Surety Bonds: Incorporating the Underlying Contract into the Bond May Require The Surety to Submit to Arbitration

Synopsis: When a surety bond incorporates the underlying contract as part of its terms and conditions, the surety may be required to submit to arbitration or pay attorney’s fees, depending on the terms of the underlying contract, according to a recent case from the United States Court of Appeals for the Fourth Circuit.

A surety must submit its claims to arbitration instead of a court when its bond incorporates its principal's contract by reference and that contract contains an agreement to arbitrate all claims "arising from or relating to" the contract.   In a recent unpublished decision from the United States Court of Appeals for the Fourth Circuit, Great American Insurance Co. v. Hinkle Contracting Corp,, a surety issued a performance bond guaranteeing a subcontractor's performance of its subcontract. When the subcontractor defaulted, the general contractor notified the surety of the default and demanded that the surety pay the general contractor under the terms of the bond. The surety then filed suit asking the court to determine that the surety was not liable under the performance bond based on defenses asserted by the surety.

In response, the general contractor moved to dismiss the suit or to stay the suit until completion of arbitration of the claims. The general contractor argued that, because the performance bond provided that the "subcontract is by reference made a part hereof," including the provision giving the general contractor the exclusive right to demand arbitration, the surety was obliged to submit its claims to arbitration. The trial court determined that the arbitration provision did not apply to the surety's claims and overruled the general contractor's motion. The contractor appealed.

The arbitration provision in the subcontract agreement stated that all claims "arising out of, or relating to the subcontract or breach thereof…shall be resolved by mediation followed by arbitration or litigation," at the general contractor's sole option. In reversing the trial court, the Fourth Circuit noted that arbitration provisions which contain the phrase "arising out of or relating to" or similar language are construed broadly in favor of arbitration of every dispute having a "significant relationship" to the subcontract. The court analyzed the surety's claims and concluded that they bore a significant relationship to the underlying subcontract and that arbitration of the claims was therefore required.

This case exemplifies a couple of established legal principles. First, like the bond in this case, many performance bonds are written to include by reference the terms of the underlying contract or subcontract. When the underlying contract is incorporated in to the bond, the surety becomes obligated to the same extent as its principal for many of the contract obligations, such as arbitration agreements or attorney's fee liability. Without that provision in this bond, the surety would not have been obligated to follow the arbitration clause.

Second, arbitration agreements are favored and routinely enforced. Broad language is interpreted broadly. As the Fourth Circuit noted in this case, "courts must resolve any doubts concerning the scope of arbitrable issues in favor of arbitration."

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