Bonding Companies Must Act In Good Faith When Settling Claims

1.  Bonding and Insurance – There is a Difference.

Although many of the major insurance companies provide both insurance and bonding services, insurance differs drastically from bonding. One of the primary differences between insurance and bonding is that if a carrier pays a loss under an insurance policy, generally the insurance company has no recourse against its own insured (the entity covered by the insurance policy). If an insured submits a claim to its insurance company, if the occurrence is covered (there is always a dispute about this issue), after the insurance company pays an insured (contractor) the contractor owes its insurance company nothing (but perhaps the deductible or Self-Insured Retention (SIR)). By agreement, the insurance company took the risk of the covered occurrence (claim) and thus, must pay when the occurrence arises. Bonding (suretyship), on the other hand, involves an entirely different arrangement. In suretyship, the bonding company (surety) guarantees payment and performance of the contractor.  Only if the contractor defaults (is unable to perform or pay) does the surety step in and complete the performance; the bonding company pays the contractor’s obligations. The distinction in bonding, however, is once the surety pays it has a right to recover those payments from its principal (the contractor). The contract between the bonding company and the contractor termed a “General Indemnity Agreement” (GIA) requires that the contractor reimburse the bonding company for the costs the bonding company incurs in curing a contractor’s potential default. The GIA generally also obligates the construction company’s owners (shareholders) personally.

2.  Bonding Company’s Right to Settle Disputes.

A question in bond defaults which often arises is: what obligation does the bonding company have to conduct an investigation to determine whether the contractor in fact is in default before it pays? For example, on a school district project plagued by errors and omissions in the contract drawings, a condition for which the contractor is generally not liable, the contractor may become so overwhelmed by the design changes that it no longer is able to meet its payment and performance obligations. This is particularly true when the owner disputes the changes and the contractor is left to finance the extra work. If under these circumstances the school district places the contractor on notice of default and notifies the bonding company to complete the remaining performance and payment obligations, the question becomes what are the surety’s rights in settling that claim. May the surety take the easy way out and simply pay the claim, recovering those funds from the contractor’s shareholders (i.e., go after what is left of the shareholders’ equity in their home(s)). Alternatively, if the bonding company performs an investigation and determines that the extra costs are due to the contractor’s poor bid and not based on the alleged defective contract documents, is the bonding company obligated to support the contractor and risk a potential bad faith claim by the school district?  A bad faith claim is generally not something for which the bonding company could be reimbursed under the GIA.  The decision to settle or not, thus can place the bonding company on the horns of a dilemma.  This issue arose in a recent Washington Court of Appeals case.

3.  Bond Safeguard Ins. Co. v. Wisteria Corporation.[i]

This matter involved a dispute between a timber company-Wisteria Corporation (“Wisteria”) and a bonding company-Bond Safeguard Insurance Co. (“Safeguard”). Wisteria contracted with the Washington State Department of Natural Resources (“DNR”) to purchase, cut, and remove certain timber. To secure Wisteria’s performance, DNR required Wisteria to post payment and performance bonds. Wisteria obtained the bonds from Safeguard. As part of the bond obligation, the shareholders (a husband and wife) of Wisteria signed a GIA, which provided that Wisteria and the shareholders would hold the bonding company harmless if Safeguard was called upon to cure a default in the Wisteria/DNR contract. As with most GIAs, this agreement included a “right to settle” provision:

“The Company” [Safeguard] shall have the exclusive right to determine for itself and the Indemnitors [Wisteria and the shareholders] whether any claim or suit brought against the Company or the Principal [Wisteria] upon any such bond shall be settled or defended and its decision shall be binding and conclusive upon the Indemnitors [Wisteria and its shareholders].

During performance of the timber contract, DNR alleged that Wisteria harvested more trees than DNR had marked. Wisteria countered that DNR had mismarked the trees and contributed to the over harvest (this defense is neither fully explained nor elaborated on in the Court’s decision). Eventually, DNR terminated Wisteria’s contract and tendered its damages to Safeguard for payment. Safeguard failed to pay DNR for over seven months.  DNR filed a complaint with the Washington Insurance Commissioner and Safeguard’s home state (Illinois) insurance regulators. Shortly after the complaint against the Insurance Commissioner was filed, Safeguard paid DNR. After paying DNR, Safeguard then sued the shareholders (husband and wife) of Wisteria for indemnity. Wisteria claimed that Safeguard was not entitled to indemnification because it failed to perform a reasonable investigation and simply paid off DNR to avoid a bad faith action by the Insurance Commissioner. Safeguard urged that Wisteria’s defenses “paled in comparison to the overwhelming evidence produced by DNR” and that it did perform a reasonable investigation. Wisteria urged the Court to adopt the legal test that the bonding company has the burden to demonstrate that it acted both in good faith and reasonably in settling with DNR. Safeguard asserted that its only burden was to show that it acted in good faith.

The Court did not decide whether the test involved both good faith and reasonableness or only good faith because the Court determined that Wisteria did not offer sufficient evidence to demonstrate that Safeguard acted either in bad faith or unreasonably.  The record simply did not support Wisteria’s position. Thus, the bonding company prevailed and the test to which the bonding company’s actions will be held, whether it has to act both in good faith and reasonably or only in good faith, was not determined by the Court.

If the test is that the surety has to act both in good faith and reasonably, that burden would effectively abrogate the bonding company’s “right to settle” provision.  Sureties would no longer have the exclusive discretion to settle claims because their settlements would be subject to inquiry by the court at a later date. There is no Washington legal precedent that defines the standards governing the surety’s ability to settle a claim and seek reimbursement. This case was not reported, and thus cannot be cited by lawyers in the written submissions to Washington Courts. Regardless, even if reported, this case gave no indication as to whether Washington Courts will require both that the surety act in good faith and reasonably or whether its only burden is to show that it acted reasonably.

Comment:  The impression in this case is that the bonding company simply settled with DNR to avoid a bad faith claim by the insurance commissioner and gave its principals (Indemnitors) no opportunity to defend themselves against the DNR’s allegations. Regrettably, the facts in this case are so sparse as to provide little insight as to what might happen were a similar case to arise in the future. There is no dispute that the bonding company must act in good faith when settling. Whether that settlement must also be reasonable, however, is a question for a later court to answer.  Washington Administrative regulations require that insurance companies (bonding companies are insurance companies) promptly investigate and settle claims.  A prompt and thorough investigation by the bonding company will allow the surety to make an informed decision and prevent the type of issues reported in the above case. 


[i] Bond Safeguard Insurance Company v. Wisteria Corporation, 2013 WL 690665 (Wash. Ct. App. Feb. 25, 2013).

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