A hefty body of law declares that “suretyship is not insurance,” and so that sureties are not subject to claims for the tort of insurance bad faith. E.g., Upper Pottsgrove Township v. Internat’l Fidelity Ins. Co., 976 F.Supp.2d 598 (E.D. Pa. 2013). But sureties often exercise the same rights as liability insurers—including the right to settle their customers’ claims without consent. Courts are divided about whether these similar rights impose similar duties. Last week, in Great American Ins. Co. v. E.L. Bailey & Co., No. 15-2149 (6th Cir., Nov. 7, 2016), the U.S. Court of Appeals for the Sixth Circuit described the duties of a settling surety under Michigan law in terms that are hard to distinguish from the duty owed by an insurer. The court found that the duty had not been breached, but it might nevertheless have opened a door for future claims.

Sureties Are Special

A surety contract typically creates a three-sided relationship among (i) the purchaser of the bond (the “principal”), (ii) the surety that issues it and (iii) an “obligee.” The principal and the obligee are generally parties to a separate transaction or series of transactions, and the principal pays the surety for a promise to pay the obligee, in the event that the principal fails to satisfy its own obligations.

In some ways, these relationships resemble those established under a liability insurance policy—not least because many surety bonds are issued by insurance companies. For example, both a surety and an insurer can, in some circumstances, settle a claim against their customer without that customer’s consent. But there are also important differences. Unlike a liability insurer, a surety usually retains the right to indemnification from the principal for the payments it makes on the principal’s behalf. The surety may also demand that the principal secure its indemnity obligation with some form of collateral. Partly as a result of these differences, a surety sometimes has the right to settle claims that its customer asserts against third parties. That was the right which the surety exercised in E.L. Bailey.

Other aspects of the surety contract resemble first-party insurance. As the Sixth Circuit observed in E.L. Bailey,

It is the obligee of a surety, not the principal, who is analogous to the insured of an insurer.”

Thus, despite “the usual view, grounded in commercial practice, that suretyship is not insurance,” Pearlman v. Reliance Ins. Co., 371 U.S. 132 (1962), many courts have held that a surety owes a duty of good faith to an obligee. E.g., Transamerica Premier Ins. Co. v. Brighton School Dist. 27J, 940 P.2d 348 (Colo. 1997) (“A special relationship exists between a commercial surety and an obligee that is nearly identical to that involving an insurer and an insured”); Loyal Order of Moose, Lodge 1392 v. International Fidelity Ins. Co., 797 P.2d 622 (Alaska 1990) (“the relationship of a surety to its obligee … is … analogous to that of an insurer to its insured”); Dodge v. Fidelity and Deposit Co. of Maryland, 161 Ariz. 344 (1989) (“As insurers, sureties have the same duty to act in good faith that we recognized in [cases establishing the tort of insurance bad faith]”).

What About The Principal?

There is no consensus, however, as to whether such a duty also extends to the principal. Some jurisdictions hold that a surety owes the same duty to both the principal and the obligee. E.g., Bd. of Directors of the Assoc. of Apartment Owners of the Discovery Bay Condominium v. United Pac. Ins. Co., 77 Hawai’i 358 (1994) (“the surety owes a duty of good faith and fair dealing to both the principal and the obligee on the bond”). Some hold that it owes no duty to either party. E.g., Associated Indemnity Corp. v. CAT Contracting, Inc. 964 S.W.2d 276 (Tex. 1998).

Many others adopt a middle position, in which the surety owes some duty to the principal, but one which is based on the contractual covenant of good faith and fair dealing, rather than the distinctive rules governing insurance bad faith. In the context of liability insurance, “bad faith” can arise in the absence of dishonesty or malice: an insurer acts in bad faith if it fails to place its insured’s interests on an “equal footing” with its own. E.g., Greenidge v. Allstate Ins. Co., 446 F.3d 356 (2d Cir. 2006); Allen v. Allstate Ins. Co., 656 F.2d 487 (9th Cir. 1981). A surety’s contractual duty of good faith, on the other hand, is breached only by actions that have an “improper motive” or “dishonest purpose.” PSE Consulting, Inc. v. Frank Mercede and Sons, Inc., 267 Conn. 279 (2004).

The differences between the insurance relationship and that of a surety and principal support this distinction, because the latter relationship cedes far less authority to the party that issued the relevant contract. A liability insurer is solely responsible for a claim against its insured up to the policy’s limits. It puts its interests ahead of those of the insured if it unreasonably refuses to settle a claim within those limits—because its refusal forces the insured to choose between assuming responsibility for the settlement or exposing itself to an excess judgment.

Unlike an insured defendant, the principal under a surety bond is ultimately responsible for the settlement’s entire cost; it has agreed to indemnify the insurer for any payments made on its behalf. It can settle claims without the surety’s permission, and without losing the benefit of the surety contract. Moreover, it has a greater incentive than an insured has to drive a hard bargain.

The Tangle In Michigan

In September 2009, E.L. Bailey & Co. contracted with the State of Michigan to serve as general contractor for the construction of a prison kitchen at the Women’s Huron Valley Correctional Facility in Ypsilanti. Under a pre-existing surety agreement between Bailey and Great American Insurance Company, the insurer issued a performance bond, guaranteeing Bailey’s obligations to the state, and a payment bond, which guaranteed Bailey’s obligations to subcontractors and suppliers.

The surety agreement required Bailey to indemnify Great American for payments it made under the bonds—and also to provide collateral for that obligation on demand, in an amount determined by the surety. It also contained an assignment to Great American of all of Bailey’s rights “growing in any manner out of” its contracts with the state and the subcontractors, in the event of a claim alleging that the contracts had been breached. It further provided that the surety had the right to settle any claim for breach of those contracts.

Eventually, Bailey found itself in a dispute with both the state and its subcontractors. Bailey and the state sued each other in a Michigan state court over delays in the completion of the prison project, for which the state claimed a right to exact liquidated damages (the “Michigan Suit”). The court sent the parties to mediation, and the mediator recommended a settlement, in which the state would pay Bailey $220,000. The state rejected that proposal.

Meanwhile, in Washtenaw County, some of Bailey’s subcontractors brought a separate action against Bailey and Great American under the payment bond (the “Subcontractors’ Suit”). In connection with that claim, the surety exercised its right to demand that Bailey provide $1.4 million in collateral, then it reduced its demand to $650,000. Although Bailey did not comply, Great American settled the Subcontractors’ Suit at a total cost (including expenses and attorneys’ fees) of more than $900,000. The surety then brought a new action against Bailey, in federal court, for breach of the surety agreement (the “Surety Suit”).

Following the state’s rejection of the mediator’s proposed settlement in the Michigan Suit, the two parties were directed to participate in a second round of alternative dispute resolution, through a process called “facilitation.” Because Bailey had failed to post collateral for the settlement of the Subcontractors’ Suit, however, Great American still had control over all aspects of this action. One day before the facilitation was to take place, on September 11, 2013, Great American informed Bailey that it had agreed to settle the Michigan Suit for a payment by the state of $358,000—over 50% more than what the mediator had recommended. Bailey alleged that it had received no prior notice that the surety was negotiating with the state. It attended the facilitation, but the state did not show up.

In December 2014, Great American amended the complaint in the Surety Suit, adding a claim for declaratory judgment. The surety sought a declaration that it had had a right to settle Bailey’s claim against the state in the Michigan Suit. The surety later moved for summary judgment on that claim, and, in opposition to that motion, Bailey argued that the claim had been settled in bad faith. The district court granted the surety’s motion, and Bailey appealed.

On appeal, Bailey argued (and Great American conceded) that the surety owed a duty under the covenant of good faith and fair dealing that was implied into the surety contract under Michigan law. Bailey contended, however, that this contractual duty was essentially the same one an insurer would owe. In support of that argument, it cited a case involving alleged bad faith settlement by an insurer: Commercial Union Insurance Co. v. Liberty Mutual Insurance Co., 393 N.W.2d 161 (Mich. 1986).

The Sixth Circuit questioned whether that case provided the rule of decision, noting that “insurance is not identical to suretyship.” Yet it appeared to accept Bailey’s definition of “bad faith.” It noted that Commercial Union did not “deviate from the definitions” of bad faith that had been used in other contexts. While stating that “honest errors of judgment are not sufficient to establish bad faith,” the court also found:

‘[T]here can be bad faith without actual dishonesty or fraud,’ such as when ‘the insurer is motivated by selfish purpose or by a desire to protect its own interests at the expense of its insured’s interest … .’”

In other words, the court found that a surety can breach its duty to a principal in the absence of the “dishonest motive” or “improper purpose” required by cases such as PSE Consulting, supra. It also appeared to accept Bailey’s argument that a surety’s “bad faith” could consist of a “failure to investigate” Michigan law governing liquidated damages provisions.

Phew!

Because a principal’s interest in claims that have been asserted against it is different from those of an insured defendant, there are—as noted above—good reasons that a surety settling those claims should not have to put a principal’s interests on an equal footing with its own. But because Bailey involved the settlement of a claim that had been asserted by a principal, these reasons were not addressed. The court held that Great American had not breached the duty it had described, because it found that Great American and Bailey “share[d] an interest in securing the highest settlement possible from the State.”

Even if [Great American] misunderstood Michigan law [relating to liquidated damages], leading it to miscalculate its liability and accept a lower settlement, ‘honest errors of judgment are not sufficient to establish bad faith.’”

It is not clear, however, that this ruling would always protect a surety that settles a principal’s affirmative claim. A case might arise in which legitimate business interests make early settlement more important for the surety than for the principal. In that case, the analysis in Bailey suggests (without deciding the issue) that the surety might be required to hold out for a larger payout.

As for settlement of claims against a principal, Bailey suggests, at a minimum, that principals should be kept fully apprised of every settlement opportunity.