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Court Holds the Door Open for Bad Faith Claims Against Sureties

As sureties and contractors are well aware, the question of whether the surety-principal relationship can—or should—be held to the same standards as the insurer-insured relationship is far from settled.

While some courts have declared outright that “suretyship is not insurance,” barring allegations of bad faith by contractors against their sureties, the argument in favor of allowing bad faith claims against sureties does have some facial appeal. Indeed, sureties often act in a manner similar to insurers, including settling claims on behalf of their principals (usually contractors) without consent.

Late last year, in Great American Ins. Co. [GAIC] v. E.L. Bailey & Co., the Sixth Circuit Court of Appeals in Michagan was confronted with a variant of this question—specifically, the proper standard for “bad faith” in the settlement of claims by a surety on behalf of its principal—and declined to answer it definitively either way.

The facts of Bailey

In Bailey, the surety GAIC settled two underlying pieces of litigation on behalf of its principal, Bailey, arising from a contract between Bailey (as general contractor) and the State of Michigan for the construction of a prison kitchen. In one suit, Bailey and the State sued each other for breach of contract for delays on the project. GAIC ultimately settled the matter—in negotiations that excluded Bailey—with the State, receiving a payment of $358,000 from the State. In the second suit, some of Bailey’s subcontractors sued Bailey and GAIC for payments owed on the project. GAIC demanded that Bailey post collateral consistent with the surety agreement and Bailey refused. Ultimately, GAIC settled the second suit as well.

After settling these suits, GAIC filed suit against Bailey, seeking:

  • indemnification for failure to provide collateral for the subcontractors’ claims and
  • a declaration that GAIC had the right to settle Bailey’s claims with the State.

Bailey’s defense to the declaratory judgment claim was that GAIC had acted in bad faith in settling with the State, because the amount was too low, because GAIC failed to advise Bailey that GAIC was engaged in direct negotiations with the State and because GAIC supposedly failed to adequately research Michigan law on liquidated damages. Bailey argued that the lesser bad faith standard applicable to insurers in Michigan—“more than negligence but less than fraud”—should apply to GAIC as surety. Under this standard, “good faith denials, offers of compromise or other honest errors” would not constitute bad faith, but because bad faith “is a state of mind, there can be bad faith without actual dishonesty or fraud” including, for example, “if the insurer is motivated by selfish purpose or by a desire to protect its own interests at the expense of its insured’s interest.”

The Sixth Circuit’s decision

After considering Bailey’s arguments, the Court refused to take a definitive position as to whether Michigan law would apply an insurer bad faith standard to a surety relationship. Nonetheless, the Court proceeded to examine the facts applying that lesser standard, ultimately ruling against Bailey in rejecting the notion that GAIC had engaged in bad faith.

First, the Court found that Bailey had presented no evidence about GAIC’s state of mind, nor any reason GAIC’s interest in settling the case differed from Bailey’s; rather, both “share[d] an interest in securing the highest settlement possible from the State.” Further, emails demonstrated negotiations between GAIC and the State were “genuinely adversarial,” indicating GAIC’s good faith, and indeed, GAIC had secured a significantly higher settlement from the State ($358,000) than the $220,000 recommended by a mediator in prior negotiations (a recommendation rejected by the State). The Court also rejected Bailey’s assertion that GAIC had concealed negotiations in bad faith, because it appeared that GAIC had only engaged in negotiations with the State for a week before telling Bailey of the likely settlement. The Court did, however, note that a “surety’s concealment of its settlement negotiations does raise concerns.”

Ultimately, Bailey’s significance may lie in its failure to resolve the debate as to whether sureties owe principals the duties insurers owe their insureds. It has preserved, for now, the ability of contractors to argue that sureties are not immune to claims of bad faith conduct in the settlement of affirmative claims.

Although a surety’s legitimate business concerns often make swift and early settlement important to the surety, if this concern does not equally serve the interests of its principal, Bailey implies that a surety may have the duty to advocate for a larger payout—even if it means prolonging negotiations and/or litigation. Regardless, sureties would be wise to keep principals fully advised of any and all settlement negotiations, especially if doing business within the Sixth Circuit’s reach. Contractors would be equally wise to remind their sureties of these obligations.

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