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Contractor Not Required to Indemnify Surety for Bad Faith Settlement with Subcontractor
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May 9, 2005
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Thelen Reid Brown Raysman & Steiner LLP
National Fire Insurance Co. of Hartford and Frank Mercede and Sons, Inc., a contractor, entered into an indemnity agreement under which National would issue surety bonds for the contractor's projects and the contractor would indemnify the surety for payments made in settling claims against those bonds. A second-tier subcontractor made payment claims against one of the bonds. The contractor disputed the second-tier subcontractor's entitlement to payment.
The contractor had subcontracted with Dominion Bridge, Inc. for structural steel fabrication and erection on an assisted living facility. Dominion entered into a second-tier subcontract with PSE Consulting, Inc. The contractor, Dominion and PSE entered into a joint check agreement under which the contractor would pay PSE up to $1.5 million, the amount of the second-tier subcontract, for work performed, plus agreed extra work, with 10 percent retention to be withheld.
The second-tier sub worked on the project between January and August 1998. The contractor paid it just over $1.3 million in six joint checks. The subcontractor filed for bankruptcy in September 1998. Soon after, the second-tier sub sent the contractor a letter stating that it was owed more than $600,000 - terming the amount "undisputed." On October 13, 1998, the second-tier sub made a formal claim of $1.1 million against the contractor's payment bond.
The bond claim was assigned to a surety claims analyst at National's parent, CNA Surety. Within two weeks, the analyst wrote the second-tier sub that much of the claim was likely subject to defenses by the contractor and requested more information, which was provided. The analyst took no further action until February 1999, when he met with the contractor, which stated it disputed the entire claim, both for retention and for extra work.
In mid-February 1999, a lawyer for the second-tier sub wrote the surety, with a copy of the letter to the Connecticut insurance commissioner, stating that the surety had breached the payment bond by failing to pay undisputed amounts owed and by failing to explain the basis for disputing any amounts within 45 days of receipt of the claim. The surety analyst wrote back that the claim was fully disputed, that good faith legal defenses existed to the claim and that the surety was conducting an investigation. The second-tier sub filed a formal complaint with the insurance commissioner. The court found that the surety did not conduct an independent investigation of the claim until September 2000, two years after it was made.
After receiving the letter from the second-tier sub's lawyer, the surety began trying to settle the claims. This included a settlement meeting attended by counsel for the surety and second-tier sub but not attended by the contractor. At the time of the claims analyst's deposition, the surety paid the second-tier sub $200,000 (for $150,000 in retention plus $50,000 in interest). The contractor had not been consulted and objected to the payment.
Shortly afterward, the surety demanded that the contractor reimburse the $200,000 and either settle with the second-tier sub or deposit $500,000 in collateral with the surety as provided in the indemnity agreement. The contractor refused.
The surety settled with the second-tier sub for another $500,000 in exchange for a full release of the surety but not of the contractor. The surety then sought recovery of payment from the contractor, which refused to pay. The surety sued the contractor to enforce the indemnity agreement, and the contractor cross-complained against the surety for breach of the implied covenant of good faith and fair dealing. The contractor settled with the second-tier sub.
Trial proceeded on the surety's claim for indemnity against the contractor and the contractor's claim of bad faith against the surety. The jury found against the surety and found for the contractor, awarding nominal damages. The trial court entered judgment on the jury verdict. The surety appealed. The Supreme Court of Connecticut affirmed. PSE Consulting, Inc. v. Frank Mercede and Sons, Inc., 267 Conn. 279, 838 A.2d 135 (2004).
On appeal, the surety argued that the indemnity agreement gave the surety "the exclusive right" to determine whether to defend or settle a bond claim. It contended that the agreement provided that any payment by the surety was "prima facie evidence" of the propriety of the payment. The Supreme Court found that the surety's discretion was not unfettered and recognized a bad faith defense, holding that any payment had to be made in good faith. The court defined bad faith as "improper motive" or "dishonest purpose." But, the misconduct need not rise to the level of fraud. Unreasonable conduct could be evidence of improper motive. Insufficient investigation of a claim accompanied by an improper motive could constitute bad faith.
The Supreme Court found that there was evidence demonstrating an insufficient investigation. It included the surety's claim analyst making only a superficial review of the claim and the analyst's delay in requesting an expert claim analysis until almost two years after the claim was submitted.
The Supreme Court found that evidence of bad faith included the surety's failure to timely and fully respond to the claim, including paying undisputed amounts and providing the basis for disputing other amounts claimed, and making excessive payments in light of the valuation of the claim by the surety's engineer.
The court held that a self-interested settlement accompanied by an improper motive could constitute bad faith. Self-interest could be found in the surety's secret settlement negotiations with the second-tier contractor, especially because the surety had denied the claims until threatened with a claim for bad faith settlement practices.
Other evidence of a self-interested settlement by the surety included the surety's fear of an enforcement action by the insurance commissioner; the surety obtaining a release for itself from bad faith and unfair trade practices claims in exchange for payments to the second-tier sub; the surety's failure to obtain a release for the contractor; and the surety's payments over the contractor's objection.
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For more information about the issues covered in this report, please contact Paul Berning in our San Francisco office at 415-369-7229 or at pwberning@thelen.com or contact your Thelen attorney. For more information about Thelen's Construction and Government Contracts Department, click here.
©2005 Thelen Reid Brown Raysman & Steiner LLP
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