by Kirsten Roe, Associate

Introduction

This is Part II of III discussing indemnitors’ counterclaims against sureties.  Part I of this discussion, previously published in the Winter-Spring 2005 issue of From the Ground Up, considered counterclaims for "bad faith" which a surety may confront when enforcing its general agreement of indemnity ("GAI") against its indemnitors for claims and losses on its bonds.  As stated in that Part I, when it comes time to reimburse the surety for its bond losses, some indemnitors will wrongfully challenge the surety with a "bad faith" counterclaim, i.e., a cross-action which alleges that the surety did not act in "good faith" towards its principal.  The claim may be that the surety made payments to claimants that the surety did not have to incur (i.e., payments not made in "good faith"), or that the surety increased its own loss under its bonds either intentionally or negligently, and/or allegedly took some action to interfere "wrongfully" with the principal’s business or construction contracts which, in turn, created or exacerbated the loss.  In California, at least, after the seminal decisions of Schmitt v. Ins. Co. of North America, 230 Cal.App.3d 245 (1991) and Cates Construction v. Talbot Partners, 21 Cal.4th 28 (1999), such "bad faith" counterclaims appear to have met their demise.

Now, with Part II of this article, the discussion turns to other types of causes of action an indemnitor may assert with a counterclaim against the surety.  Such counterclaims may be for breach of contract based on the surety bond as a contract, or breach of the terms of the GAI, or breach of alleged verbal contracts.  Part III of this article, in an upcoming issue of From the Ground Up, will discuss tortious interference claims against sureties, sometimes referred to as the new "bad faith" counterclaim.


Part II – Indemnitors’ Breach of Contract Counterclaims

As introduced above, another avenue which indemnitors use to attempt to avoid their obligations to the indemnified surety is a counterclaim for "breach of contract".  Allegations of breach of the GAI are the most common grounds for indemnitors’ breach of contract counterclaims.  Indemnitors have also added a few variations on the breach theme, namely, breach of the surety bonds themselves as written contracts, and breach of supposed extraneous verbal agreements alleged to have been created between the principal and indemnitors.

•    Breach of the GAI

Indemnitors’ breach of contract counterclaims based on the GAI typically allege that the surety has taken some action or failed to act and thereby breached the GAI.  Many times, however, the indemnitor fails to allege which specific term of the GAI was breached.  The simple reason for this common pleading failure is that the surety’s GAI terms expressly permit most, if not all, of the surety’s actions which the indemnitors allege to be in breach of the contract.  That is, depending on its terms, the GAI usually grants the surety broad rights to protect its interests, including the right to take possession of its principal’s contracts, contract funds, and other property; the right to be collateralized and indemnified by the indemnitors; the right to issue hold funds letters to project owners to protect its rights; the right to decline to issue bonding for the principal; the right to record the GAI as a financing statement to secure its rights, among other rights, all as spelled out in the GAI.

The courts will generally enforce such provisions of the GAI in favor of the surety.  Consequently, courts have recognized that the terms of the GAI giving the surety the right to adjust, settle or compromise any claim on any surety bond issued by that surety, and the right to act as the principal’s attorney-in-fact are "incidents of an ordinary surety-principal relationship".  Schmitt, supra, 230 Cal.App.3d at 256.  Courts that have been called upon to consider the GAI, including two Ninth Circuit courts, have routinely enforced a surety’s rights, including the right to specific performance of the GAI.  See, e.g., Safeco Ins. Co. of America v. Schwab, 739 F.2d 431,433 (9th Cir. 1984); Milwaukie Construction Co. v. Glens Falls Insurance Co., 367 F.2d 964 (9th Cir. 1966); General Ins. Co. v. Howard Hampton Inc., 185 Cal.App.2d 426 (1960).  More than once, the Ninth Circuit has noted, "[t]here can be no question but that a surety is entitled to stand upon the letter of his contract, and his undertaking is to be construed strictly in his favor." Com’l Ins. Co. of Newark v. Pacific-Peru Construction Corp., 558 F.2d 948, 953 (9th Cir. 1977).  See, e.g., Safeco Ins. Co. of America v. Schwab, 739 F.2d 431, 433 (9th Cir. 1984); Milwaukie Construction Co. v. Glens Falls Ins. Co., 367 F.2d 964 (9th Cir. 1966).  Indeed, Schmitt, supra, 230 Cal.App.3d at 256 makes it clear that the rule is that a surety is entitled to enforce its GAI and, equally important, that a surety’s liability is set by the terms of the contract:

[A] surety on an official bond undertakes no liability for anything which is not within the letter of his contract.  The obligation is strictissimi juris; that is, he has consented to be bound only within the express terms of his contract and his liability must be found within that contract or not at all. 

Thus, by its very terms, the GAI will often render the indemnitor’s counterclaim nonactionable when premised on a theory of breach of the GAI.

•    Breach of Payment or Performance Bond

As an alternative to a breach of the GAI counterclaim, an indemnitor’s counterclaim may allege a cause of action based on a claimed breach of the payment or performance bonds as written contracts; sometimes referred to as a breach of bond action.  Under California law, however, this is a likely dead end for indemnitors.  The terms of the bonds do not inure to the benefit of the principal or the indemnitors, and as stated in Schmitt, supra, and Cates, supra, the surety owes no special duty to either the principal or even the obligees under the bonds; the surety’s obligations being limited to the express terms of the bonds and implicated only in the event of non-performance by the principle to the obligee.  In sum, while this cause of action appears to be premised on the notion that the bond is some kind of insurance policy for the benefit of the principal or indemnitors, such a cause of action cannot be maintained under California law; that law holding that surety bonding is not insurance and does not give rise to special insurance-like duties.  Schmitt, supra, 230 Cal.App.3d 245; Cates, supra, 21 Cal.4th 28. See also, Lumbermans Mutual Casualty Co. v. Agency Rent- A-Car, Inc., 128 Cal.App.3d 764, 769 (1982) ("A surety bond is not an insurance policy").

•    Breach of Alleged Verbal Contracts Extraneous to the GAI

A surety, being essentially a financial institution, has zero economic incentive to stray from the GAI, the terms of which run wholly to its benefit and grant it broad rights to protect its interests.  Indemnitors, however, do sometimes assert, in good faith or otherwise, alleged verbal agreements extraneous to the GAI which they claim were entered into between the indemnitors and the surety.  The non-performance of the purported verbal agreement becomes the basis of the indemnitor’s counterclaim.  For the purposes of responding to such a counterclaim, the surety should look to the fundamentals of contract law.

First, a GAI routinely includes an integration clause and limits modification of the GAI to signed writings.  An integration clause, in conjunction with the parol evidence rule, will, typically, bar an indemnitor’s assertion of verbal agreements alleged to have been created contemporaneously with the execution of the GAI.  See, e.g., Banco do Brasil, S.A. v. Latian, Inc., 234 Cal.App.3d 973 (1991) (finding it not only an "incredible proposition" that a bank would make a "cavalier oral commitment" outside of the subject written agreement, as alleged by the counterclaimants, but also that the existence of such an oral commitment was expressly denied by the contract which contained an integration clause).

Alternatively, if the indemnitors claim that the alleged verbal agreement was entered into after execution of the GAI rather than contemporaneously, the analysis is two-part; the integration clause again being the first crucial step, followed by the common GAI clause permitting modification only by a signed writing.

Even without regard to the express terms of the GAI, the rule in California is that a written contract can only be modified by a contract in writing.  A contract in writing may be subsequently modified by an oral agreement only if (i) the written contract does not contain an express provision requiring that modification be in writing; and (ii) such oral agreement has been performed by the parties or, as an executory oral agreement, it is supported by a new consideration.  California Civil Code section 1698.  Marani v. Jackson, 183 Cal.App.3d 695, 701, 704 (1986).  As described in Marani, supra, 183 Cal.App.3d at p. 704, at the very least, an oral agreement which is executory in nature and which is proposed as a modification to a written agreement must be supported by new consideration to be a valid modification of a written agreement.  In most cases, the GAI is the only agreement, and there has been no separate oral agreement or any separate consideration for any supposed separate verbal contract.  See also, Marinovich v. Kilburn, 153 Cal. 638, 642 (1908) (holding that "an agreement to do, or the doing of, that which one is already bound to do, does not constitute a consideration for a new promise.") The GAI thus provides not only the full understanding between the indemnitors and sureties with respect to the obligations described therein, but furthermore, is integrated with respect to the methods and ability of a party to change the agreement or to make separate promises.  See Marani, supra.

Moreover, California common law expressly holds that where a written contract contains an express clause providing that no modification may be made other than in writing, all allegations of a supposed oral modification are to be stricken by the court and disregarded as a matter of law.  See Marani, supra, 183 Cal.App.3d at 705.  See also, Beggerly v. Gbur, 112 Cal.App.3d 180, 189 (1980) (holding that where "the written agreement expressed a clear intent to preclude oral modification of the kind claimed…a modification which directly contradicted the terms of the written contract", that attempted modification will be incapable of being stated as a matter of law, stricken and disregarded from the counterclaim).

Consequently, a motion to dismiss, together with a motion to strike can be effective to expunge an indemnitor’s improper allegations of an alleged verbal contract when the GAI includes an integration clause and a clause that no modification may be made to the GAI except by signed writing.

Conclusion

At the outset, no indemnitor expects to be called upon later to make good on a surety’s bond losses.  When the call is issued, however, sureties must be ready to defend their actions.  The terms of the GAI and the fundamental principles of contract law are oftentimes the best defense against indemnitors’ bad faith "whines".  The final part of this article, Old "Whine" in New Bottles: Indemnitors’ Counterclaims Against Sureties in California, will be included in a subsequent edition of From the Ground Up.


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