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Annual survey of fidelity and surety law, 2001.

By Ronald A. May, R. Earl Welbaum, Randall I. Marmor and Roger P. Sauer


A. Bonds under Federal Laws

1. Procedural

Ninety-day notice commenced when rented pilings were returned to subcontractor, not when pilings stopped being used.

This Fifth Circuit case represents one more installment in the already lengthy legal history of the Miller Act's requirement that the claimant under a bond give notice within 90 days after furnishing work or materials.

A general contractor had agreed to perform construction work on a Veterans Administration hospital in Biloxi, Mississippi. The construction required two cofferdams, and the subcontractor responsible for them entered into a rental agreement with the claimant in this case to provide the necessary pilings. The question arose as to whether the time started running on the notice requirement when the subcontractor returned the pilings or when they were removed from the site.

The federal district court in Mississippi held that the time started running when the pilings were removed. On appeal, this decision was reversed, and the Fifth Circuit ruled the 90 days commenced when the pilings were returned to the supplier. The action therefore was timely. J.D. Fields & Co. v. Gottfried Corp. (1)

2. Substantive

Subcontractor could recover from contractor and Miller Act surety for either breach of contract or quantum meruit.

Maris Equipment Co. v. Morganti Inc. (2) is a federal district court decision from New York. The project was a $103 million federal detention center in Brooklyn. While most of the court's lengthy opinion is devoted to elements of damage, the significant legal issues involve the basis for the lawsuit itself.

The subcontractor, who eventually prevailed after a four-week trial, was seeking recovery not only under the Miller Act but also under the theory of quantum meruit. Most of the jury's verdict was rendered under the quantum meruit claim. The district court eventually ordered a remittitur and the parties were able to settle the damage claim. A few weeks later, the court issued another opinion awarding prejudgment interest. (3)

Bid bond held non-responsive to federal agency's solicitation where substituted form inadvertently failed to include bond's penal sum.

Bid bond held non-responsive where bid was by joint venture, but bond was issued in name of corporation as principal although joint venture and corporation were same legal entity.

It's somewhat unusual, but two cases involving bid bonds were decided by the United States Court of Federal Claims within a few days of each other.

In the first case, Interstate Rock Products v. United States, (4) the plaintiff wanted to bid on a road job at Bryce Canyon National Park and notified its bonding agent, who had the interesting name of Budd O. Scow, that it needed a bid bond. The bond was procured in the correct amount and included the appropriate penal sum. The original copy of the bond included some illegible parts, however, apparently caused by facsimile transmission, and Scow was requested to issue another bond.

This time the bond was legible, but. "inadvertently" the penal sum was left blank. When the bids were opened, the plaintiff's low bid was rejected in favor of a bid half a million dollars higher. After an interminable discussion of 19 pages, the court finally concluded that the inadvertent omission of the penal sum invalidated the bid.

The other bid bond case involved the construction of a contract with the Army Corp of Engineers for modernization of a school in the District of Columbia. The bid bond named as principal James G. Davis Construction Corp. The bid, however, was made in the name of Davis/HRGM, a joint venture. It seems to have been uncontradicted that the two entities were identical. Nevertheless, the court found the bond non-responsive. Davis/HRGM Joint Venture v. United States. (5)

B. State and Local Bonds

1. Procedural

Statute of limitations on action against surety began to run when work completed, not when work accepted.

In Arbor Vitae-Woodruff Joint School District No. 1 v. Gulf Insurance Co., (6) a school district filed a declaratory judgment action seeking a declaration that the statute of limitations on actions under a contractor's surety bond began on the date the district's architect accepted the work. The surety

contended that the statute began to run on the date the contractor completed its work. Since the latter contention comported with the statute under which the public works bond was issued, the Wisconsin Court of Appeals reversed the judgment in favor of the school district and remanded the case to dismiss the claim against the surety.

Claimant's failure to give notice to contractor within 15 days after work commenced bars claim.

In this Georgia case, a sub-subcontractor sued the subcontractor, the general contractor and the surety for earth moving services performed in construction of a school. The Georgia statute on payment bond claims required that those furnishing labor or services give a notice of commencement no later than 15 days after work is commenced. The claimant in this case failed to do so, and the Georgia Court of Appeals held that the claim was barred. J. Kinson Cook Inc. v. Weaver. (7)

2. Substantive

Principal on bond could not recover against surety for bad faith refusal to pay claims.

In Masterclean Inc. v. Star Insurance Co., (8) the claimant, Masterclean Inc., contracted with the University of South Carolina to remove asbestos from a university building. It obtained a performance bond, and when it was declared to be in default, the university made a claim against Star Insurance Co., the surety, while at the same time formally terminating the contract with Masterclean. The surety eventually concluded that its principal, Masterclean, had defaulted, but the surety refrained from settling any bond claims pending negotiations with the university, which in the meantime had hired a replacement contractor. Ultimately, the university and the surety negotiated a settlement for $900,000, of which the surety paid $100,000 and the defaulting plaintiff contractor, Masterclean, $800,000.

Masterclean then sued its own surety in state court, claiming that Star could have mitigated the damages by undertaking its obligations under the bond sooner. The case was removed to federal district court, which then sought an answer to a certified question as to whether South Carolina recognizes a cause of action in tort by a principal against its surety for bad faith refusal to pay first-party benefits to its obligee.

The Supreme Court of South Carolina concluded that South Carolina law did recognize an action for bad faith refusal to pay insurance claims, but it held that the doctrine did not apply to sureties. The court pointed out, however, that this fact would not prevent the principal from asserting a surety's bad faith as a defense to an indemnification claim.

No recovery against surety for defalcation by "disbursing agent" that surety had required.

Multi-state Contracting Corp. v. Midwest Indemnity Corp. (9) is a somewhat puzzling case. The construction contract was with the U.S. Air Force, so it would appear that the surety bond provided by the principal must have been a Miller Act bond. The surety and a separate business entity, referred to as "underwriter," required that the principal contractor use a "disbursing and escrow agent" to handle funds received from the Air Force on the project. The principal contracted with such an entity, which proceeded to lose some of the funds in "failed investments." At this point, the principal sued its own surety under an agency theory, rather than the Miller Act.

The Georgia Court of Appeals held that while the use of the disbursement agent may have been a condition to the issuance of a bond, that requirement did not make the surety liable for its defalcations.

Pre-claim notice to surety not required where concrete cutting services were labor rather than materials.

The contractor on a school remodeling project in the State of Washington subcontracted for certain mechanical work. The subcontractor, in turn, contracted for "concrete cutting, sawing and coring." When the subcontractor failed to pay its sub-subcontractor, the latter sued the subcontractor, the general contractor and the general contractor's surety. The defendants moved for summary judgment on the ground that the sub-subcontractor had failed to provide a pre-claim notice under the bonding statue.

The trial court refused to grant summary judgment, and its action was affirmed on appeal to the Washington Court of Appeals, the court holding that the concrete cutting services provided by the plaintiff did not involve furnishing materials but only labor, and that the bond statue's notice requirement did not apply to such claims. National Concrete Cutting Inc. v. Northwest GM Contractors Inc. (10)

Estimating and bidding preparation services to contractor not covered by contractor's payment bond.

The plaintiff in this case entered into an oral agreement with the contractor under the terms of which the plaintiff was to perform certain estimating and bidding preparation services and to be compensated by a weekly payment, plus a 6 percent commission on the gross receipts from bid projects. The other party to the transaction obtained a contract for work on the Raleigh-Durham International Airport.

The contractor had financial difficulties and failed to pay the plaintiff. He sued the contractor and the contractor's surety. A judgment in favor of the surety was affirmed on appeal to the North Carolina Court of Appeals, the court holding that all the work done by and for the contractor was fully performed before the bonding contract was entered into. Monteau v. Reis Trucking & Construction. (11)

Payroll services furnished by claimant to contractor not covered by payment bond.

Two almost identical cases from different states reached identical-results in Gulf Insurance Co. v. GFA Group, (12) a Georgia case, and Jean Simpson Personnel Services v. G & G Concrete, (13) from Louisiana. In each case the work performed was described as "payroll services." The service provider issued payroll checks on its own account, remitted withholding taxes, paid workers' compensation premiums and performed similar services.

In both cases, the states' intermediate appellate courts held that the service provider was not providing labor or material to the project itself so as to come under the terms of either the Louisiana or the Georgia statutes. In both cases, the lower courts had found in favor of the service providers, and those decisions were reversed on appeal.


A. Third-party Beneficiaries

Subcontractors and materialmen were not third-party beneficiaries of lease agreement between shopping mall developer and retail store owner, since payment bond was intended to benefit mall property, and any benefit to contractor and materialmen were incidental.

In Chic Creations of Bonita Lakes Mall v. Doleac Electric Co., (14) Chic Wigs, a d/b/a of Chick Creations Inc., contracted with CBL, a developer, to relocate a store to the Bonita Springs Mall. The payment provision in the shopping center lease required that Chic Wigs provide a payment bond as to the general contractor, a lien waiver from the general contractor executed by all subcontractors, and evidence that all payments for the construction of the store had been made. The Chic Wigs owner stipulated that none of the contingencies was satisfied.

The subcontractors and materialmen argued that contractual provisions breached by Chic Wigs as to, among other things, the securing of a payment bond, was intended for the direct benefit of the subs to ensure that they were paid for their materials and labor.

The Mississippi Court of Appeals found that the primary purpose of the contract provisions was to avoid liens being filed on the mall property. It reasoned that the contract was between CBL and Chic Wigs, and the provisions were intended to benefit the mall. The court added that the subs would have benefited had Chic Wigs performed all of its contractual obligations, "but the benefit would have been merely incidental to the primary purpose of which was the avoidance of liens on the property."

The court affirmed that the subs were not entitled to relief as third party beneficiaries.

B. Liability of Surety

Doubling subcontractors' judgment against general contractor's surety on payment bond for unfair or deceptive trade practices was correct measure of damages.

At issue in R.W. Granger & Sons Inc. v. J & S Insulation Inc. (15) was the validity of a $410,245 punitive damages judgment against United States Fidelity and Guaranty Co. in favor of J&S Insulation. J&S was a subcontractor to R.W. Granger & Sons, for whom USF&G was the surety.

The Massachusetts Supreme Judicial Court held that the jury verdict against Granger and the certainty that USF&G, as Granger's surety, would be responsible for paying that verdict, as well as interest and attorneys' fees, was more than sufficient to subject USF&G to the requirements of the Massachusetts statute. The court also stated that the evidence also supported the trial judge's conclusion that USF&G failed to "effectuate prompt, fair and equitable settlement," noting that USF&G made its first settlement offer more than four months after the jury verdict and J & S's demand and that the surety offered no explanation for its subsequent delay in making payment to J & S.

The court held that J&S proved that USF&G acted willfully and knowingly in a manner prohibited by the Massachusetts statute, entitling it to multiple damages. The award to J&S of $845,653, which represented double the amount of the underlying judgment against USF&G, together with interest, was not excessive and consistent with the legislative intent.

C. Right to Arbitration

General contractor did not waive right to arbitration by filing action in court.

In Zager Plumbing Inc. v. JPI National Construction Inc., (16) JPI, a general contractor, entered into a subcontract, including an arbitration clause, with Zager Plumbing. JPI sued Zager, seeking to discharge a construction lien recorded by Zager, and attached a demand for arbitration to the complaint. JPI obtained a transfer bond to transfer the construction lien to the bond. Zager contended that by filing the action, JPI waived its right to arbitration. Affirming the trial court's decision that the right to arbitration had not been waived, the Florida Court of Appeal stated that there is an strong public policy (17) in favoring arbitration:
   The procedure followed by JPI in this case was a reasonable means to invoke
   the expedited procedure for clearing liens from real property, while
   preserving the contractual mechanism for litigating the merits of the
   parties' dispute. Until Zager filed its answer and counter-claim under
   [Florida statutes] subsection 713.21(4), it could not be known whether
   Zager intended to enforce the construction lien or would be content to rest
   solely on its contractual claim. (18)

The court added that Zager would not be prejudiced by allowing this procedure.

D. Indispensable Parties

Once a bond is in place, individual purchasers of land are not indispensable parties.

In Schaffer v. Frank Moyer Construction Inc., (19) Moyer contracted with Michelle LaMasters and Steven Hartung, the purchasers, to build a custom house. Moyer hired Gregory Schaffer to do the trim carpentry work on the home.

Moyer fired Schaffer and hired another subcontractor to complete the work. Schaffer perfected a mechanic's lien and filed suit. Moyer posted a bond in accordance with an Iowa statute, and the trial court dismissed the purchasers from the suit thereafter.

Moyer contended that the dismissal of the purchasers from the suit required reversal. The Iowa Supreme Court held that once the bond was in place, the purchasers were no longer indispensable parties. The court reasoned that the bond discharged the lien, leaving the property free from any encumbrance. It cited Section 572.15 of the Iowa Code, which provides that an owner, principal contractor or intermediate subcontractor may discharge a mechanic's lien by filing a bond in twice the amount of the lien.

E. Bankruptcy

Preferential transfer to subcontractor is protected from avoidance under new value exception based on release of bonding company's contingent equitable lien in contract balance held by owner.

In In re GEM Construction Corp. of Virginia, (20) GEM, the bankrupt debtor, entered into a contract with Stovall Associates Inc., under which Stovall agreed to supply materials and labor in connection with interior storm windows and glazing work on a project at a seminary. As part of the general contract, GEM obtained a payment bond on the project from Markel Insurance Co. As security, the bond contained a provision that "funds earned by the contractor in the performance of the construction contract are dedicated to satisfy obligations of the contractor and the surety under [the bond], subject to the owners' priority to use the funds for the completion of the work."

Bankruptcy Code [section] 547(b) allows a trustee to invalidate certain pre-bankruptcy transfers of a debtor, generally referred to as preferences. An exception is contained in Section 547(c)(1), which states that a trustee may not void a transfer that is in exchange for new value being given in a substantially contemporaneous exchange.

After completing work on the site, Stovall sent a certified letter to Markel and the seminary demanding payment under the bond. Within 90 days prior to the filing of bankruptcy, GEM made a $81,874 payment to Stovall for the full balance due under the subcontract. The court previously held by partial summary judgment that the trustee met the burden of proof that the payment to Stovall constituted a preferential payment under Section 547(b).

Stovall asserted several theories as affirmative defenses for the argument that it gave new value for the funds received. One of the theories was that the lien waiver released Stovall's claim against the bond, thereby releasing funds held by the owner from an equitable lien by the bonding company.

The bankruptcy court reasoned that the subcontractor had a "matured claim against the surety bond, the surety had an equitable lien on the contract amounts held by the owner, and the owner could fully recoup the amount from retainage due debtor-contractor." It added that "since GEM's payment to Stovall avoided the imposition of an equitable lien by Markel on the contract amounts held by [the seminary], there was no diminution of the estate."

Thus, the court concluded, "the release of the subcontractors' rights against the surety, which in turn could have exercised its lien rights, constituted new value being given in a substantially contemporaneous exchange." It went to hold that the preferential transfer to Stovall was "protected from avoidance under the new value exception based on the release of the bonding company's contingent equitable lien in the contract held by the owner."


A. Employee Dishonesty

Bank officer who failed to disclose facts to loan committee did not manifest intent to cause loss, absent specific purpose to cause a loss and to confer a benefit on third parties.

In Federal Deposit Insurance Corp. v. National Union Fire Insurance Co., (21) the FDIC, as receiver for a failed bank, sought coverage under the bank's financial institution bond for loan losses attributed to the fraudulent acts of the bank's vice president. The federal district court granted the insurer's motion for summary judgment, finding that the FDIC had failed to show that the bank officer had acted with the necessary manifest intent to cause a loss to the bank or to obtain a financial benefit.

The FDIC maintained that the bank officer concealed critical information, which, if disclosed, would have impacted the loan committee's decision to advance more than $19 million for a construction project. The court refused to infer that the bank officer concealed information with the intent to cause a loss to the insured.

It noted that the officer's conduct, at worse, could be characterized as incompetent or negligent, but that he had no evil purpose. The court held that an employee's recklessness or even knowledge that a result is substantially certain does not satisfy the manifest intent requirement, absent evidence that the employee had the specific purpose and belief that a loss would result.

The claim also failed, the court went on, because the bank officer did not intend to confer a benefit on himself or any third party. The FDIC argued that he intended to benefit the borrowers and the third-party subcontractors who were owed payment for work performed. The court concluded there cannot be an intent to confer an improper benefit a third party who is the intended recipient and proper beneficiary of those funds. It pointed out that all funds were dispersed in the normal course of business to the persons the loan committee intended to receive the funds.

Administrator who stole funds from estate did not manifest intent to cause a loss to his employer.

In Shoemaker v. Lumbermens Mutual Casualty Co., (22) the plaintiff, as executrix, claimed that the former executor of the decedent's estate had embezzled more than $60,000 of the estate's funds. She sought recovery of the loss under an employee dishonesty policy issued to the executor's employer, a company, that provided guardianship services.

The federal district court for the Western District of Pennsylvania entered summary judgment for the insurer, finding that the executor did not act with the manifest intent required for coverage under the policy.

The executor had drawn checks on the estate's account primarily to cover his employer's attorney's and administrator's fees. The conduct resulted in the criminal prosecution and imprisonment of the executor for theft of funds from the estate, but the court found no evidence that the executor, by his conduct, intended to cause a loss to his employer.

In defining the term "manifest intent," the court applied the objective standard articulated by the Third Circuit in Resolution Trust Corp. v. Fidelity and Deposit Co. of Maryland, (23) which requires an insured to prove that the employee acted with the specific object or desire to cause a loss. The issue, the court observed, is not whether the employee was reckless or substantially certain a result may occur, but whether the actor knew that the loss was an inevitable consequence of his acts. The court concluded that there was no evidence the executor knew or expected that his theft of funds from the estate would result in a loss to his employer.

Loan officer who advanced loan proceeds to spouse's company manifested intent to cause loss.

In BancInsure Inc. v. BNC National Bank N.A., (24) a bank's loan officer extended credit to a company in which her husband had acquired an ownership interest. The loans were insufficiently secured, and following default the bank sought recovery of its loss under a financial institution bond. The insurer paid a portion of the loss under a reservation of rights and then sought a declaration of its obligations and a refund of its payment. Following trial, the federal district court held that only two of the transactions were covered by the bond.

The Eighth Circuit affirmed. It adopted the definition of the term "manifest intent" it used in First Dakota National Bank v. St. Paul Fire and Marine Insurance Co., (25) holding that manifest intent is a "clearly evident intent" that may be interred from all facts and circumstances indicating a person's state of mind. Because the officer had increased the customer's line of credit on two of the transactions by using funds earmarked to reduce the balance of the loan, the court concluded that she acted with the necessary manifest intent to cause a loss as to those transactions.

B. Definition of Employee

Principal who owned and controlled insured corporation was its alter ego, not employee.

In Orleans Parish School Board vs. Custom Insurance Co., (26) the plaintiff hired GIA to administer its health care benefits program and to process employees' medical claims. GIA's president, Carter, misappropriated the plaintiff's funds, and it sought recovery of the loss under GIA's crime policy, which covered employee theft. The federal district court granted the insurer's motion for summary judgment, finding that Carter was not an "employee" as defined in the policy.

The policy defined "employee" as a person whom the insured has the right to govern and direct in the performance of his services. The court noted that Carter owned 100 percent of the voting stock of GIA's holding company, which owned 100 percent of GIA, and that Carter made all corporate decisions without oversight by GIA's board of directors. Carter was the alter ego of the corporation, the court concluded, not a person the corporation had the right to govern and direct, and therefore he was not an employee within the meaning of the policy.

Where policy does not define "employee" as person subject to insured's direction and control, officer who controlled insured was not its alter ego.

In Securities and Exchange Commission v. Credit Bancorp Ltd., (27) the receiver for a defunct investment firm asserted claims under the firm's primary bankers blanket bond and excess crime policies for loss allegedly resulting from a complex securities fraud perpetrated by Richard Blech. In its affirmative defense, the insurers claimed that Blech was the alter ego of the investment firm and therefore was not an employee under the policy.

The federal district court granted the plaintiff's motion for summary judgment and struck the insurers' alter ego defense.

The primary policy defined "employee" as the "assured's officers, clerks, servants, and other employees while employed by the assured." The court held that where the terms of the policy do not require that an individual be subject to the direction and control of the corporation in order to qualify as an "employee," the insurer cannot argue that an officer is the alter ego of the company and not an employee.

Data processing company under contract with insured was "employee" as defined in policy.

In Hudson United Bank v. Progressive Casualty Insurance Co., (28) Hudson's predecessor, Regent, entered into a contract with K-C to provide data processing services in support of its auto insurance premium finance business. Regent required accurate information to track payments and, on default, to obtain a refund on the unused portion of insurance premiums. K-C's fee was based on a percentage of profits. Hudson claimed that K-C entered inaccurate and misleading data in the computer system, which prevented Regent from seeking refunds of insurance premiums and resulted in overpayment of K-C based on non-existent profits.

Hudson sought recovery under the fidelity insuring agreement of Regent's insurance policy. The insurer moved to dismiss the claim, arguing that the complaint failed to allege the occurrence of a fraudulent or dishonest act by an employee of Regent, as required by the policy.

The federal district court denied the motion, finding that the facts alleged in the complaint adequately stated a cause of action.

As defined in the policy, an "employee" included a "natural person, partnership or corporation authorized to perform services as data processor of checks or other accounting records (not including preparation or modification of computer software or programs)." The court concluded that the complaint stated a claim based on the conduct of an employee, because it alleged that K-C had entered accounting data into the computer system.

C. Computer Coverage

Complaint stated claim under computer system rider based on fraudulent data entry by company under contract with insured.

In the same case, the plaintiff also sought recovery under the computer systems rider of Regent's policy. The insurer argued that the rider did not afford coverage because, under the terms of the rider, the computer system into which fraudulent data were entered must be "operated by the insured, whether owned& or leased." The court observed that the complaint alleged that Regent had acquired some interest in K-C's computer system and that K-C operated the system on Regent's behalf. On these facts, the court held that the complaint stated a claim for relief under the rider.

D. Exclusions

Loan loss exclusion did not bar coverage under computer system rider where losses derived from fraudulent data and not loan defaults.

Also in the same case, the insurer argued that the loan loss exclusion in the policy excluded coverage under the computer system rider. The exclusion applied to all loss resulting from complete or partial non-payment of, or default on, any loan or extension of credit.

The court held that the complaint, read in a light most favorable to the plaintiff, did not assert a loss resulting from a default by the borrowers, but rather alleged that the loss stemmed from the failure to cancel insurance policies and to seek refund of premiums.

E. Discovery

Insured's prior knowledge of officers' misconduct was not discovery of loss, because insured did not appreciate that loss due to theft had occurred.

In Gulf USA Corp. v. Federal Insurance Co., (29) Gulf claimed that Federal improperly denied its claim under a crime policy, which covered employee theft discovered during the term of the policy. The federal district court granted Federal's motion for summary judgment, but the Ninth Circuit Appeals reversed.

Gulf contended that its former president and other officers had misappropriated funds in the course of a series of real estate transactions. In 1991, it reached a settlement with the officers, and a shareholder lawsuit complaining of the same conduct was dismissed at that time. In 1993, after Gulf renewed its insurance coverage, it notified Federal of a loss attributed to the officers' fraudulent conduct. Federal argued that plaintiff had discovered the loss in 1991, and therefore notice of loss was untimely under the terms of the policy.

The Ninth Circuit held that plaintiff did not discover the loss in 1991. Relying on the U.S. Supreme Court's decision in American Insurance Co. v. Pauly, (30) the court stated that discovery occurs only when an insured becomes aware of facts that would justify a careful and prudent man in charging another with fraud or dishonesty.

The court rejected the plaintiff's position that discovery requires actual knowledge of fraud, but it also turned down Federal's argument that discovery arises when the insured has facts to reasonably question an employee's honesty. Instead, the court stated, the insured must discover dishonest acts and appreciate the significance of those facts.

The court held that while Gulf may have been aware of facts in 1991 to cause it to be suspicious that fraudulent acts had occurred, it did not have knowledge until 1993 that would lead a reasonable person to conclude that a loss due to theft had occurred.

F. Limit of Liability

Loss involving conduct of two employees acting separately was not single "occurrence."

In Ran-Nan Inc. v. General Accident Insurance Co. of America, (31) a convenience store operator sought coverage for more than $64,000 allegedly stolen by two employees during the fourth and fifth renewal periods of a commercial crime policy. The policy had a limit of liability of $25,000 per occurrence. The insurer paid the insured $25,000 but declined to honor the remainder of the loss.

The Fifth Circuit affirmed the entry of judgment in favor of the insured.

The insurer maintained that, under the policy, a loss "involving one or more employees" constitutes a single occurrence. The court concluded that the term "involving" in that clause referred to a group of employees conspiring to steal and does not apply when two employees are acting separately. The court noted that, in determining the number of occurrences for purposed of employee dishonesty coverage, a majority of courts analyze the cause of the loss, rather than the number of injurious effects. It that two independent causes existed for the insured's total loss, and therefore each theft represented a separate occurrence.

Succession of fraudulent transactions by three employees over several year period was single occurrence.

In Valley Furniture and Interiors Inc. v. Transportation Insurance Co., (32) the plaintiff was insured under a policy that included employee dishonesty coverage, with a limit of $50,000 per occurrence. It sought payment under the policy of more than $200,000 allegedly embezzled by three employees over a six-year period. The insurer paid the $50,000 occurrence limit, declining the remainder of the claim, and the plaintiff sued in Washington state court to obtain payment for the remainder.

The trial court entered summary judgment for the insurer, and the Washington Court of Appeals affirmed.

The policy defined "occurrence" as all loss "involving a single act or a series of related acts." The court held that the definition was not ambiguous and that it referred to a succession of logically connected acts, linked by time, place, opportunity, pattern and method. The court concluded that the three employees had acted in concert and that the loss resulted from a single occurrence.

G. Termination and Cancellation

Receiver was entitled to assert claims because discovery by insured preceded receiver's appointment and because insurer waived rescission defense.

In Securities and Exchange Commission v. Credit Bancorp Ltd., cited at footnote 27, the receiver for a failed investment firm sought recovery under primary and excess policies that included coverage for loss resulting from employee dishonesty. The SEC claimed that the company's former president had embezzled more than $200 million from customers. The insurers asserted as an affirmative defense that coverage under the policy terminated on "the appointment of a receiver or manager," and therefore coverage was not afforded for the loss.

The federal district court granted the SEC's motion for summary judgment and struck the affirmative defense, holding that the receiver was entitled to pursue the claim because, before the receiver was appointed, the insured already had discovered the loss and notified the carriers of the potential claim.

The court acknowledged that some claims by customers had been brought against the insured after the receiver was appointed, but that other claims, involving the same conduct, had preceded the appointment and constituted notice of all claims based on those facts. Finding that discovery of loss occurs when an insured has notice of loss or circumstances that could give rise to loss, the court held that discovery preceded the appointment of the receiver and had occurred when the earlier claims were asserted.

The insurers also argued that they were induced to issue the policies by the insured's misrepresentations during the underwriting process, rendering the policies void ab initio. The insured represented in its insurance application that it was a financial services company engaged in "lending and project management," but the insurers maintained that the company was created to defraud customers and never engaged in any legitimate business.

The court noted that a misrepresentation or omission can be the basis for rescission only if an underwriter considered the misrepresented or omitted facts when it evaluated the risk. The court concluded that the insurers had ratified the policies because they were aware of evidence of fraud sufficient to lead a prudent person to inquire into the matter, and therefore the insurers were not entitled to rescind coverage based on the alleged misrepresentation.

Failure to disclose officers' fraudulent acts on renewal application did not warrant rescission because insured did not know it had incurred loss due to thefts.

In Gulf USA Corp. v. Federal Insurance Co., cited at footnote 29, the insurer sought rescission of an employee theft policy based on the insured's failure to disclose facts on an insurance application relating to allegedly fraudulent real estate transactions.

The federal district court granted Federal's motion for summary judgment, but the Ninth Circuit reversed.

The insured claimed that it sustained a loss arising from fraudulent real estate transactions in which its former officers had engaged. The insured reached a settlement with the officers in 1991, renewed its insurance coverage in 1993, and thereafter notified the insurer of a loss based on the officers' dishonest conduct.

The insurer maintained that the insured was obliged, on its renewal application, to apprise the insurer of facts relating to the allegedly fraudulent transactions, and the insurer sought rescission of the policy on that basis. The court held that the failure of the insured to disclose the transactions on the renewal application did not warrant re scission. While the insured may have been aware of fraudulent acts in connection with the transaction, the court stated, it did not yet have actual knowledge that it had incurred a loss due to theft.

H. Recoveries

Recoveries, less costs of obtaining them, were properly prorated between insurer and insured.

In BancInsure Inc. v. BNC National Bank N.A., cited at footnote 24, a borrower defaulted on loans, which were inadequately secured, and the bank sought recovery under a financial institution bond for the resulting losses. The bank claimed that the loan officer who advanced the funds had acted dishonestly because her husband was a part owner of the borrower. In concurrent administrative proceedings, the loan officer and her husband reached a settlement with the Office of the Comptroller of the Currency in which they agreed to pay $473,700 as restitution for the bank's losses.

The insurer sought a declaration of its payment obligations and subrogation rights under the policy. The federal district concluded that two of the loan transactions, amounting to about $181,500, were covered by the fidelity portion of the bond, and the court apportioned to the insurer 25 percent of the restitution payments.

The Eighth Circuit affirmed. It held that the trial court had properly applied principles of legal subrogation to work an equitable adjustment between the parties. It noted that the insurer's subrogation rights were limited to the amount it paid, but that the amount had to be reduced to $118,350 as an equitable offset for the costs the insured had expended to obtain the settlement. Based on the reduced amount, 25 percent of the recoveries were allocated to the insurer.

Insurer may pursue recovery of loss from principal's spouse who enjoyed benefits of embezzled funds.

In Federal Insurance Co. v. Smith, (33) Federal insured a life insurance company under a policy that included coverage for employee theft. Following payment of a claim and the death of the responsible employee, Federal brought suit against the employee's wife for recovery of the loss. After a bench trial, the federal district court, applying Virginia law, entered judgment for Federal, finding that the insurer, as subrogee, had standing to sue the defendant for conversion and unjust enrichment.

The defendant's husband, while employed by the insured, engaged in a fraudulent insurance scheme involving submission of fake death benefits claims. He deposited the funds into a joint checking account on which he and his wife were signators. The court determined that most of the stolen funds had been used to pay the wife's and the couple's debts and personal expenses.

Under Virginia law, the court concluded, the wife had exercised wrongful dominion over and therefore converted checks that came into her possession and that she deposited into the joint checking account. The court added that the wife also had converted the other checks, whether or not she physically handled them, by accepting the stolen insurance proceeds for the purpose of paying her creditors. As to a portion of the embezzled funds, the court also ruled that Federal was entitled to judgment on the alternative ground of unjust enrichment.

Made-whole doctrine did not preclude enforcement of settlement agreement requiring insured to share recoveries with insurer.

In District No. 1--Pacific Coast District v. Travelers Casualty and Surety Co., (34) a fidelity insurer brought suit against its insured, a labor union, to obtain a portion of the funds recovered by the union from its dishonest employees and co-conspirators. The District of Columbia Court of Appeals affirmed the entry of summary judgment in favor of the insurer.

Union officers had engaged in a scheme to rig union elections. Following the merger with another union, they also paid themselves fraudulent severance payments. The insurer denied coverage under the policy for the portion of the claim relating to payment of wages, but agreed to pay the union the amount of its severance fraud loss. The parties executed a settlement agreement in which, "subject to the excess loss provision of the policy," the union agreed that the insurer was entitled to receive certain of the recoveries, which the union thereafter obtained from the officers and their conspirators.

The court concluded that the "excess loss provision," referred to in the agreement, described the recoveries section of the policy, which allocates recoveries to an insured to the extent that it sustains loss covered by the bond exceeding the limit of liability. The court noted that the union did not incur a covered loss in excess of the coverage limits. It concluded that, under the settlement agreement, the insurer was entitled to receive 75 percent of the recoveries from two employees, and all of the recoveries obtained from the co-conspirators, provided the recoveries could be traced to the severance fraud.

The union asserted that it was entitled to keep all of the funds recovered from the employees and conspirators. It contended that, under the common law made-whole doctrine, it was entitled to receive full recovery of its salary loss before the insurer was entitled to any recovery. But the court held that the made-whole doctrine had no application because the parties had modified their rights by contract.


A. Indemnity

Surety succeeds on counterclaim for indemnity where principal claimed wrongfully failed to renew performance bond to secure environmental cleanup costs.

In Texas Soil Recycling Inc. v. Intercargo Insurance Co., (35) Texas Soil, which was engaged in performing environmental cleanups, leased a site near Houston from Waste Reduction Systems Inc. for its operations. Waste Reduction operated a landfill adjacent to the site and used the supposedly remediated soil from Texas Soil as fill dirt for landfill. The lease required Texas Soil to obtain a $75,000 performance bond to secure environmental cleanup costs, if any, made necessary at the termination of the party's lease. Texas Soil obtained its bond from Intercargo Insurance Co. through Rose-Tillmann Inc., an insurance broker. Four people associated with Texas Soil gave a general indemnity agreement to Intercargo.

Intercargo renewed its bond for one year, extending into 1994. However, during 1993, Texas Soil and Waste Reduction Systems entered into an amended lease that required Texas Soil to renew the performance bond at least 45 days prior to the bond's expiration. If this was not done, Texas Soil could be defaulted under its lease unless it obtained a renewed bond within 20 days after written notice of the failure to renew. Default gave Waste Reduction Systems the option of terminating the lease and removing Texas Soil from its premises.

In early 1994, a confusing set of circumstances began to arise, whereby various alleged oral promises to renew the bond were made by the broker. In any event, the dam broke in February 1994, when Waste Reduction Systems both notified Texas Soil that its lease was being terminated and made a claim on the Intercargo bond.

A host of claims and litigation ensued, including Texas Soil against Intercargo for breach of contract, fraud, negligence, negligent misrepresentation, grossly negligent misrepresentation and violation of the Texas Deceptive Trade Practices Act, all for failure to renew the bond.

Texas Soil lost on all scores in the Fifth Circuit. First, reasoning that Texas Soil's injuries occurred in February 1994 when it was evicted from its leasehold, the court held that most of its claims were time barred by the Texas two-year rule. Next, paying close attention to the documentation that passed between Texas Soil and Intercargo--namely, the performance bond and the general indemnity agreement--the court noted that the second of these documents specifically stated that Intercargo had "the right, at its option and its sole discretion, to issue or cancel or decline the execution of any bond, or renewal thereof." Finally, in failing to find an agency relationship between surety and broker, the court focused on the limited power of attorney and found the broker's authority to extend no further than that.

With these rulings in place, there was little left for the court to do but to act on the general agreement of indemnity, which it did.

B. Subrogation

"Compensated surety" rule not applied to defeat claims by fidelity insurer against bank that wrongfully paid its insured checks to employee wrongdoer.

Mutual Service Casualty Insurance Co. v. Elizabeth State Bank. (36) provides a long, detailed and intricate look at the various rights and liabilities that may arise when a fidelity insurer pays on checks that were used by a faithless employee to misappropriate funds from the insured and later seeks to recover from the bank that paid the checks.

Mutual Service Casualty Insurance Co. issued a fidelity policy to a concern known as Jo Daviess Services Inc., a farm service cooperative. Its controller, Arlyn Hemmen, handled the company's books and records. Daviess maintained two accounts at the Elizabeth State Bank--a day-to-day operating account and a "treasury tax and loan" account (TT&L) into which the bank's commercial customers deposited federal withholding taxes. As needed, Daviess transferred funds from its operating account into the TT&L account.

Under the terms and conditions of the agreement governing the operating account at the bank, only "authorized signers" could withdraw or transfer funds from that account. Hemmen was not so authorized, but periodically he prepared checks payable to the order of the bank for the company's general manager's signature. Since Daviess did not owe any money to the bank, the only legitimate reason for making a check so payable would be to accomplish a transfer of funds from the operating account into the TT&L account. Hemmen was able to present the checks to the bank for payment and either have some of the proceeds go back to him in cash or, on some occasions, the entirety of the proceeds. Hemmen was never even required to endorse the checks.

The Seventh Circuit spent considerable space discussing the' interplay between rights and defenses under Article 3 of the Uniform Commercial Code and the common law. The bank lost on all scores, with the court holding that it was neither a holder in due course nor did it have a right to supplant its common law obligations to Daviess under the UCC.

Mutual Service and Elizabeth State also squared off under the compensated surety defense. The Seventh Circuit took an exhaustive look at Illinois law, which controlled, and claimed to "find no Illinois case that squarely addresses the validity of the compensated surety defense," although it acknowledged the presence of "hints" that Illinois follows the doctrine of superior equities. Having said this, it also noted that no case was to be found using the compensated surety defense to bar an insurer from suing a third party that caused its insured to suffer loss.

The solace it found was in the cited Illinois trend to recognize the difference between subrogation claims arising from express contract, rather than equity. Hence, under principles of federalism, the court believed that the Illinois Supreme Court, even were it to recognize the compensated surety defense, would not permit it to be invoked in cases of contractual subrogation.

Fidelity insurer permitted to participated in recovery by its insured against wrongdoer.

In BancInsure Inc. v. BNC National Bank N.A., cited at footnote 24, BancInsure issued a financial institution bond to BNC National. It made a claim in excess of $800,000 in connection with credit transactions handled by a former employee, Debra Gronlie. Evidently under protest, BancInsure paid the claim in full and then sought a declaratory judgment action in federal district court to secure the return of some of what it had paid. In fact, the district court ordered $404,810.15 be repaid.

In a rare stroke of good fortune, following an administrative action by the Office of the Comptroller of the Currency, the loan officer and her husband, to whom much of the funds had gone, agreed to repay $473,400. The Eighth Circuit held that the district court was correct in permitting the fidelity insurer to recover the sums paid under its bonds.

Surety's equitable right of subrogation trumps prior security interest that was properly perfected before bonds were executed.

In United States Fidelity & Guaranty Co. v. APAC-Kansas Inc., (37) the surety of a defaulted contractor sued in federal district court, claiming its priority right to the unpaid and earned contract balances owed to the contractor. The owner-obligee interpleaded the contract balances into court. In the suit, the surety, as well as Clarkson Construction Co. as assignee of a perfected security interest in the accounts receivable of the defaulted principal, both claimed the funds.

Affirming the surety's long-standing equitable right of subrogation, the federal district court rejected the assignee's arguments that its perfected security interest that predated the execution of the bonds had priority over the surety. The court granted summary judgment to the surety.

Federal tax liens take priority over subrogation rights of surety; second-and third-tier subcontractors protected under payment bond issued to first-tier subcontractor.

In In re M & T Electrical Contractors Inc. v. Capital Lighting & Supply Inc., (38) the U.S. Bankruptcy Court for the District of Columbia ruled that the subrogation rights of the surety were not entitled to preference over certain federal tax liens that attached to a subcontractor on the project on the subcontractor's default. The surety argued that its equitable right to subrogation should take priority.

After reviewing the history of equitable subrogation under the U.S. Supreme Court's decision in Pearlman v. Reliance Insurance Co., (39) the court noted that the equitable right of subrogation is fixed only once the bond issued by the surety is breached by the contractor. Exploring Pearlman and its progeny, the court recognized that those cases rely on a relation-back doctrine that allows sureties to overcome intervening rights of other creditors. In this case, it went on, the relation-back doctrine did not apply.

The right of subrogation was defined as a "shadowy thing until it is given substance" once the contractor defaults and causes the surety to pay. According to the court, the relation- back doctrine of Pearlman was insufficient to render this potential, inchoate right perfected at the time that a federal tax lien intervened before a default occurred. In other words, the equitable lien under Pearlman will not take priority over a tax lien that attaches prior to the amount owed on the bond becomes fixed due to the contractor's default.

The court also noted that the payments due were progress payments, not payments for retainage. Citing Missouri law, it held that the surety's rights to progress payments may arise only once a default has occurred, and unlike cases where payments represent retainage only, may not relate back to defeat other creditors. The court did not address this issue under Virginia law, noting that federal tax liens take priority under the choateness doctrine, regardless of whether Virginia follows a relation-back rule regarding progress payments.

The court also found that a payment bond issued to a first-tier subcontractor "reached down" to protect not only the second-tier subcontractor but also a third-tier subcontractor, as well for equipment that was delivered by the third-tier subcontract to a project at Dulles airport. A liberal interpretation of payment bonds in favor of unpaid suppliers comports with Virginia law and the remedial purpose of Virginia's public bond statute, the court stated.

The court also noted that the first-tier subcontractor had an independent legal duty to pay the third-tier subcontractor's claim due to the execution of the payment bond by the first-tier subcontractor. When facts were conceded at trial that clearly demonstrated that the payment bond extended to protect the third-tier subcontractor, the court determined that the first-tier subcontractor necessarily "recognized that there existed an obligation on the part of [the first-tier subcontractor] to see that [the third-tier subcontractor] was paid, as that is the nature of the bond, a form of surety agreement."

In doing so, the court recognized the status of third-party beneficiaries under the bond and also acknowledged that the one bond presented two suretyships. Initially, the first-tier subcontractor agreed to act as a surety for the third-tier subcontractor. Next, the surety agreed to act as a "sub-surety" and be secondary liable to the third-tier subcontractor if the first-tier subcontractor failed to make timely payment.

The court also concluded that the surety was entitled to reimbursement from the first-tier subcontractor because of the indemnity agreement between them and under the equitable right to reimbursement or restitution. Even before resorting to that right, the court found that a surety possesses the implied right to performance under a bond by its principal and could bring suit to compel the principal's performance.

C. Right to Settle

Once surety's liability is fixed, surety permitted to negotiate settlement less than full amount of liability without notifying principal.

Seguros del Estado S.A. v. Scientific Games Inc., (40) involved three agreements. The first was a contract between Scientific Games Inc. and an entity of the government of Colombia that required Scientific Games to create and manage a national instant lottery in Colombia. The second was a performance bond in favor of the Colombian government, and the third was the indemnification agreement between Scientific Games and its surety.

The Colombian governmental entity issued a "declaration of caducity" that terminated the lottery contract based on a breach by Scientific Games, and it also declared that Scientific Games and its surety were jointly and severally liable for $4 million under the terms of the contract. Scientific Games sought reconsideration of the termination, but its application was denied. Then Scientific Games challenged the determination in a Colombian administrative court, but this also was denied.

When the action in the U.S. District Court in Georgia was filed, Scientific Games' appeal was still pending in the Colombian court system.

The 11th Circuit initially disposed of the international comity and lis alibi pendus issues, as well as statute of limitation issues. It then addressed the substantive claim challenging the surety's right to settle and its claim for indemnification. The court concluded that based on Colombian law, once the declaration of caducity became final and executable, despite the fact the formal appeal was pending, the Colombian government had an enforceable judgment that was subject to execution. Faced with a potential $4 million exposure, without notice to the indemnitors, the surety successfully negotiated a settlement of $2.4 million.

The 11th Circuit affirmed the district court's grant of summary judgment and its award of $2.4 million to the surety. The court concluded that the bond was properly renewed and that the bond and indemnification agreement were in effect when the declaration of caducity was issued. Consequently, since the surety was obligated to pay under the bond and its settlement and compromise of that judgment was reasonable, it was entitled to enforce its indemnification rights.


A. Liability of Surety

Underlying judgment against principal creates prima facie case of liability against surety and is sufficient to defeat surety's motion for summary judgment where surety did not establish defense as matter of law.

In Davis v. First Indemnity of America Insurance Co., (41) First Indemnity issued a motor vehicle dealer's surety bond for $25,000 for Jim and Allan Beasley, who did business as Beasley Auto Sales. In February 1994, Davis purchased a vehicle from Beasley, but Beasley failed to deliver good title to Davis for several months, and Davis was unable to obtain insurance for the vehicle. While the vehicle was uninsured, it was wrecked while being driven by Davis's grandson.

In April 1997, Davis obtained a final default judgment against Beasley for $10,000 in actual damages, plus prejudgment interest, fees and other damages. Then in January 1998, Davis filed suit against First Indemnity, seeking to recover his damages on the surety bond. The surety moved for summary judgment, arguing that Davis refused to accept title. The trial court granted summary judgment for First Indemnity.

The Texas Court of Appeals stated that although First Indemnity could have presented any valid defense that would have defeated Davis's cause of action at the time of the underlying judgment, the judgment against Beasley Auto Sales created a prima facie case of liability against the surety. The court went on to hold that such prima facie evidence of the surety's liability was sufficient to defeat the motion for summary judgment because First Indemnity did not establish a defense as a matter of law.

(1.) 272 F. 3d 692 (5th Cir. 2001).

(2.) 163 F. Supp. 2d 174 (E.D.N.Y. 2001).

(3.) 175 F. Supp. 2d 458 (E.D.N.Y. 2001).

(4.) 50 Fed. Cl. 349 (Fed. C1. 2001).

(5.) 50 Fed. Cl. 539 (Fed. C1. 2001).

(6.) 639 N.W. 2d 788 (Wis. App. 2001).

(7.) 556 S.E. 2d 831 (Ga. App. 2001).

(8.) 556 S.E. 2d 371 (S.C. 2001).

(9.) 556 S.E. 2d 524 (Ga. App. 2001).

(10.) 27 P. 3d 1239 (Wash. App. 2001).

(11.) 553 S.E. 2d 709 (N.C. App. 2001).

(12.) 554 S.E. 2d 746 (Ga. App. 2001).

(13.) 803 So. 2d 992 (La. App. 2001).

(14.) 791 So. 2d 254 (Miss. App. 2000).

(15.) 754 N.E. 2d 668 (Mass. 2001).

(16.) 785 So. 2d 660 (Fla. App. 2001).

(17.) Citing Lapidus v. Arlen Beach Condominium Ass'n, 394 So. 2d 1102, 1103 (Fla. App. 1995).

(18.) 785 So .2d at 662, citing Matrix Constr. Corp. v. Mecca Constr. Inc., 578 So. 2d 388, 389 (Fla. App. 1991).

(19.) 628 N.W. 2d 11 (Iowa 2001

(20.) 262 B.R. 638 (Bkrtcy. E.D. Va. 2000).

(21.) 146 F. Supp. 2d 541 (D. N.J. 2001).

(22.) 176 F. Supp. 2d 449 (W.D. Pa. 2001).

(23.) 205 F. 3d 615 (3d Cir. 2000).

(24.) 263 F. 3d 766 (8th Cir. 2001).

(25.) 2 F. 3d 801 (8th Cir. 1993) (applying South Dakota law).

(26.) 162 F. Supp. 2d 506 (E.D. La. 2001).

(27.) 147 F. Supp. 2d 238 (S.D.N.Y. 2001).

(28.) 152 F. Supp. 2d 751 (E.D. Pa. 2001).

(29.) 259 F. 3d 1049 (9th Cir. 2001).

(30.) 170 U.S. 133 (A.P. 1898).

(31.) 252 F. 3d 738 (5th Cir. 2001).

(32.) 26 P. 3d 952 (Wash. App. 2001).

(33.) 144 F. Supp. 2d 507 (E.D. Va. 2001).

(34.) 782 A. 2d 269 (D.C. 2001).

(35.) 273 F. 3d 644 (5th Cir. 2001).

(36.) 265 F. 3d 601 (7th Cir. 2001).

(37.) 151 F. Supp. 2d 1297 (D. Kan. 2001).

(38.) 267 B.R. 434 (2001).

(39.) 371 U.S. 132 (1952).

(40.) 262 F. 3d 1164 (11th Cir. 2002).

(41.) 56 S.W. 3d 106 (Tex. App.--Amarillo 2001).

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 2001 survey. Part I appeared in the January 2002 issue of Defense Counsel Journal, page 88.

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" and "Miscellaneous," by IADC member R. Earl Welbaum of the Miami (Coral Gables) firm of Welbaum, Guernsey, Hingston, Greenleaf & Gregory.

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

"Sureties' Remedies," by IADC member Roger P. Sauer of the Westfield, New Jersey, firm of Lindabury, McCormick & Estabrook.

The survey acknowledges the assistance of Michael J. Rune II, Rick Yabor and Cole S. Kain.

The survey material is edited by IADC member Charles W. Linder Jr. of the Indianapolis firm of Linder & Hollowell. While the contributors' principal work is identified by the above categories, some of their work may appear in another category.
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Title Annotation:part 2
Author:Linder, Charles W., Jr.
Publication:Defense Counsel Journal
Geographic Code:1USA
Date:Jul 1, 2002
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