The recent Maryland Court of Special Appeals opinion in the case of Schneider Electric v. Western Surety Company underscores the sometimes problematic interaction of incorporation by reference clauses in surety bonds.

Schneider Electric was engaged to perform work as a subcontractor for a medical facility located in Maryland. The project was administered by the U.S. Army Corps of Engineers. Schneider Electric, in turn, entered into a sub-subcontract with National Control Services (NCS) in accordance with a Master Subcontract Agreement (MSA) between Schneider Electric and NCS. Importantly for present purposes, the MSA included a mandatory arbitration clause.

The MSA also required NCS to provide a performance bond naming Schneider Electric as obligee for 100 percent of the sub-subcontract value, which was $2,050,000. The performance bond was issued by Western Surety and incorporated by reference both the MSA and the sub-subcontract.

As a result of a payment dispute, NCS refused to perform work required by the sub-subcontract with Schneider Electric, notwithstanding a clause in the sub-subcontract which required NCS to “diligently perform the Work … despite the pendency of any dispute ...” Schneider Electric proceeded to hire other contractors to complete what it contended was work that was the responsibility of NCS.

As a result, and pursuant to the MSA, Schneider Electric filed a demand for arbitration against NCS. Schneider’s demand for arbitration also named Western Surety as a respondent. Schneider claimed damages of $1,473,100, plus attorney fees and interest.

Western Surety filed suit to enjoin its participation in the arbitration, contending that—based on the terms of the performance bond—Western Surety was not subject to the mandatory arbitration provision contained in the MSA. The lower court agreed with Western Surety that Western Surety had not agreed to arbitrate claims under the performance bond. Schneider appealed. While the appeal was pending, the arbitration proceeded against only NCS, with an award entered by the arbitrator in favor of Schneider Electric and against NCS in the amount of $1,653,924.21 in damages, attorney fees, arbitrator fees and interest.

The issue on appeal was whether Western Surety was bound to the arbitration provision in the MSA based on the incorporation by reference language contained in the performance bond, even though Western Surety was not a signatory to the MSA.

As a threshold issue, the court noted that the underlying project implicated interstate commerce and considered whether, based on the Federal Arbitration Act, federal common law or state law governed the underlying issue of contract interpretation. In view of a 2009 U.S. Supreme Court case and several subsequent U.S. Court of Appeals’ opinions, the Court of Special Appeals concluded that state law governed, not federal law.

Based on settled Maryland contract law, the court stated that its task was to determine “from the language of the agreement [the performance bond] what a reasonable person in the position of the parties would have meant at the time the agreement was effectuated.” The court then proceeded to review the terms of the performance bond to determine what a reasonable person would have meant at the time the surety bond was entered.

Reaching the Determination

First, the court noted the performance bond referenced that Western Surety was bound to NCS’ performance of the sub-subcontract and the MSA. The court then considered the particular language of the performance bond by which Western Surety bound itself “jointly and severally” to “the performance of the Construction Contract [the sub-subcontract].” The court then also noted that the purpose of the MSA was to “ensure that NCS would ‘perform work’ described in the [subsubcontract].”

In focusing on the terms “performance” and “perform work” in the operative agreements, the court found that Western Surety had obligated itself only to the “performance of the work it agreed to complete and not to every contractual provision in the incorporation by reference chain” of the performance bond, sub-subcontract and MSA.

Second, the court addressed paragraph 9 of the bond, which provides that “any proceeding … under this Bond may be instituted in any court of competent jurisdiction in the location in which the work or part of the work is located and shall be instituted within two years after Contractor default ...” The Court found to hold that arbitration of claims under the performance bond was compelled would be to improperly read this provision out of the bond.

Based on its review of the language of the performance bond, MSA and sub-subcontract, the Court of Special Appeals upheld the decision of the lower court and found that Western Surety was not compelled to arbitrate with Schneider Electric its obligations under the performance bond in the event of default by NCS. The Court of Special Appeals opinion in the Schneider Electric opinion presents several helpful practice pointers.

Lessons Learned

First, if a party wants claims under a surety bond to be arbitrated consistent with the underlying contract, it should provide that all of the terms and conditions of the underlying contract are incorporated into the bond and not just provisions that relate to the performance of the work.

Second, in the event that the underlying contract does not provide that all of the terms are incorporated, a party should review the surety bond that is supplied and, if there is any issue as to whether arbitration is compelled, require the surety to agree to a rider to the surety bond incorporating the dispute resolution clause of the underlying contract.

Finally, if the surety objects to arbitration and there is any question as to whether the bond provides for arbitration of disputes, a party should file a protective civil action in the appropriate court against the surety and then move to stay the civil action pending the outcome of the arbitration. At the same time, the party should invite the surety in writing to observe and participate in the arbitration.

The purpose of this approach is twofold:

1. the filing of the action avoids any risk that any contractual or statutory time period for filing against the bond (usually one year or two years) will expire and allow the surety to escape its obligations on a technicality; and
2. the invitation letter strengthens the contractor’s claim that the surety is bound by the underlying liability finding from the arbitration pursuant to the doctrine of collateral estoppel.