Surety Bonds - A Basic Primer and the Insolvency Twist

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I suggest the following simple ten ways to avoid malpractice in litigation:

FIDELITY AND SURETY June 2014

IN THIS ISSUE Searching for a “lifeline” in Surety basic principles should the Surety become insolvent.

SURETY BONDS

A BASIC PRIMER AND THE INSOLVENCY TWIST

ABOUT THE AUTHOR Carl Anthony Maio, Esquire, is a Partner at the law firm of Fox Rothschild LLP, whose

principal office is in Philadelphia, Pennsylvania. Carl is Chair of the Corporate Insurance

Practice Group where he emphasizes in Reinsurance Arbitrations, Corporate Insurance Merger

and Acquisition, Licensure, Regulatory Compliance, Demutualizations, and represents clients

nationally and internationally. Carl has been practicing law forty-one years and enjoys the

honor of being a continuous member of IADC for the past thirty-one years. Having served as

Chair, Vice Chair and Program Chair for many IADC standing and substantive committees,

Carl has authored many articles published by the IADC, inclusive of: committee newsletters;

the Defense Counsel Journal; and, has often times been a presenter at IADC Midyear

Meetings, Annual Meetings, and Special Presentations. Carl is admitted to practice in

Pennsylvania, Maryland, District of Columbia, and the International Court of Justice. He is

AV Preeminent rated by Martindale-Hubbell, and has been recognized for multiple years as a

Pennsylvania Super Lawyer. He can be reached at [email protected].

ABOUT THE COMMITTEE The Fidelity and Surety Committee serves all members who represent fidelity and surety carriers. Committee

members publish newsletters and journal articles, including an annual update of recent developments in the

law. Learn more about the Committee at www.iadclaw.org. To contribute a newsletter article, contact:

Samuel J. Arena, Jr.

Vice Chair of Newsletters Stradley Ronon Stevens & Young, LLP

[email protected]

The International Association of Defense Counsel serves a distinguished, invitation-only membership of corporate and insurance

defense lawyers. The IADC dedicates itself to enhancing the development of skills, professionalism and camaraderie in the

practice of law in order to serve and benefit the civil justice system, the legal profession, society and our members.


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International Association of Defense Counsel

FIDELITY AND SURETY COMMITTEE NEWSLETTER June 2014


Much has been written about the effects of the

economy upon the construction industry. This Newsletter will focus upon a unique

perspective applicable to the surety context.

Commercial and sometimes residential

construction compels the necessity for a

contractor to obtain a surety bond to

guarantee performance leading to the

successful conclusion of a construction

project. Upon that occasion, a general

contractor will obtain a surety bond from an

authorized underwriter.

In basic terms, a surety bond is a contract

under which one party (surety) guarantees the

performance of certain obligations of the

second party (principal) to a third party

(obligee). Generally in the commercial

context and more specifically for public entity

projects construction contractors provide the

project owner, for which they are performing

operations, with a bond guaranteeing that it

will complete the project by a specified date

set forth in the construction contract in

accordance with all plans and specifications.

Usually one or more in any combination of

the following three types of bonds are

underwritten to secure the contractor’s

performance. The American Institute of

Architects (AIA) is the most common source

of standard construction contracts and bond

forms defining the responsibilities of

contracting parties with respect to

indemnification in the purchase of insurance

coverage. In this context, this Newsletter will

not address contractor’s all risk insurance or

contractor’s professional liability insurance.

Nor will this Newsletter speculate upon the

liability of a producer who places a bond with

an underwriter whose financial strength rating

is less than “secure”.

Three types of bonds are most common.

1. Bid Bond. Issued in conjunction with

construction bidding processes. This

bond acts as a guarantee that, if

awarded the contract based on the bid

submitted, the contractor will enter

into a contract to perform the work at

the price quoted. If the contractor

declines to enter into a contract to

perform the work at the agreed upon

price, the bid bond will reimburse the

obligee (owner) the difference

between the defaulting contractor’s

bid and the next lowest bid, up to the

penal sum of the bond.

2. Performance Bond. This bond

guarantees that the contractor will

perform the work in accordance with

the construction contract. The

purpose is to protect the owner from

financial loss up to the penal sum limit

of the bond should the contractor fail

to fulfill its contractual obligations.

3. Payment Bond. This last bond form

guarantees that suppliers and

subcontractors will be paid for

materials and labor furnished to the

contractor. A project owner generally

insists upon a payment bond that upon

completion, the project is free of

contractor mechanic’s liens.

An essential part of the surety’s underwriting

process is the preparation and execution of a

General Agreement of Indemnity (GAI). The

GAI is akin to a personal indemnification

guaranty. In short, this is a two party contract

between the surety and the principal

(contractor) that if the principal fails to

perform the surety may prosecute a civil

action against the principal in the event the



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surety becomes obligated to pay a portion or

all of the penal sum of the bond. Most GAI’s

provide the surety with measures to protect itself from a decaying situation. Three basic

rights are contained within the GAI:

1. Collateral Security;

2. Inspection of the Principal and

Indemnitor’s financial books and

records; and

3. Settlement of claims without the

approval of the principal.

One of the economic consequences that has

become all too apparent, in circumstances

when a contractor defaults, is usually because

of the poor financial condition of the

contractor. Efforts to exercise the surety’s

rights pursuant to the GAI has more

frequently resulted as a recognized

consequence in this economy, that being the

insolvency of the contractor. If the surety

underwriter has an adverse selection book of

business, the likelihood is over time the surety

will find itself in hazardous financial

condition because it has not been able to

recoup losses from the personal GAI. In part,

this is what has happened to two sureties

fairly recently:

a. First Sealord Surety, Inc., a

Pennsylvania domiciled surety; and

b. Centennial Insurance Company,

domiciled in New York.

Recognizing that other business of insurance

factors may have played a role in the ultimate

financial condition of both companies, be that

as it may, each were ordered into liquidation

by the respective insurance departments

having financial condition oversight. When

that unfortunate event happens, a liquidator is

appointed to manage the runoff of the

insolvent estate. Complicating the issue, is

that some states do not recognize surety as a

line of business eligible for Guaranty Fund

protection. Looking back at the types and

nature of bonds described earlier in this Newsletter, one can see that if the surety is

declared insolvent, further complicated by a

jurisdiction which does not permit a Guaranty

Fund claim, then obligees, project owners,

and even the principal are adversely affected

and subject to risk.

Upon that occurrence, legal intervention to

investigate whether or not the surety has

reinsurance may prove prudent. Reinsurance,

by way of treaty or agreement, is where an

insurance company including a surety,

transfers risk to another insurance company

called a “reinsurer”. Therefore, a reinsurer, in

consideration of a premium paid by the surety

in this example, agrees to indemnify the

reinsured for part or all of the liability

assumed by the ceding company. The legal

focus will concentrate upon a careful

investigation of the treaty provisions in the

reinsurance contract specifically looking for a

“cut through” endorsement. This

endorsement is a provision in the reinsurance

contract that sets forth how the reinsurer will

pay any loss covered by the reinsurance

contract directly to the insured when the

surety is insolvent. This provision is

sometimes called an Assumption

Endorsement and may also contain drop down

properties. However, not all state court

decisions uniformly agree upon the propriety

of drop down principles.

In conclusion, the lawyer and law firm

experienced in undertaking construction law

and surety law matters can perform the

requisite due diligence and risk management

to evaluate a reinsurance agreement to

determine if any of the parties may seek direct

relief from the reinsurer, when a surety is

declared insolvent.



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PAST COMMITTEE NEWSLETTERS

Visit the Committee’s newsletter archive online at www.iadclaw.org to read other articles published by

the Committee. Prior articles include:

MAY 2014

Enforcement of Jurisdiction/Venue Provisions of Indemnity Agreements

Steven Weinberg

APRIL 2014

Enforcing Forum Selection Clauses after Atlantic Marine

G. Steven Ruprecht and Diane Hastings Lewis

MARCH 2014

Bad News for Construction Insurers Might be Good News for Sureties

David W. Kash and Bruce Kahn

NOVEMBER 2013

Getting to Zero: A Method of Projecting Losses on Your Client’s Next Surety Claim

David W. Kash, Bruce Kahn and Steve Leach

AUGUST 2013

Davis-Bacon Act: Subcontractor's Obligation to Pay Prevailing Wages

G. Steven Ruprecht

JULY 2013

Can a Contractor Implead the State in an Action Brought Against it by its Subcontractor?

Charles “Bud” Herman

FEBRUARY 2013

Getting to Zero Through a Great Takeover Agreement

Bruce Kahn and David Kash

OCTOBER 2012

Pay-if-Paid Clauses Valid in Indiana Says the Seventh Circuit

Steven J. Strawbridge and Cade Laverty

JULY 2012

Recent Decision by the United States Supreme Court Dealing with the Statute of Repose

Charles “Bud” Herman




Surety Bonds - A Basic Primer and the Insolvency Twist

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