these arguments were rejected by the Ninth Circuit.

Finally, the lender argued that even if recoupment was proper, this application would impair the lender's perfected security interest in the pooled assets. The court ruled instead that when a third-party holds a security interest in a claim by the plaintiff, application of the recoupment doctrine does not impair the interest but rather seeks to determine the value of the initial claim. In this case, the recoupment claim, when applied to the $17,000 in rentals, resulted in a determination that the value of the lender's security interest was worthless.

Surety completing construction projects must consider all options and even then can have surprises.

When the dust settled on a 12-year-old contractor default, California imposed new duties on bonding companies to comply with their obligation to perform in good faith when completing a project. In Arntz Contracting Co. v. St. Paul Fire & Marine Insurance Co.,(17) a classic situation arose in which, when a principal claims it was wrongfully terminated and the obligee calls on the surety to undertake completion, the surety now "must weigh the viability of competing claims and the consequences of its possible responses to those claims so that it can, in good faith, decide if it is `desirable or necessary' to take over the project to protect its interests."

In 1982, St. Paul issued performance and payment bonds in favor of the Richmond Housing Authority for Arntz, the project's general contractor. St. Paul spent approximately $4 million to complete the $4.6 million contract, but was awarded only $2.7 million of indemnification in California state court. Off-sets further reduced its recovery to $813,000. However, on the contractor's claim, the jury awarded $16.5 million in compensatory damages, prejudgment interest and fees of about $8.4 million, plus an additional $100 million in punitive damages on a theory of intentional interference with the principal's respective economic relations with future sureties.

The trial court vacated the punitive damages award. Both parties appealed: St. Paul to enlarge the indemnification award but to reverse the remaining judgment against it; Arntz to reverse the award of any amount of indemnification and to reinstate the punitive damages award.

Sorting out the contentions, the California Court of Appeal noted that numerous disputes attended the completion of the project before and after Arntz's termination. The owner demanded complete removal and replacement of certain stucco, sheet metal and roofing, which Arntz vehemently protested (Arntz effectively controlled the completion contractor under a relet agreement). In a bifurcated bench trial on indemnification, the trial court found that St. Paul had been "presented with overwhelming proof that those [removal and replacement] expenses were `unnecessary and unwarranted.' St. Paul's authorization of those expenses was without 'rational justification' and constituted `unreasonable economic waste.'" The trial court's denial of indemnification for those particular expenses was affirmed by the court of appeal, which supported the finding of no "good faith belief that it was `desirable or necessary' to follow the directive" of the housing authority to remove and replace the stucco, sheet metal and roofing completely.

The appellate court also concluded that, contrary to the surety's argument, the trial court did not confuse the good faith standard applicable to an insurer, but rather applied the general standard of good faith and fair conduct implied in every California contract.

The appellate court also rejected Arntz's contention that St. Paul's compliance with unreasonable demands rendered it a "volunteer" not entitled to indemnification. It also turned aside what it termed the "proposition that a surety's every subsequent act in managing the project arises under the bond and immunizes the surety from personal accountability." In reviewing the record below, the court observed that this surety was sued directly by the owner for its own alleged malfeasance in the management and construction of the project, and that the owner's grievances "were not claims that arose under the bonds it had issued to Arntz." The standard, it said, is "substantial evidence that the alleged malfeasance and resulting damages are unrelated to any wrongdoing by the principal." Because the surety allowed the owner to retain $500,000 from amounts it claimed from the contract balance, "the construction contract payments waived by St. Paul to settle the litigation was for extra work unreasonably undertaken in cynical reliance on a 'blank check' of indemnification from Arntz."

Still, the court reaffirmed the proposition that a surety may settle a case for its own benefit, without automatically precluding indemnification for bad faith and, moreover, an obligee's bad faith claim against a surety may still be reasonable grounds for settling. This was not such a case, however.

With respect to Arntz's claims of wrongful conduct by St. Paul constituting intentional interference with respective economic relations, the court of appeal was unpersuaded. Arntz claimed that its prospective relations with other sureties was precluded by (1) St. Paul's termination of further bonding of Arntz, (2) placing Arntz "in claims" and (3) sending alleged false reports to reinsurers. All three grounds were rejected. Wrongful termination of a bonding relationship without good cause "sounds in contract, not tort." Placing the contractor "in claims" is an internal practice reasonably related to legitimate business interests and was not intended to preclude Arntz from obtaining other sources of bonding. Moreover, reporting such a status was truthful, and Arntz failed to put in any direct evidence that any other sureties even inquired of St. Paul about Arntz's claim status.

Finally, the court rejected Arntz's complaints about the reports to reinsurers as omitting acts potentially favorable to Arntz. "A surety is not required to prepare reports to its reinsurers with assiduous objectivity," the court stated. "These succinct reports are designed to advance the legitimate business objective of apprising reinsurers of potential losses on a bond, and need not present an exhaustive and charitable chronicle."

Thus, while this case is not devoid of favorable findings for the industry, the award was affirmed well in excess of the penal limit. Thus, in the Golden State of California, completion of a project is not automatically the more economical way to go in the event of a principal's default.

III. FIDELITY AND FINANCIAL INSTITUTION BONDS

A. Discovery

Discovery occurs when insured is aware of facts that would cause ordinarily prudent person to "assume" that loss had occurred.

In Federal Deposit Insurance Corp. v. Insurance Co. of North America,(18) the U.S. District Court for Massachusetts interpreted in detail the definition of "discovery" in Section 3 of a Standard Form 24 financial institution bond.

The FDIC, as receiver, sought recovery under the bond for loan losses caused by the insured's assistant vice president and an attorney employed by the insured. The employees, in collusion with other persons not employed by the bank, conspired to make mortgage loans in contravention of banking regulations, primarily by overstating purchase prices of properties in order to inflate their apparent equity values.

INA maintained that the insured's notice of loss was untimely. In deciding the issue, the court examined when the insured had discovery the loss. Section 3 of the bond stated:

Discovery occurs when the insured first

becomes aware of the facts that would cause

a reasonable person to assume that a loss of a

type covered by the bond has been or will be

incurred, regardless of when the acts causing

or contributing to such loss occurred, even

though the exact amount or details of loss

may not then be known.... Discovery also

occurs when the insured receives notice of an

actual or potential claim in which it is

alleged that the insured is liable to a third party

under circumstances which, if true, would

constitute a loss under this bond.

The court rejected the FDIC's argument that Section 3 requires proof of the insured's knowledge of a specific fraudulent intent on the part of the dishonest employee. The court held that discovery occurs when the insured is aware of facts that would cause an ordinarily prudent person to "assume" that a loss of some kind had occurred.

The court also addressed the burden of proof applicable to discovery under Section 3, concluding that the insured's burden to prove the probability of a covered loss is substantially greater than the degree of probability of loss required under the discovery provision. The burden of proof for purposes of discovery is less than a preponderance of the evidence because, the court noted, discovery occurs "even when the exact amount or details of loss may not then be known." The court concluded that an insured does need to know the actual state of mind of the employees or the exact amount of benefit those employees received in order to have a level of awareness constituting discovery of the loss.

The court granted INA's motion for summary judgment, finding that the insured's notice of loss had been untimely. It concluded that discovery had occurred, first, when the insured was served with several third-party complaints alleging that bank employees had engaged in a fraudulent loan scheme; second, when the vice president admitted to another bank officer that her husband had purchased a condominium without making a down payment; and third, when the insured hired a law firm to investigate the situation.

B. Employee Dishonesty

Employer's diversion of employee benefit plan premiums to pay employer's business obligations is loss due to employee dishonesty.

In Jefferson Parish Clerk of Court Health Insurance Trust Fund v. Fidelity & Deposit Co. of Maryland,(19) the clerk of the Jefferson Parish Court established a self-insurance trust fund to provide health insurance benefits to its employees. The trust fund was insured under a commercial crime policy concerning loss caused by employee dishonesty. During administration of the plan, the clerk failed to deposit insurance premiums previously withheld from the pay of office employees, and the trust fund eventually was unable to meet it financial obligations.

In a Louisiana state court trial, judgment was entered for the trust fund. The surety appealed, but the Louisiana Court of Appeals affirmed.

The insurer contended that trust fund never proved it suffered a "loss" due to employee dishonesty. But the court held that the clerk's failure to deposit the premiums in a timely manner resulted in a direct economic benefit to the clerk's office and a loss to the trust because the premiums were never allowed to accumulate interest or investment income for the trust fund. The court concluded that the clerk's misuse of the premiums was dishonesty within the meaning of the policy.

Act of revenge is insufficient to establish manifest intent.

In General Analytics Corp. v. CNA Insurance Cos.,(20) an unidentified employee of General Analytics altered purchase orders received from the Internal Revenue Service for equipment purchases. When the IRS refused to accept delivery of the equipment, General Analytics suffered a loss because it could not return the equipment to the supplier or sell it to other customers.

CNA denied the claim under a commercial crime policy, contending that General Analytics had not proved that an employee acted with the manifest intent to benefit himself or a third person, as required by the policy's definition of employee dishonesty. CNA appealed from the entry of sum- mary judgment in favor of General Analytics.

The trial court had concluded that the subjective intent or motive of the employee was not a necessary component of a claim involving the dishonest acts of an unidentified employee. But the Fourth Circuit reversed, ruling that employee dishonesty policies require proof that the employee acted with a particular purpose -- a specific intent analogous to that required by the criminal law. The court held that a dispute of material fact remained on the issue of whether a dishonest employee of the insured acted with the manifest intent to benefit that employee or a third person.

Evidence was undisputed that an employee had caused the insured to fill altered purchase orders, and General Analytics maintained that the employee thereby conferred a benefit on the supplier in the form of profits from the sale and caused a loss to General Analytics resulting from ordering improper merchandise. Other evidence suggested the alterations may have been caused by a disgruntled employee who was unhappy about the termination of a co-worker. The court observed that the suspected employee had no apparent reason to confer a benefit on the supplier, suggesting that the employee may have acted from revenge and not for the purpose of benefiting himself or herself or the supplier.

Expert testimony alone on the issue of employee dishonesty is insufficient to create issue of fact concerning occurrence of dishonest acts.

In First United Finance Corp. v. United States Fidelity & Guarantee Co.,(21) the Fifth Circuit held that expert testimony offered by the insured regarding the alleged dishonesty of a former employee was insufficient to raise a material issue of fact and to preclude summary judgment in favor of the surety. The court observed that the insured's experts' opinions were based primarily on the experts' knowledge of the accused employee's relationship to a third party, whom the experts knew was accused of fraudulent conduct involving companies other than the insured. The court concluded that the expert's opinions could not be substituted for evidence of dishonesty and that the experts' general knowledge of banking practices may only assist, not replace, the fact finder.

C. Forgery

Check endorsement by attorney on behalf of the payee is not a forgery.

In Reliance Insurance Co. v. First Liberty Bank,(22) the insured under a financial institution bond accepted for deposit a draft bearing an alleged forgery and sought recovery under the bond for the resulting loss. The draft was made payable to "Knight's Furniture Company, Inc. & Earnest J. Yates, Its Attorney." Yates presented the draft to the insured for deposit into his law firm's trust account. The draft was endorsed "Knight's Furniture Company, Inc. by Earnest J. Yates, its attorney and Earnest J. Yates."

Reliance filed a declaratory judgment action in the U.S. District Court for the Northern District of Georgia, contending that the endorsement was not a "forgery" within the definition of the bond. The bond provided that forgery "does not mean a signature which consists in whole or in part of one's own name signed with or without authority in any capacity, for any purpose."

The court granted summary judgment in favor of Reliance, finding that Yates's signature clearly consisted of his own name. Under the exclusion, it was irrelevant whether Yates had authority to sign on behalf of Knight's Furniture, the court held.

Allegations in third-party complaint of fraudulent activity by employee invokes attorney's fees and court costs provisions.

First National Bank of Louisville v. Lustig,(23) has involved extensive and prolonged litigation of a bank's claim under a bankers blanket bond for recovery of loan losses. Following remand from an earlier appeal,(24) the federal district court entered judgment on a jury verdict in favor of the insured, and an additional appeal ensured.

One of the issues raised on appeal involved coverage under the bond for third-party litigation defense costs. The judgment included an award of $1.8 million in attorney's fees and costs incurred by the bank in defending three lawsuits filed by third-party complaints. The surety pointed out that there was no allegation that the employee acted with intent to cause the bank to sustain a loss and, because the complaints alleged that the insured knew about the employee's fraudulent activities before the fraudulent loans were made, coverage has been terminated.

The attorneys' fees and court costs provision of the bond, set forth in General Agreement F, stated:

The underwriter shall indemnify the insured

against court costs and reasonable

attorneys' fees incurred and paid by the

insured in defending any suit or legal

proceeding brought against the insured to enforce the

insured's liability or alleged liability on

account of any loss, claim or damage which, if

established against the insured, would

constitute a collectible loss under this bond in

excess of any deductible amount.

The Fifth Circuit applied the "pleadings only rule," under which a surety's duty to reimburse its insured arises when a third party sues the insured on allegations that, if taken as true, potentially state in a cause of action under the bond. The court determined that all three complaints arose from the fraudulent activities of the insured's employee and stated potential causes of action. The court also ruled that whether the bond's termination clause ended coverage was irrelevant in determining if a potential cause of action was stated.

E. Limit of Liability

Series of 24 related acts constitutes one occurrence for $5,000 limit.

In Christ Lutheran Church v. State Farm Fire and Casualty Co.,(25) the insured's policy included coverage for loss due to employee embezzlement, with a limit of liability of $5,000 "for loss in any one occurrence." The insured brought an action to recover $32,760 after its treasurer issued 24 separate checks to himself on various occasions in various amounts. After the parties stipulated to the facts, the North Carolina state trial court entered judgment in favor of State Farm.

On appeal, the insured contended that the policy language was ambiguous and that the policy permitted recovery of up to $5,000 for each act by the employee. The North Carolina Court of Appeals disagreed, ruling that the policy limit applied to "loss in any one occurrence" and that the policy unambiguously provided that "all loss involving a single act, or a series of related acts, caused by one or more persons is considered one occurrence." Relying on Diamond Transportation System v. Travelers Indemnity Co.(26) and Business Interiors Inc. v. Aetna Casualty & Surety Co.,(27) the court concluded that the employee's issuance of the 24 checks was a "series of related acts" within the policy definition and constituted one occurrence.

Only one limit is recoverable if occurrence is over successive periods with different sureties and same limits.

In Bethany Christian Church v. Preferred Risk Mutual Insurance Co.,(28) the insured suffered a loss of approximately $82,500 over a three-year period resulting from the dishonest acts of a single employee. During that time, the insured was covered by three separate one-year policies, each covering loss due to employee dishonesty and each with a $50,000 limit of liability. The first two policies were issued by Atlantic Mutual and the third by Preferred Risk. The insured suffered a loss of approximately $1,500 during the first policy year, $29,500 during the second, and $51,500 policy limit for loss sustained during the term of Preferred's policy.

Preferred contended it was liable only for approximately $19,000, which was the difference between its policy limit of $50,000 less the $31,000 paid by Atlantic Mutual. Preferred contended that the insured's loss resulted from a series of related acts constituting one "occurrence" under the policy, and therefore the insured could not recover more than the highest limit in effect during the coverage period.

The U.S. District Court for the Southern District of Texas agreed with Preferred's analysis and held that its liability was limited to approximately $19,000. The policy defined "occurrence" as "all loss caused by or involving one or more `employees' whether the result of a single act or a series of acts." The court said that definition was not limited to a single bond period. Relying on Diamond Transportation(29) and Potomac Insurance Co. of Illinois v. Lone Star Web Inc.,(30) the court held that the insured's recovery from all of its insurers was limited to a combined total of $50,000, the policy limit in effect at the time the loss was discovered.

The court held that the "other insurance" provision limited the total recovery from all three policies to the $50,000 limit in effect at the time of discovery of the loss, since all three policies covered one occurrence.

Whether acts of embezzlement constitute one occurrence depends on whether acts are connected in time, place, opportunity, pattern and method.

In American Commerce Insurance Brokers Inc. v. Minnesota Mutual Fire & Casualty Co.,(31) the insured under a business insurance policy brought an action to recover losses of approximately $190,000 caused by dishonest acts of one employee. The employee embezzled funds by converting customers' cash payments and by inducing customers to leave blank the payee line on their checks and then inserting her name as payee. She also caused unauthorized checks to be issued to her. The policy stated that the most the insurer would pay "in any one occurrence" was $10,000, and the policy defined occurrence as "all loss or damage: (1) caused by one or more persons; or (2) involving a single act or series of related acts."

The insured alleged that the loss involved multiple occurrences because the dishonest acts were not related and, alternatively, that the provision defining occurrence as a "series of related acts" was ambiguous. Before the Minnesota state trial court, the insurer conceded that the insured suffered loss resulting from two occurrences because the employee had utilized two distinct methods of embezzlement: pocketing payments received from customers and issuing unauthorized payroll checks and petty cash checks to herself. The trial court granted summary judgment in favor of the insurer and ordered it to pay $20,000 for losses cause by two occurrences.

The Minnesota Court of Appeals reversed, finding that the phrase "series of related acts" was ambiguous, and it remanded the case for a determination of the insured's reasonable expectations of coverage. The Minnesota Supreme Court reversed that decision.

The surety contended that the employee's acts of embezzlement constituted two "series of related acts" because a common methodology or modus operandi could be discerned from her conduct. The insured countered that the employee utilized at least seven different schemes to embezzle funds on 155 separate occasions, resulting in discrete losses of insured property.

The supreme court termed illogical the insured's contention that each embezzlement was a separate occurrence. The court reasoned that under the insured's theory, an insured would be required to pay 155 separate deductible amounts, and if the employee committed separate acts of embezzlement, each of which were less than the deductible, then the insurer would have no liability. The court also noted that the insured had paid only $553 per year for coverage and that permitting it to recover up to $10,000 for each separate act of embezzlement would allow a potentially unlimited windfall recovery.

The curt also rejected the insured's argument that the employee's scheme represented seven occurrences, stating that the insured's "micro-distinguishing" of related acts subverted the purpose of the policy phrase "series of related acts." Relying on Business Interiors,(32) the court held that a trial court may consider several factors in concluding whether dishonest acts are part of a "series of related acts, including whether the acts are connected by time, place, opportunity, pattern, and most importantly, method or modus operandi." Applying this interpretation, the court concluded that the employee's issuance of unauthorized checks to herself formed part of one "series of related acts" and her misappropriation of customer payments formed part of another "series of related acts."

The court declined to apply a strict application of the Business Interiors holding, under which all of the employee's conduct likely would have constituted only one occurrence. Rather, the court applied a "cause test," under which an occurrence is determined by the cause or causes of the resulting injury.

Definition of occurrence includes scheme to cause loss to insured.

In the Jefferson Parish Clerk case(33) a self-insurance plan trust fund was insured under a commercial crime policy covering loss due to employee dishonesty, with a limit of liability of $50,000 for any one occurrence. The trust fund was established to provide health insurance benefits to employees of the clerk of the court. During the administration of the plan, the clerk diverted premiums withheld from employees' paychecks to pay non-insurance related expenditures incurred in operating the clerk's office. As a result, the fund sustained a loss in excess of $50,000. After trial in a Louisiana state court, judgment was entered for the insured. The trust appealed from that portion of the judgment limiting the insurer's liability to $50,000.

The fund contended that since the clerk withheld premiums from multiple employees on multiple occasions, the loss consisted of more than one occurrence and that more than one policy limit should apply. The Louisiana Court of Appeals rejected that argument, ruling that all of the acts were integral parts of a single scheme to provide the clerk with additional funds to operate his office and that the number of claimants or participants in the fund was irrelevant to the scheme. The court reasoned that the clerk's actions created a direct economic loss to one entity, the trust fund, and that losses to the multiple employees were indirectly related to the clerk's failure to timely pay premiums and did not constitute separate occurrences.

F. Timeliness of Notice, Proof of Loss and Suit

Prejudice to surety is not condition of late notice defense.

In Federal Deposit Insurance Corp. v. Insurance Co. of North America,(34) the FDIC brought an action to recover under a Standard Form 24 financial institution bond. The bond required that notice be given "at the earliest practicable moment, not to exceed 30 days." The insured provided notice to INA approximately 60 days after it discovered the loss. INA denied the claim, and the insured brought suit to recover under the bond.

Granting summary judgment to INA, the U.S. District Court for Massachusetts held that under Massachusetts law a surety need not show prejudice resulting from a lack of timely notice. The court reasoned that the insured conducted its own investigation before informing INA of the possibility of potential loss, and in so doing, it denied INA prompt and unimpaired access to the evidence for which INA had contracted. The FDIC contended that the insured had not discovered the loss until approximately 29 days before it gave notice to INA. The court noted, however, that while the insured reported the situation to the Federal Bureau of Investigation within 10 days, it waited approximately 29 days to give notice to INA.

Two-year suit limitation in bond is not tolled during time surety investigates claim.

In Federal Deposit Insurance Corp. v. Hartford Accident & Indemnity Co.,(35) the FDIC brought an action under a savings and loan blanket bond to recover loss allegedly caused by the insured's former president. The insured discovered the loss on October 27, 1988, but did not file suit until November 15, 1990. Hartford contended that the insured failed to comply with the bond's suit limitation provision, which required that an action be brought no later than "the expiration of 24 months from discovery of such loss."

In an earlier decision,(36) the Eighth Circuit ruled the contractual suit limitation period was valid under South Dakota law. After remand, the district court concluded that the limitation period was tolled during the time the carrier investigated the claim and that the limitation period began to run after the carrier denied the claim.

Back again in the Eighth Circuit, again the court disagreed, noting that the district court had disregarded South Dakota law and had followed a minority of courts that have used a tolling theory to enlarge a contractual suit limitation period. The court noted that a majority of courts have refused to toll a limitation provision during the initial non-suit period or during an insurer's investigation of a fidelity claim.

The court also ruled that Hartford did not waive and was not estopped from asserting the contractual suit limitation provision. The court noted that when Hartford completed its initial investigation and denied coverage, the insured had more than seven months in which to commence suit, but instead waited more than five months to object to Hartford denial. The court also observed that Hartford never lulled the insured into inaction by negotiations or promises of payment, or by failing to deny liability until after the contractual limitation period had expired.

Absence of prejudice to surety does not excuse untimely proof of loss.

In a case of first impression, the federal district court in Kansas in National Union Fire Insurance Co. of Pittsburgh v. Resolution Trust Corp.,(37) held that Kansas law does not require a surety to show prejudice when denying a claim for failure to submit a timely proof of loss. The surety had issued two successive financial institution bonds that required the insured to submit sworn proofs of loss within six months after discovery of loss. The RTC, as receiver for the insured, filed suit 25 months after the insured first notified the surety of loss.

The court granted the surety's motion for summary judgment. It pointed out that Kansas courts have refused to require insurers to show prejudice in denying claims under insurance policies for failure to file a timely proof of loss. Under Kansas law, it stated, a surety on a fidelity bond functions in a capacity similar to that of an insurer under an insurance contract.

G. Miscellaneous

Surety bound by insured's allocation of salvage to loss of income rather than loss of principal.

In First National Bank of Louisville v. Lustig,(38) the insured suffered more than $20 million in losses due to fraudulent loans issued by a dishonest loan officer. Prior to settlement with the surety, the insured sold for $10 million real property that collateralized the loans. The insured allocated the sale proceeds to unpaid interest, recovery of which was barred by the bond's "potential income" exclusion. The sureties maintained that recoveries must be allocated against the outstanding principal balance of the loans, thereby reducing the insured's covered losses. The trial court permitted the insured to allocate the proceeds to the unpaid interest. Section 7(c) of the financial institution bond provided:

Recoveries, whether effected by the

underwriter or by the insured, shall be applied net

of the expense of such recovery first to the

satisfaction of the insured's loss in excess of

the amount paid under this bond, secondly,

to the underwriter as reimbursement of

amounts paid in settlement of the insured's

claim, and thirdly, to the insured in

satisfaction of any deductible amount. [Court's

emphasis.]

On appeal to the Fifth Circuit, the sureties contended that Section 7 governed the allocation of recoveries whether or not payment had been made under the bond. The court noted that Section 7(a) and (b) of the bond clearly contemplated assignment or recovery only "in the event of payment under this bond," and that Section 7(c) likewise addressed recoveries applied to satisfy the insured's loss in excess "of the amount paid" under the bond.

The sureties contended that such an interpretation was inconsistent with Section 7(e), which provided: "The insured shall execute all papers and render assistance to secure to the underwriter the rights and causes of action provided for herein. The insured shall do nothing after discovery of loss to prejudice such rights or causes of action." But the court determined that Section 7(e) did not act as a "catch-all" provision to limit actions by an insured when the insurer has not made payments under the bond.

IV. SURETIES' REMEDIES

A. Indemnity

Surety seeking reimbursement of fees and expenses from its indemnitor incurred defending bond claim must show that fees were reasonable.

In International Fidelity Insurance Co. v. Jones,(39) the surety sued an indemnitor for expenses, including attorney's fees, incurred defending a performance bond claim. The surety argued that as long as the attorney's fees were incurred in "good faith," the reasonableness of the fees could not be placed in issue in an action to compel reimbursement.

The Appellate Division of the New Jersey Superior Court rejected this argument and concluded that, although the attorney's fees may have been expended in "good faith," they nonetheless must meet the additional standard of reasonableness.

Statute of limitations for indemnification is three years from either date of judgment or settlement, and not date underlying cause of action accrues; attorney's fees in suit for indemnity not recoverable.

In Republic Insurance Co. v. Pat Di-Nardo Auto Sales Inc.(40) the defendant argued that the surety's indemnification claim was barred by Connecticut's six-year statute of limitations. The surety, however, successfully argued that Section 52-598a of Connecticut General Statutes, entitled "An Act Concerning the Statute of Limitations in Actions for Indemnification and Attorney Grievance Procedures," which was enacted during the pendency of the action, was applicable.

The Connecticut Superior Court agreed and concluded that since the statute provides in part that "an action for indemnification may be brought within three years from the date of the determination of the action against the party which is seeking indemnification by either judgment or settlement", the action was timely filed.

The court also concluded that the surety was entitled to its reasonable attorney's fees incurred on the bond claim but not for the fees incurred in the indemnification action.

Surety seeking indemnity may pay even more on indemnitor's counterclaim based on deception.

The state Deceptive Trade Practices Act is designed to protect consumers from fraudulent and unconscionable business practices. The Texas Court of Appeals held that bonds in Texas are not "goods" for purposes of the Texas act, but when related to the sale of securities, they can ground liability under the act if a course of action was unconscionable, even in the absence of fraud.

The Insurance Co. of North America issued guaranty bonds in connection with the promissory notes given for investors in certain syndicated oil and gas partnerships marketed through a Florida company, which sought the services of a solid, recognized bonding company to enhance its market appeal. INA included its own information in the private placement memoranda of the various programs. Under a leveraged purchase agreement, notes were secured by INA bonds for which investors signed an indemnification agreement. Within a month of purchasing the bonds, investors received new surety documents containing a disclaimer as to INA's involvement. The sales agent claimed the new documents contained no new terms but corrected a "printing error" and had to be signed. After paying only one loan installment, however, the investors discovered the inherent risk of the programs and defaulted on the notes.

The surety instituted suit, and the investors counter-claimed under the DTPA, along with other theories of recovery. The jury absolved the investors of liability on the indemnity agreements and promissory notes in connection with their purchases, and the investors were awarded a judgment at a high recovery level as permitted under the DTPA, totaling $435,000, plus attorney's fees of $400,000. The indemnification agreements were declared unenforceable.

The court affirmed in Insurance Co. of North America v. Morris.(41) Relying on the better reasoned of two lines of cases, the court determined that surety bonds issued in connection with limited partnership interests do not constitute "goods" under the DTPA. It concluded, however, that services related to the sale of securities are actionable and that the record in the case before it supported a finding of unconscionability against the surety. Thus, companies bonding in Texas may be subject to the enhanced penalties of consumer legislation.

B. Subrogation

Surety subrogated to common law offset right of U.S. Department of Labor.

In In re Chateaugay Corp.(42) LTV Steel Co., self-insured for payment of black lung disease benefits to mine workers, posted a surety bond guaranteeing such payments through Aetna Casualty and Surety Co.

LTV filed under Chapter 11 of the Bankruptcy Code and ceased making any black lung disease payments. For the next few months, the U.S. Department of Labor made the payments. Later Aetna was required to begin making payments under its bond, thus becoming a general creditor in the bankruptcy. It also claimed to be subrogated to the statutory rights of the Department of Labor to recover from the mine operator.

LTV also had a very sizable tax refund due from the United States, and Aetna claimed to succeed to that as well. The obvious contest arose.

Upholding the bankruptcy court, the district judge held that the Department of Labor had no interest in the tax refund. It found that the Tax Intercept Statute, 26 U.S.C. [sections] 6302(d) and 31 U.S.C.A. [sections] 3702(A), was not available to the department. As the statutory route was the exclusive manner in which federal agencies could obtain the right to setoff non-tax debts against tax refunds, there was nothing to which Aetna could succeed.

The Second Circuit reversed, holding that the Department of Labor also had a common law right to setoff its non-tax debts against tax refunds and that the Tax Intercept Statute did not preempt common law rights. In addition, the court found that a settlement between LTV and the department, which had been approved by the district court, met the "payment in full" standard of the Bankruptcy Code, 11 U.S.C.A. [sections] 509(c).

Aetna was held fully subrogated to the Department of Labor's rights.

Fidelity insurer may bring an action as subrogee of insured against insured's employee and D&O carrier.

In Krawczyk v. Bank of Sun Prairie,(43) Ohio Casualty issued a bankers blanket bond insuring the Bank of Sun Prairie against loss from theft. Several third parties sued the insured, one of its employees and its D&O carrier, alleging that the bank and its employee had negligently and in breach of their fiduciary duties transferred trust funds to unauthorized entities. After settling the claims against the bank, Ohio Casualty moved to substitute itself for the plaintiffs and the bank in the underlying actions in order to pursue, as their assignee, their claims against the employee and the D&O carrier.

Ohio Casualty appealed from the trial court's order denying its motion to substitute, and the Wisconsin Court of Appeals reversed.

The defendants relied on First National Bank v. Hansen,(44) a Wisconsin Supreme Court case holding that a fidelity bond insurer which pays a bank's loss attributed to a bank employee's fraudulent or dishonest acts is not subrogated to the bank's right to sue its directors for their negligence in failing to prevent the loss. The court distinguished Hansen, finding the case in applicable to Ohio Casualty's claim.

The court reasoned that Hansen precludes the surety from suing an insured's officers and directors for "negligently permitting" another employee to default in his duty to the insured. It does not, the court went on, prevent a fidelity insurer from being subrogated to the claims the insured has against the officers or employees whose intentional or negligent conduct caused the loss.

C. Bankruptcy

Contingent claim of surety disallowed.

Aetna wrote two bonds for Georgia Tubing Corp. relating to its permit from the State of Georgia to allow the storage of hazardous waste on its premises. Although Aetna had not made any payments under its bonds, it filed a proof of claim when the principal took bankruptcy, contending that it "may be required to make payments pursuant to some or all of the bonds in the future," and further asserting a right of subrogation. The claim was disallowed by the bankruptcy court and the district court.

Affirming, the Second Circuit in Aetna Casualty and Surety Co. v. Georgia Tubing Corp.(45) held that Section 502(e)(1)(B) of the Bankruptcy Code barred Aetna's claim as "contingent as of the time of allowance or disallowance of such claim." Left open, however, were the potential claims that might arise should Aetna be called on the make payments to the State of Georgia with regard to post-bankruptcy liabilities of the debtor. These rights were preserved.

Fraud of accountant may be imputed to client and avoid discharge of debt to surety.

A bankruptcy debtor, Gloira Bonnanzio, had invested in a tax shelter that appeared highly inappropriate when measured against her personal financial situation. She did this through an accountant who had been recommended by an acquaintance. Apparently, the accountant took any number of liberties in submitting financial information about her to the National Union Fire Insurance Co., which issued a bond securing her debt to purchase the investment. Little or no attention seemingly was paid by her to what the accountant did or to the papers she signed.

For reasons both procedural and substantive, the Second Circuit in In re Bonnanzio(46) reinstated the bankruptcy court's holding that the debtor's conduct, reckless though it was, did not rise to an actual intent to deceive. However, it reversed and remanded on the question of whether the accountant's deception could be imputed under principles of agency to the debtor herself.

In addition, noting the lack of definitive Second Circuit law on point and the divergence of authorities in other circuits, the court suggested that the fact finder below should pay attention to whether the debtor either knew or should have known of the accountant's fraud. Another inquiry was to be whether the accountant had acted "in a manner completely adverse to the principal's interest." Consideration was also to be given to the debtor's "retention of a benefit". Yet another issue to be considered on remand was the reasonableness of the surety's reliance on the financial information provided.

Surety denied preferred status, although paying labor claims.

LTV Steel, a subsidiary of the bankrupt, had secured bonds from Aetna covering its obligations under worker's compensation laws in a number of states, but not all. At the time of the bankruptcy, while Aetna was obligated to pay $38 million in prepetition worker's compensation claims, workers in any number of states would have to look to the bankrupt estate for similar payment.

Before the plan of reorganization was filed, all the worker's compensation demands were classified as general unsecured. Under the plan however, unpaid workers were guaranteed full payment, while those, such as Aetna, that had derivative claims from workers already paid the same amount, remained as general unsecured creditors. The court acknowledged that the classification meant that the debtor's plan provided special treatment to workers and that its implementation would result in reimbursement to Aetna of only approximately 40 cents on the dollar.

Aetna made a strong equitable argument regarding its status as subrogee. It reasoned that without its participation, the workers that it had paid would have required the same payment in full, protection that unpaid workers were now to receive under the plan. But the Second Circuit in In re Chateaugay Corp.(47) rejected that argument on the ground that Aetna, while admittedly a subrogee, was subrogated only to general unsecured claims. It found that Aetna could not "piggyback" its claims onto those of unpaid workers that, in the long run, the surety would have "incorporated those risks into its rates."

The court also paid considerable heed to the premise that unpaid workers would need to have their demands met in order for the economic viability of the corporation and reorganization to have any realistic prospects. After all, the court reasoned, Aetna had already paid the claims of workers in the states where it provided bonding, so they could no longer be a threat to the economic future of the company.

Aetna also was held not to have achieved priority status by claiming an excise tax priority.

D. Priority

Surety precluded from contesting federal tax levy.

Alan Faden had invested in a limited partnership, financing most of his investment. Through the Insurance Co. of North America, he provided a surety bond for his obligation and signed an investor bond, indemnification and pledge agreement in favor of INA. Faden defaulted, and INA secured a state court judgment against him.

Faden and his wife later filed for protection under Chapter 7 of the Bankruptcy Code. Their attorney asked them to provide INA's correct mailing address so that it could be notified of the bankruptcy. They failed to do this, and their attorney secretary accidentally misaddressed the notice. As a consequence, INA was unaware of the proceedings. After learning of the Fadens' discharge, INA filed adversary proceedings to determine the debt as still valid and not discharged pursuant to the bankruptcy.

Both the bankruptcy court and the district court ruled in favor of INA. The Fifth Circuit affirmed in In re Faden,(48) holding that Section 523 of the Bankruptcy Code penalizes a debtor for failing to list all creditors and debt on applicable schedules. The burden is on the debtor to comply with this mandate. Noting that although a bankrupt is not required to exhaust every possible avenue of information to ascertain a creditor's address, reasonable diligence is to be shown. The court found particularly persuasive the fact that the indemnity agreement clearly indicated where notices to INA were to be sent, information which the Fadens completely failed to provide to their attorney.

Also challenged on appeal was the failure to reopen the discharge and grant permission to amend and ultimately list the debts to the surety. Inquiring into the reason the debtors failed to list INA, the court gave deference to the bankruptcy court's findings that Faden's conduct was something more than a mere inadvertence and was intentional or reckless.

Mailing to surety misaddressed allows potential survival of debt in bankruptcy.

Fidelity and Deposit Co. of Maryland v. City of Adelanto(49) involved a clash between two federal statutes of limitation, 26 U.S.C. [sections] 7426(a)(1), nine months for claims against the Internal Revenue Service for wrongful levy, and 26 U.S.C.A. [sections] 2410 (a)(1), allowing six years to bring a quiet title action.

The City of Adelanto, which was a nominal defendant, had hired Cates Construction to build a project, which F&D bonded. Cates abandoned the project, and F&D spent approximately $2 million in completion costs, as well as the payment of Cates's creditors. Approximately a $600,000 contract balance was owed, on which the IRS filed a notice of federal tax lien and subsequently a levy. When F&D sought to be paid the proceeds by the city, the city declined because of the levy.

In seeking to invoke the longer statute of limitation, F&D cited two cases that concerned taxpayer protests. However, the Ninth Circuit cited the perceived congressional policy that the government needs to know "sooner rather than later" whether it must look to other assets of the taxpayer to satisfy the taxpayer liability, and it refused to allow F&D any greater leeway than the nine-month limitation. It also held that subsequent Supreme Court decisional law found exceptions only in the case of refund suit.

E. Quantum Meruit

Quantum meruit theory is available to completing surety as alternative to contact theory but may not be against a surety.

Chilton Insurance Co. bonded the subcontractor on a public works project. The sub defaulted, and the surety entered a takeover agreement with the general contractor to complete the work. The takeover agreement provided that the surety was to be paid in accordance with the terms of the subcontract. but the general failed to pay because of complaints about the completing surety's performance. The surety sued for breach of contract and included, among other claims, a quantum meeruit theory of recovery.

Before trial, the general contractor was granted partial summary judgment dismissing the surety's quantum meruit claim on the ground that the existence of an express agreement covering the work Chilton was obligated to perform precluded an action for recovery in quantum meruit.

Noting that this is the general rule, the Texas Court of Appeals in Chilton Insurance Co. v. Pate & Pate Enterprises(50) nevertheless reversed, holding that "an exception exists in construction cases, thereby permitting a breaching plaintiff to recover in quantum for the value of services and materials rendered, less any damage suffered by the defendant. . . . The key to the plaintiff s right to recover in such cases is the defendant's acceptance, use, and enjoyment of the benefits conferred by the plaintiff."

The court observed that an express agreement does not bar a surety from the opportunity to prove a claim for recovery under a quantum meruit theory as a alternative to a contract theory. But what is the result if a subcontractor's surety must look to the general contractor's surety to pay? The Chilton court further clarified that the liability of the general contractor's surety "is solely contractual in nature and does not extend to any equitable remedies."

In appropriate cases, this appears to be both sword and shield to companies bonding in the Lone Star state.

V. MISCELLANEOUS

Surety on guardian's performance bond may be charged with prejudgment interest in excess of penal limit.

In 1981, Ohio Casualty Insurance Co. bonded a husband and wife as co-guardians of their daughter's estate created by settlement of an automobile accident claim for about $36,000. The parties divorced, and loans from the trust to the husband were not repaid. In 1993, the mother filed an action for breach of fiduciary duty against her former husband and their surety. The jury awarded $72,300, the excess over the penal limit reflecting the jury's calculation of pre-judgment interest.

The surety defendant relied on the former leading case of Polk v. American Casualty Co.,(51) which held that a "surety on the bond of a guardian is not chargeable with interest from the date of loss to the estate of the ward when the interest will result in a recovery larger than the fact amount of the bond." But relying on other statutory and decisional authority, the Court of Appeals of Kentucky in Ohio Casualty Insurance Co. v. Wilson(52) found that pre-judgment interest is "appropriate when the damages are fixed and certain." The court concluded that the loss to the child's estate was liquidated and that prejudgment interest could be awarded, even if by doing so, the penal limit of the bond was exceeded the penal limit. However, the court added, pre-judgment interest should be computed only from the date of notice, not the date of loss, and it remanded for an apparent error below in so computing.

Surety is discharged with obligee accepts promissory note and second mortgage in full payment of its principal's debt.

In Williams Cattle Co. Inc. v. Gus Juengling & Son Inc.,(53) the seller of livestock brought an action against the a packer and its surety, Aetna, which issued a bond pursuant to the Packers and Stockyards Act, based on the meat packer's failure to pay for cattle and the surety's refusal to make payment under the bond.

The principal, Juengling, failed to pay the obligee, Williams, for the cattle, and unbeknownst to Aetna, Juengling executed a promissory note and a second mortgage whereby Juengling agreed to pay Williams $371,173. Shortly after executing the agreement, Williams filed a claim against the Aetna bond. Then Williams's counsel telephoned Aetna and requested that processing of the bond claim be suspended until further notification. In accordance with the note and mortgage, Juengling paid Williams $82,000 and then defaulted. Williams requested that Aetna pay the claim.

The Ohio Court of Appeals court found that because the note was clearly and unequivocally accepted "in full payment" for the underlying obligation, the surety was discharged. While Aetna also argued that it was discharged as a matter of law because the obligee extended the time for the principal to pay the debt. The court did not reach this issue, but it saw the trend as being that a compensated surety is discharged only to the extent that it is prejudiced.

Customs Service prevented from "end run" on stale claim.

Hanover Insurance Co. issued customs bonds to Gambles Import Corp. in connection with potential anti-dumping duties. In November 1992, the United States commenced an action against Hanover that was untimely by a few months under the six-year statute of limitations of 28 U.S.C. [sections] 2415(a). On Hanover's motion, the Court of International Trade dismissed.

In response, the Customs Service continued to demand payment and threatened Hanover with administrative sanctions, including a directive that regional customs directors not accept goods covered by bonds underwritten by Hanover. It also threatened to remove Hanover from the government's approved surety list.

In United States v. Hanover Insurance Co.,(54) the Federal Circuit upheld the lower court's decision in all respects and continued the injunctive relief against the government action. It refused to accept that Congress intended the limitation period contained in the statute to be circumventable by administrative action. If this were so, it reasoned. there would have been a specific exception.

Surety prevented from contesting extension as liquidated date by Customs Service.

Intercargo Insurance Co. was surety for an importer, M. Genauer, for whom the Customs Service had sought an extension of time for liquidating products imported into the United States -- that is, determining the duty to be assessed on the imported items. Pursuant to 19 U.S.C. [sections] 4(a), Customs is required to complete liquidation within one year of entry of the goods unless an extension is sought under the statute. Apparently, information frequently is needed but is missing at the time goods enter the United States, and consequently the need for such information is one of the specific statutory grounds for obtaining the extension.

Intercargo had obtained a favorable decision from the Court of International Trade based on Custom's failure to specify in the extension notice any of the articulated statutory grounds. The Federal Circuit reversed in Intercargo Insurance Co. v. United States,(55) calling this defect "harmless error" and noting as well the absence of any prejudice to the surety. The court also perceived a "natural interest in the regulation of importation" that "should not fall victim to an oversight by commerce."

(1.) 682 A.2d 1173 (Md. 1996).

(2.) 99 F.3d 907 (9th Cir. 1996).

(3.) 94 F.3d 548 (9th Cir. 1996).

(4.) 202 B.R. 424 (E.D. Mich. 1996).

(5.) 682 So.2d 1130 (Fla.App. 1996).

(6.) Sch. Bd. of Volusia County v. Fidelity Co. of Maryland, 468 So.2d 431 (Fla.App. 1996).

(7.) 924 S.W.2d 68 (Tenn. 1996).

(8.) 935 F.Supp. 1156 (D. Kan. 1996).

(9.) 472 S.E.2d 482 (Ga.App. 1996).

(10.) 678 A. 2d 699 (N.J. 1996).

(11.) See footnote 5.

(12.) 88 F.3d 592 (8th Cir. 1996).

(13.) 679 So.2d 78 (Fla.App. 1996).

(14.) 940 F.Supp. 1245 (N.D. Ill. 1996).

(15.) 95 F.3d 1392 (9th Cir. 1996).

(16.) Rieter v. Cooper, 507 U.S. 258 (1993).

(17.) 54 Cal.Rptr.2d 888, 899 (Cal.App. 1996).

(18.) 928 F.Supp. 54 (D. Mass. 1996).

(19.) 673 So.2d 1238 (La.App. 1996).

(20.) 86 F.3d 51 (4th Cir. 1986). (21.) 96 F.3d 135 (5th Cir. 1996).

(22.) 927 F.Supp. 448 (N.D. Ga. 1996).

(23.) 96 F.3d 1554 (5th Cir. 1996).

(24.) 962 F.2d 1162 (5th Cir. 1992).

(25.) 471 S.E.2d 124 (N.C.App. 1996).

(26.) 817 F.Supp. 710 (N.D. I11. 1993).

(27.) 751 F.2d 361 (10th Cir. 1984).

(28.) 942 F.Supp. 330 (S.D. Tex. 1996).

(29.) See footnote 26.

(30.) Unpublished decision, 1994 U.S, Dist. Lexis 12651 and 1994 WL 494784 (N.D. Tex. 1994). Not reported in F.supp.

(31.) 551 N.W.2d 224 (Minn. 1996).

(32.) See footnote 27.

(33.) See footnote 19.

(34.) See footnote 18.

(35.) 97 F.3d 1148 (8th Cir. 1996).

(36.) 25 F.3d 657 (8th Cir. 1994).

(37.) 923 F.Supp. 1402 (D. Kan. 1996).

(38.) See footnote 23.

(39.) 682 A.2d 263 (N.J.Super. App. Div. 1996).

(40.) 678 A.2d 516 (Conn.Super 1995), aff'd, 677 A.2d 21 (Conn.App. 1995).

(41.) 928 S.W.2d 133 (Tex.App. 1996).

(42.) 94 F.3d 772 (2d Cir. 1996).

(43.) 553 N.W.2d 299 (Wis.App. 1996).

(44.) 267 N.W.2d 367 (Wis. 1978).

(45.) 93 F.3d 56 (2d Cir. 1996).

(46.) 91 F.3d 296 (2d Cir. 1996).

(47.) 89 F.3d 942 (2d Cir. 1996).

(48.) 96 F.3d 792 (5th Cir. 1996).

(49.) 87 F.3d 334 (9th Cir. 1996).

(50.) 930 S.W.2d 877 (Tex.App. 1996).

(51.) 816 S.W.2d 178, 180 (Ky. 1991).

(52.) 923 S.W.2d 904 (Ky.App. 1996).

(53.) 667 N.E.2d 469 (Ohio App. 1995).

(54.) 82 F.3d 1052 (Fed.Cir. 1996).

(55.) 83 F.3d 391 (Fed.Cir. 1996).
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Title Annotation:part 2
Author:May, Ronald A.; Marmor, Randall I.; Welbaum, R. Earl; Sauer, Roger P.; Linder, Charles W., Jr.
Publication:Defense Counsel Journal
Date:Jul 1, 1997
Words:13817
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