In a March 28, 1997 decision, the Second Appellate District held that surety bonds are sufficiently like insurance that a surety may be held liable for punitive damages for tortious breach of the implied covenant of good faith and fair dealing. In Cates Construction, Inc. v. Talbot Partners, 97 C.D.O.S. 2385, TIG Insurance ("TIG") issued a performance bond on behalf of Cates Construction ("Cates"), a building contractor, as principal, naming the developer, Talbot Partners ("Talbot"), as obligee. As is customary, the performance bond provided that in the event of default by Cates, TIG would either complete the construction contract or make arrangements to hire another contractor to complete the work. Partway through the project, Cates refused to continue unless it received additional payments, even though both its records and those of Talbot showed that Cates had been overpaid for the work completed up to that point in time. Cates then abandoned the project and, at TIG's request, gave a notice of voluntary default to Talbot.
Although TIG initially started to complete the work using a different contractor, it later joined as plaintiff in a lawsuit filed by Cates against Talbot. Talbot cross-complained on the bond. The project was never completed and Talbot lost the property when the lender foreclosed.
The court held that the performance bond issued by TIG, as surety, was sufficiently like insurance, and that the obligee under a bond was like an insured, such that TIG could be held liable for breach of the implied covenant of good faith and fair dealing. In so holding, the court noted that surety bonds fell within the statutory definition of "insurance," and that sureties were regulated by the Department of Insurance. The court also reasoned that bad faith liability should be imposed because:
- surety bonds, like insurance, are not purchased for a profit, but to protect against calamity;
- since the obligee had already purchased protection against loss, it could not seek any other recourse if the surety failed to perform; and
- insurance was quasipublic in nature.
Notwithstanding the Cates decision, there are some fundamental differences between insurance and surety bonds. Unlike the bilateral insurer-insured relationship, there is a tri-partite relationship between the principal, who buys the bond, the obligee, who is named as the beneficiary of the bond, and the surety, who guarantees the principal's performance of the contract. A surety is not required to provide a defense or immediately pay a settlement without the principal's default. See, e.g., Schmitt v. Insurance Co. of N. Am., 230 Cal. App. 3d 245, 281 Cal. Rptr. 261 (1991), rev. denied. Indeed, in contrast to insurance, the surety is entitled to a defense from the principal. Moreover, while an insurer has no right of subrogation against its insured, a surety is entitled to reimbursement from its principal. See, e.g., American Inter-Fidelity Exch. v. American Re-Insurance Co., 17 F.3d 1018, 1022 (7th Cir. 1994). Because payment of a bond claim immediately triggers the principal's obligation to reimburse the surety, the surety cannot pay disputed claims prematurely without a thorough investigation and a determination that the claim is meritorious, and that the principal is in fact liable for breach of its obligations under the construction contract. In recognition of the relationship between the surety, the obligee and the principal, sureties are exempted from certain provisions of the Fair Claims Settlement Practice Regulations. (See Section 2695.1, Preamble.)
The facts of the Cates case were unique in that there was no dispute that the contractor had wrongfully abandoned the project. Indeed, the contractor even sent a notice of voluntary default. In most cases, however, the facts will not be so clear cut, and there will be a genuine dispute between the principal and the obligee. The Cates decision places sureties in an unpalatable position. If, on the one hand, a surety fails to pay a claim by the obligee promptly, the surety may, under the Cates rationale, be liable for "bad faith" and subject to punitive damages. If, on the other hand, the surety prematurely pays the obligee's claim in the face of justified opposition from the principal, the surety may have compromised its indemnity rights against the principal. This will continue to be an unsettled and troublesome area of the law until the issue is resolved by the California Supreme Court.
*article courtesy of SCCBA Insurance Newsletter.