Many general contractors are involved in projects that require the posting of payment and performance bonds. These bonds are put in place to protect the project owner, subcontractors and suppliers by putting the financial strength of a surety behind the general contractor’s obligations to perform the work and make payments for the project.

However, the bonding arrangement is frequently misunderstood by construction company owners who may overlook the fact that, unlike insurance, the general contractor and its principals must pay the surety back if it pays a claim brought by a protected party under a general indemnity agreement. On the other side of the fence, sureties may also overlook their obligations in the claim review process (or perhaps not employ best practices) before paying out on claims and seeking repayment under the general indemnity agreement (GIA), resulting in legal disputes over whether the terms of the GIA can be enforced.

A GIA is a contract between the surety and principal (and other indemnitors) which obligates the indemnitors to protect the surety from any loss or expense sustained because of payment on bond claims. GIAs are commonplace in the construction industry and the agreement is the primary difference between a surety bond and traditional insurance policy.

The agreements are the product of a surety’s review of the principal’s financials and operations and, in additional to a corporate guarantee, require personal guarantees from the individuals who control the principal (as well as investors, spouses or subsidiaries/affiliates). In short, in exercising its due diligence, the surety does not expect to suffer a loss from issuing the bond. And traditionally, GIAs have been impenetrable; if the surety suffers a loss, the indemnitor is on the hook1.

Central to most disputes involving GIAs is the validity of the surety’s decision to settle or pay out claims made under a bond. Sureties cite to so-called “prima facie evidence”2 and “right-to-settle”3 clauses in their GIAs, which courts have routinely upheld and enforced according to their terms. Put another way, sureties have wide discretion to settle claims made under a payment bond.

However, a surety’s discretion is not unlimited. Most jurisdictions recognize a duty of good faith and fair dealing inherent in contracts between sureties and their principals and will only enforce claims to recoup payments made under a bond pursuant to a GIA where the payments were made in good faith4. What constitutes a breach of the duty is where the battles are waged. “Bad faith,” “absence or lack of good faith,” or the “breach of the duty of good faith and fair dealing” and the burden of proof necessary therefore depends on the situs of the action.

In many jurisdictions, bad faith requires proof beyond simple negligence: It is the product of an improper motive or dishonest purpose – intentional conduct which presents a high bar to overcome5. However, in certain jurisdictions, courts have loosened the standard for an indemnitor’s bad faith defense, flipping the narrative (and burden) to whether the surety acted in good faith in deciding to pay on a bond claim. For example, in Maryland, the considerations in determining whether a surety made a reasonable, good faith settlement under the terms of the bond and GIA include:

• the obligations of the surety as provided by the terms and coverage of the bond;
• whether the principal has made more than generalized demands that the surety deny the claim;
• the cooperation, or lack thereof, by the principal, in dealing with the surety; and
• the thoroughness of the investigation performed by the surety6.

At the extreme end of the spectrum, some courts will apply an objective negligence standard – again with the burden on the surety to show that decision was reasonable7.

Regardless of whether an affirmative defense or claim to void an obligation under a GIA requires evidence or proof of fraud, improper motive and a dishonest purpose, unreasonable conduct or negligence, the first and most relevant question asked is whether the surety conducted a proper or reasonable investigation before deciding to settle claim. And, ultimately, conduct that might, or might not, disallow a principal’s obligation under a GIA on the issue of bad faith (or the absence of good faith) is a fact-intensive inquiry. Because of this, and regardless of the jurisdiction, when deciding whether to pay on claim, sureties should:

• perform a thorough and objectively reasonable investigation of the merits of the claim;
• communicate concerns with the principal’s defenses and invite or entertain a meaningful discussion with the principal; and
• thoughtfully explain the basis for a decision to allow payment on claim.

Similarly, general contractors should remain cognizant of the existence of and the obligations under the GIA, make themselves heard or otherwise seek an active role in the claim review process, and ultimately acknowledge that the obligation to repay the surety will remain, absent extraordinary circumstances.