Out With The Old In With The New – Novation
October 4, 2022
In this Surety Today Blog post we will consider the doctrine of novation. Many times over the course of my career I have run into the situation where the surety has multiple indemnity agreements that relate to a particular default. Sometimes, the multiple agreements arise because the surety is just updating from an old form agreement to a new form. Sometimes new indemnitors are being added and sometimes indemnitors that were on the original agreement are not signatories to the new agreement – some drop off, some add on. Most recently, I had the situation where there was an original indemnity agreement executed in 2012 by the then husband and wife and their contracting company in which both were officers. Then, five years later a new indemnity agreement was executed by the husband and the original company and with a new corporate indemnitor added. The wife was not a signatory to the new agreement. It turns out the husband and wife were separated and she was no longer involved with the original company and had no involvement in the new company. As luck would have it, the new entity on the new indemnity agreement was the principal on several bonds that went into default and the wife that did not sign the new indemnity agreement was the only solvent indemnitor. So, an indemnity action was instituted against the wife and the other indemnitors.
Naturally, the wife filed a motion to dismiss asserting that she was no longer liable because the new indemnity agreement was a novation and the old indemnity agreement was no longer valid. We defeated her motion to dismiss thanks in large part to the language of the two indemnity agreements that made it very clear that neither agreement was intended to replace the other. So, I thought it would be a good idea to discuss the law of novation in case you run into this type of issue in the future. In addition, novation can come up in more circumstances than just multiple indemnity agreements. For example, if the surety enters into a settlement agreement where the principal and surety are settling with an obligee or other claimant. Sometimes the broad language of a release could be construed as a novation of the indemnity agreement between the surety and principal. Another example could be a takeover agreement where the surety and indemnitor are both signatories, it is possible that the broad language of the integration clause in an agreement could give rise to a novation argument. Accordingly, the surety must be aware of novation and guard against an inadvertent application of the doctrine.
To establish a novation, a party must prove that there was a valid original agreement, that all or some of the parties to the original agreement entered into a valid new agreement and that there was intent for the new agreement to extinguish the original agreement. I. W. Berman Props. v. Porter Bros., Inc., 276 Md. 1, 7 (1975); Young v. Benton, 131 P. 1051, 1052 (Cal. Ct. App. 1913); Miran v. Convergent Outsourcing, Inc., No.: 3:16-CV-00692-AJB-JMA, 2017 WL 1410296, at *3 (S.D. Cal. Apr. 20, 2017). A novation can only arise when a new contract is made with the intent to extinguish an existing contract. I. W. Berman Props., 276 Md. at 7; BarGale Industries, Inc. v. Robert Realty Co., Inc., 275 Md. 638, 646 (1975); Leisner v. Finnerty, 252 Md. 558 (1969); District Nat’l Bank of Washington v. Mordecai, 133 Md. 419 (1919); Wells Fargo v. Bank of Am., 38 Cal. Rptr. 2d 521, 525 (Cal. Ct. App. 1995) (“Pursuant to California law, a ‘novation is the substitution of a new obligation for an existing one.’”) (quoting Cal. Civ. Code § 1530). Thus, to establish a novation, a party must demonstrate that there was intent among the parties to extinguish the old obligation and substitute a new one for it. Adler v. Walker & Dunlop, Inc., 245 Md. 153, 159 (1967); also Noor v. Katz, No. B275176, 2017 WL 4129026, at *2 (Cal. Ct. App. Sept. 19, 2017). The burden of proof will be on the party asserting the novation. Holzman v. Fiola Blum, Inc., 125 Md. App. 602, 627 (1999); Howard v. Cty. of Amador, 220 Cal. App. 3d 962, 977, 269 Cal. Rptr. 807, 817 (Ct. App. 1990).
To determine the intent of the parties the courts will typically look to the language of the two contracts. In my case, the original indemnity agreement noted that it was a continuing agreement and the language clearly contemplated subsequent agreements and the possibility of additional indemnitors. Similarly, the later indemnity agreement clearly stated that the agreement was in addition to any other agreements and that it was not intended to replace any other agreements. Thus, the best defense to a novation argument is clear language in the agreements. In the context of a settlement agreement or takeover agreement, the best practice is to add a paragraph expressly preserving the surety’s rights under the indemnity agreement.
In situations where one or more of the original indemnitors is not a signatory to the later agreement, courts throughout the country that have considered the effect of a later indemnity agreement have rejected the novation argument. Dahl v. Brunswick Corp., 277 Md. 471, 482–84 (1976) (citations omitted). For example, in National Surety Corp. v. Prarieland Construction, Inc., 354 F. Supp. 2d 1032 (E.D. Mo. 2004), indemnitors on an earlier indemnity agreement argued that a subsequent indemnity agreement that omitted them as signatories acted as a novation that released them from liability. 354 F. Supp. 2d at 1038. The court /disagreed, stating that “[n]o reasonable factfinder could conclude from this evidence, even drawing all inferences in favor of the [indemnitor defendants], that National Surety intended to release them from their obligations under the 1999 agreement.” Id., see also Fed. Ins. Co. v. C.D. Henderson Inc., No. A-07-CA-982-SS, 2009 WL 10635909 (W.D. Tex. Jan. 27, 2009), modified on reconsideration, No. A-07-CA-982-SS, 2009 WL 10670098 (W.D. Tex. Feb. 20, 2009) In Polartec, LLC v. 180S, LLC, No. CIV. CCB-07-2396, 2009 WL 905609, at *5 (D. Md. Mar. 27, 2009), the Court noted that Maryland courts have found a novation only where there is evidence establishing a clear and definite intent to extinguish the original obligations, and that a change of parties alone is not enough to demonstrate that intent.
Finally, in my case, the indemnity agreement had an express provision for terminating an indemnitor’s obligation under the agreement. But the original indemnitor failed to take any steps to terminate her obligations. In United Pac. Ins. Co. v. Johnson-Gillanders Co., 280 F. Supp. 90 (D.N.D. 1968), the Court stated that “[a] contract of indemnity continues in force during the time provided by its terms.” 280 F. Supp. at 94 (citing Employers Mutual Casualty Co. v. Piedmont Supply Co., 197 F. Supp. 159 (M.D.N.C. 1961); Employers’ Liability Assurance Corporation v. Tebbs, 137 F. Supp. 869 (D. Wyo. 1956). The Court further observed that upon execution of the agreement of indemnity the indemnitors knew that it was a continuing obligation and could only be terminated by sending written notice of withdrawal to the surety as provided in the agreement. In Allstate Enterprises, Inc. v. Heriford, 772 P.2d 466, 469 (Utah Ct. App. 1989), the court in denying a novation argument held that the failure of the indemnitor to give the required notice resulted in the indemnitor continuing to be bound under the indemnity agreement and such failure was evidence of intent to continue to be bound. Id.
Every surety claims handler needs to have a good awareness of the doctrine of novation so that you can make sure in any subsequent agreements involving the surety, principal and/or indemnitors, that steps are taken to preserve pre-existing agreements, especially the general indemnity agreement.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321/mstover@wcslaw.com) or any member of the Surety and Fidelity Practice Group.