Surety Case Law Note: Bad Faith Statute In Pennsylvania Does Not Apply to Sureties
March 21, 2023
In this Surety Today Blog post we consider a Case Law Note addressing the issue of whether a surety is subject to the Pennsylvania insurer bad faith statute. Spoiler Alert: the answer is no! The case is:
EASTERN STEEL CONSTRUCTORS, INC. V. INT’L FID. INS. CO., 2022 Pa Super 149, 282 A.3d 827, 832–33 (2022), reargument denied (Nov. 9, 2022)
This case covers two relevant subjects for sureties. First, there is a thorough discussion of a surety’s liability for an arbitration judgment against the principal, including attorney’s fees. However, that, in and of itself, is not particularly noteworthy. Second, and the subject of this post, is the court’s ruling on the applicability of the Pennsylvania bad faith statute to a surety, an issue of first impression for Pennsylvania state courts. As a bonus, the court does a great job in the opinion of discussing the distinction between suretyship and insurance.
The case arose from a project for the construction of a science center on the campus of a public university. The university entered into multiple prime contracts, including one with Ionadi Corp. (“General Contractor”) to supply and erect the structural steel. The General obtained surety bonds from IFIC on the AIA A312 (2010) bond form. The General Contractor subcontracted part of the work to Eastern Steel Constructors, Inc. (Eastern). Eastern performed work pursuant to the subcontract. Although the General Contractor timely paid the first five monthly payment requests, it subsequently either did not pay, partially paid, or paid late the remaining payment requests. The irregular payments caused Eastern to suffer cash flow problems. While work was ongoing, Eastern notified IFIC that the General Contractor was in default and requested from the surety prompt payment plus legal and statutory interest. Although the surety made some payments to Eastern, the subcontractor contended that by the end of the project it was still due $253,788, exclusive of interest, attorneys’ fees, costs, expenses and penalties.
After completion of the subcontract work, Eastern filed a demand for arbitration with the General Contractor. Eastern notified IFIC of the arbitration, but the surety declined to participate. On the day the arbitration hearing began, the General Contractor filed for Chapter 11 bankruptcy. Eastern requested the bankruptcy court to lift the automatic stay, which was granted. When the bankruptcy court lifted the automatic stay, Eastern restarted the arbitration. The arbitrator issued an award in favor of Eastern, for both unpaid materials and labor and arbitration fees and expenses, including attorneys’ fees.
The arbitration award was entered as a judgment against the General Contractor in the court. Unable to enforce the judgment against the General Contractor because of the bankruptcy, Eastern sued IFIC asserting multiple counts including breach of contract—enforcement of the arbitration award and bad faith under the Pennsylvania Insurer Bad Faith statute.
Pennsylvania law – 42 Pennsylvania Statutes and Consolidated Statutes Ann. § 8371 (West) provides that:
In an action arising under an insurance policy, if the court finds that the insurer has acted in bad faith toward the insured, the court may take all of the following actions:
(1) Award interest on the amount of the claim from the date the claim was made by the insured in an amount equal to the prime rate of interest plus 3%.
(2) Award punitive damages against the insurer.
(3) Assess court costs and attorney fees against the insurer.
IFIC contended that the statute did not apply because the terms “insurance policy” and “insured” contained in the statute did not apply to sureties or surety bonds. The court noted that the applicability of the bad faith statute to sureties was an issue of first impression for the Pennsylvania appellate courts. The court began its analysis by discussing the traditional rules of statutory interpretation including the rule that the intent of the legislature was to be determined by the plain language of the statute. The court also noted that because the bad faith statute was a “penal provision” it must be construed strictly. According to the plain language of the statute, it was only intended to apply to an action arising under an “insurance policy.” The court observed that the legislative history of the statute revealed that the General Assembly did not engage in any discussions on suretyship or whether it intended to include sureties within the meaning of the term “insurance policy.” Indeed, “insurance policy” is not defined in that section of the statute.
The court consulted Black’s Law Dictionary to determine the ordinary meaning of the statutory terms. “Insurance policy,” was defined as “[a] contract of insurance.” The term “insurance” was defined as “[a] contract by which one party (the insurer) undertakes to indemnify another party (the insured) against risk of loss, damage, or liability arising from the occurrence of some specified contingency.” An insurer is “[s]omeone who agrees, by contract, to assume the risk of another’s loss and to compensate for that loss.” An insured is “[s]omeone who is covered or protected by an insurance policy.”
Further, the court noted that the Pennsylvania Supreme Court in the past had endorsed an understanding expressed by the United States Supreme Court in the well-known case of Pearlman v. Reliance Insurance Co., 371 U.S. 132, 140 n. 19, 83 S.Ct. 232, 9 L.Ed.2d 190 (1962), wherein the Court stated that “the usual view, grounded in commercial practice, [is] that suretyship is not insurance.” The Court continued, explaining that surety bonds are in the nature of commercial guarantee instruments rather than policies of insurance.
The Eastern Steel court observed that suretyship is not subsumed by the definition of insurance and concluded that fundamental differences naturally exist between contracts involving insurance and suretyship and began listing some of those differences. First, the court noted that insurance policies are bilateral contracts where an insurer and its insured share a direct contractual relationship, and the understanding of that relationship is that the insurer will compensate the insured for loss or damage upon proper proof of claim and without resort to litigation. Suretyship contracts, on the other hand, are tripartite in nature where one party, the surety, agrees on behalf of another party, the principal, to make whole a protected party for debts incurred by the other party. In suretyship, the risk of loss remains with the principal while the surety merely lends its credit so as to guarantee payment or performance in the event that the principal defaults.
Second, citing to Bruner and O’Connor, 4A Bruner & O’Connor Construction Law § 12:7 (2021) the court observed that the role of the surety is different from that of an insurer because:
The surety bond is a financial credit product, not an insurance indemnity product;
The surety has a “contractual” relationship with two parties that often have conflicting interests, causing the surety to balance these interests when responding to claims;
The surety bond form customarily is written or furnished by the obligee rather than the surety;
The surety customarily is requested to assure performance of construction contracts that are sufficiently large to warrant bonding and typically are entered into by parties with commercial sophistication, relative parity of bargaining power and access to ample legal and technical advice;
The bond premium usually is paid by the contractor to the surety out of the contract price, rather than directly by the obligee to the surety, although it is not uncommon for obligees to reimburse contractors for the premium; and
The pricing of the premium by the surety is not based upon risk of fortuitous loss, but assumes reimbursement to the surety from the principal and indemnitors for any loss.
Third, the Eastern Court continued, insurers assume risk on the assumption that insurance premiums paid will exceed any loss sustained, whereas sureties attempt to be reasonably certain they will not sustain any loss. This is reaffirmed by the fact that a surety generally will not issue a bond to a principal unless the principal executes an indemnity agreement to indemnify the surety against any losses the surety may sustain.
Fourth, the court observed that special damages for bad faith would be appropriate only in the context of insurance where the parties – the insurer and the insured – share a direct bilateral relationship. However, a surety and a protected party, such as the claimant on a payment bond, share no such direct contractual relationship by which the surety agreed to pay the claimant.
Fifth, the court noted that the bad faith statute is a statutorily-created tort action. It applies only in the context of insurance, excluding claims for breach of an ordinary contract, such as surety bonds. This exclusion is commensurate with Pennsylvania law where punitive damages are awarded typically only in tort actions. Thus, the court reasoned, it would be illogical to extend a bad faith action to ordinary contracts. Put differently, because a surety stands in the shoes of its principal, and an obligee could not have brought a bad faith claim – attendant with a right to seek punitive damages – against the principal, it follows that such a cause of action also should be unavailable against the surety. Permitting an obligee to recover punitive damages against a surety would expose the surety to greater liability than its principal. This would be incompatible with Pennsylvania law, where “it is axiomatic that the liability of a surety is not greater than that of a principal.”
The claimant pointed out that under the Pennsylvania Unfair Insurance Practices Act (“UIPA”), a separate statute, the term insurance policy includes suretyship. The UIPA provides that “Insurance policy … means any contract of insurance, … suretyship … issued, proposed for issuance or intended for issuance by any person.” Eastern claimed that the Bad Faith statute and the Unfair Practices Act are in pari materia. Statutes are considered to be in pari material when they relate to the same persons or things, and statutes or parts of statutes in pari material shall be construed together, if possible. However, the pari materia canon of construction is triggered only if the words of a statute are ambiguous and here the court did not believe that the bad faith statute was ambiguous. Further, under Pennsylvania law “where a statutory term is specially defined in one statute but undefined in a later statute, a court must assume that the omission was intended by the legislature and that the special definition applies only to the one statute and not to the latter statute.”
Accordingly, the court held that the Pennsylvania bad faith statute does not apply to suretyship. It is always good to see a court get the issue of the distinction between suretyship and insurance correct and to see that bad faith exposure did not extend to suretyship.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321 or email@example.com) or any member of the Surety and Fidelity Practice Group.
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