Surety Case Law Note: Whether an Arbitration Provision Bound the Surety Under Texas Law
September 19, 2023
In this Surety Today blog post we will provide a Case Law Note to consider the issue of whether an arbitration provision in the underlying contract was binding on the surety under Texas law. The case is:
TRANS-VAC SYS., LLC v. HUDSON INS. CO., No. 08-22-00232-CV, 2023 WL 4146295 (Tex. App. 6/23/23)
A general contractor, on a project for the US Army Corps of Engineers, contracted to build a new healthcare complex at the Fort Bliss Army Base in El Paso, Texas (the Project). The GC hired Trans-Vac Systems, LLC (Trans-Vac) to construct a pneumatic laundry service for the complex. In turn, Trans-Vac contracted with MGB Group, Inc. (MGB) to perform a portion of the work. Hudson Insurance Company (Hudson) issued performance and payment bonds for MGB. The Subcontract required that in the event of a dispute between Trans-Vac and MGB an arbitration was required pursuant to the terms of the Federal Arbitration Act (FAA) and under the American Arbitration Association’s (AAA) rules. The performance bond itself did not contain an arbitration provision, however, the Subcontract was incorporated by reference into the performance bond.
MGB completed a portion of its work, however, it subsequently defaulted. Trans-Vac sent a formal notice to MGB regarding its default under the Subcontract, giving it 24 hours to take corrective action. When MGB failed to take corrective action, Trans-Vac chose to complete the work through a different subcontractor and thereafter charge the costs of completion to MGB. However, the record did not indicate that Trans-Vac notified Hudson of MGB’s default at that time.
Almost two years later, Trans-Vac sent a letter formally notifying Hudson of MGB’s default and advising Hudson that it had hired another subcontractor to perform MGB’s remaining work on the Project at a cost of $1,058,966. This was a $600,000 Subcontract and over $200,000 had been paid out at the time of default.
In response, Hudson sent a letter to Trans-Vac denying the claim advising that because it had failed to provide Hudson with timely notice of MGB’s default, Hudson was prejudiced from exercising its bargained-for-right to mitigate damages by arranging for the completion of the work under the Subcontract.
Several years later, Trans-Vac filed a demand for arbitration against Hudson with the American Arbitration Association (AAA). Hudson objected to the arbitration and refused to participate. Subsequently, Hudson filed a complaint for declaratory relief in court asserting that Trans-Vac’s claim against Hudson’s performance bond was time-barred and that Trans-Vac’s claim against Hudson’s bond was not subject to arbitration because Hudson did not have an arbitration agreement with Trans-Vac. Trans-Vac filed a response to Hudson’s petition and also filed a counterclaim against Hudson and a motion to compel arbitration. The trial court denied Trans-Vac’s motion to compel arbitration.
Trans-Vac appealed the denial of its motion to compel arbitration, arguing that Hudson was bound by the arbitration provisions in the Subcontract based on the Subcontract’s incorporation by reference in the Performance Bond.
Under Texas law, a party seeking to compel arbitration has the burden to prove that (1) a valid and enforceable arbitration agreement exists, and (2) the claims raised fall within that agreement’s scope. J.M. Davidson, Inc. v. Webster, 128 S.W.3d 223, 233 (Tex. 2003); see also Rachal v. Reitz, 403 S.W.3d 840, 843 (Tex. 2013); In re Rubiola, 334 S.W.3d 220, 223 (Tex. 2011). The question of whether a valid and enforceable agreement exists includes proving that both parties consented to the agreement. See Aerotek, Inc. v. Boyd, 624 S.W.3d 199, 204 (Tex. 2021). Thus, although the law generally favors arbitration, it does not create an obligation to arbitrate where none exists; arbitration is a “matter of consent, not coercion,” and a party may not be compelled to arbitrate where it has not consented to do so. See Volt Info. Scis., Inc. v. Bd. of Trs. of Leland Stanford Junior Univ., 489 U.S. 468, 478 (1989); In re Kellogg Brown & Root, Inc., 166 S.W.3d 732, 737 (Tex. 2005).
Once the moving party establishes a valid and binding arbitration agreement, a presumption exists that the parties’ dispute falls within the scope of the agreement, and “courts must resolve any doubts about an arbitration agreement’s scope in favor of arbitration.” See In re FirstMerit Bank, N.A., 52 S.W.3d 749, 754 (Tex. 2001); see also Rubiola, 334 S.W.3d at 225 (in determining the agreement’s scope, courts employ a “strong presumption in favor of arbitration”). Nonetheless, “the strong policy in favor of arbitration cannot serve to stretch a contractual clause beyond the scope intended by the parties or to allow modification of the unambiguous meaning of the arbitration clause.” Carter v. ZB, Nat’l Ass’n, 578 S.W.3d 613, 619 (Tex. App.—Houston [14th Dist.] 2019, no pet.).
In determining the scope of an arbitration provision within a contract, a court “must examine and consider the entire writing in an effort to harmonize and give effect to all the provisions of the contract.” FirstMerit Bank, 52 S.W.3d at 754 (citing J.M. Davidson, 128 S.W.3d at 229). Even though the arbitration clause wording may be broad, language elsewhere in the agreement may limit its scope. Id. Normally, because arbitration is contractual in nature, only parties to an arbitration agreement can be compelled to arbitrate. See Kellogg, 166 S.W. 3d at 737–39 (citing Bridas S.A.P.I.C. v. Government of Turkmenistan, 345 F.3d 347, 356 (5th Cir. 2003)); see also Rubiola, 334 S.W.3d at 224 (Tex. 2011) (ordinarily, “parties must sign arbitration agreements before being bound by them”). However, Texas courts have long recognized the six theories, arising out of common principles of contract and agency law, that may bind non-signatories to arbitration agreements: “(1) incorporation by reference; (2) assumption; (3) agency; (4) alter ego; (5) equitable estoppel, and (6) third-party beneficiary.” Kellogg, 166 S.W.3d at 739; see also Taylor Morrison of Tex., Inc. v. Ha, 660 S.W.3d 529, 532 (Tex. 2023). In this case, Trans-Vac relied solely on the theory of incorporation by reference, pointing out that the Subcontract containing the arbitration provision was incorporated by reference into the Performance Bond. The court noted that this issue was a “gateway” question for the court to determine. In re Labatt Food Serv., L.P., 279 S.W.3d 640, 643 (Tex. 2009); In re Weekley Homes, L.P., 180 S.W.3d 127, 130 (Tex. 2005).
The appellate court agreed with Hudson that the parties’ general intent in incorporating the Subcontract into the Performance Bond was to make Hudson aware of MGB’s contractual obligations that it was undertaking to guarantee. See AgGrow Oils, L.L.C. v. Nat’l Union Fire Ins. Co. of Pittsburgh, PA, 242 F.3d 777, 781 (8th Cir. 2001). The court noted that if Hudson had undertaken to perform it would have “stood in the shoes” of MGB and would have been subject to the arbitration provision, however, Trans-Vac did not give Hudson the opportunity to remedy MGB’s default; instead, it remedied the default itself. Thus, the only pending dispute between the parties was whether Trans-Vac fulfilled its obligation to make a timely demand for payment under the terms of the Performance Bond. The court held that “[u]nder these circumstances, Hudson cannot be said to stand in MGB’s shoes for the purposes of litigating this particular dispute.” See Dobson Bros. Constr. Co. v. Ratliff, Inc., No. 4:08CV3103, 2009 WL 806800, *11 (D. Neb. Feb. 27, 2009) (rejecting the argument that a surety “stands in the shoes” of its principal when the surety never assumes the principal’s duties, as a surety bond is not the same as an insurance policy); Weaver & Tidwell, L.L.P. v. The Guarantee Co. of N. Am. USA, No. 05-10-00557-CV, 2011 WL 635261, at *3 (Tex. App.—Dallas Feb. 23, 2011, no pet.) (mem. op.) (holding that a surety did not stand “in the same shoes” as its principal—and therefore was not subject to the terms of an arbitration clause in an agreement between the principal and the defendant—where the surety’s claim was not based on any of the terms or requirements of the contract containing the arbitration clause and was instead based on an independent tort claim for fraud and breach of fiduciary duty).
The appellate court further agreed with Hudson that the Subcontract’s incorporation by reference into the Performance Bond did not automatically give rise to an inference that Hudson consented to arbitrate disputes relating solely to whether Trans-Vac complied with the Performance Bond terms. AgGrow Oils, 242 F.3d at 781 (mindful that arbitration is a matter of consent, not coercion, court was “unwilling to construe an incorporation clause whose obvious purpose was to clarify the extent of the surety’s secondary obligation as also reflecting a mutual intent to compel arbitration of all disputes between the surety and the obligee under the bond”). The court noted that other courts have distinguished disputes arising from the parties’ performance obligations in an underlying construction contract from those arising solely from a violation of the terms of a performance bond. See, e.g., Id.; see also Fid. & Deposit Co. of Maryland v. Parsons & Whittemore Contractors Corp., 48 N.Y.2d 127, 131, 397 N.E.2d 380, 382 (1979) (distinguishing between disputes arising from the parties’ obligations in the underlying construction contract and disputes arising solely under performance bond terms); Gloucester City Bd. of Educ. v. Am. Arbitration Ass’n, 333 N.J. Super. 511, 523, 755 A.2d 1256, 1262 (App. Div. 2000) (distinguishing between claims relating to the parties’ performance obligations under a construction contract and those involving the surety’s personal defenses arising from the bond provisions).
In this case, since the only dispute between the parties was Hudson’s affirmative defense that Trans-Vac’s claim for payment was time-barred by the Performance Bond terms, i.e., a “unique” bond defense, the court examined the arbitration provision itself to determine if the parties intended for that particular dispute to be subject to arbitration.
The court looked at the issue of the distinction between an agreement that contains “broad” and “general” language indicating that it applies to “any claims arising from or relating to the contract” and an agreement that contains “specific” or “narrow” language demonstrating an intent to only bind the signatories to the agreement. Hudson argued that numerous courts have held that when an arbitration agreement specifies the parties to whom it applies, e.g., the contractor and subcontractor, a different analysis applies. In that instance, if the dispute between the surety and the contractor does not involve performance issues under the contract, and instead only involves issues relating to the terms of the performance bond, then the dispute does not fall within the scope of the arbitration agreement.
The court noted that the distinction between general and specific arbitration agreements has been generally recognized in Texas case law as a factor in determining the agreement’s intended scope. See Greystone Multi-Family Builders, Inc. v. Tes Elec., LP, No. 01-15-00640-CV, 2016 WL 3362208, at *5 (Tex. pp.—Houston [1st Dist.] June 16, 2016, no pet.); Granite Re, 2015 WL 1869216, at *5. The Subcontract arbitration provision by its terms applied to Trans-Vac and MGB specifically. The appellate court held “Given the specific language in the Subcontract requiring only Trans-Vac and MGB to engage in the dispute resolution provisions with regard to disputes between them, we conclude that the contract does not reflect the parties’ intent to require Hudson to arbitrate its disputes with Trans-Vac arising solely under the Performance Bond.” The court also noted that the Performance Bond terms confirmed that the parties did not intend for Hudson’s unique bond defenses to be subject to arbitration. The Performance Bond stated, “[a]ny suit under this bond must be instituted before the expiration of two years from date on which final payment under the subcontract falls due.” A rider to the bond also provided that Chapter 2253 of the Texas Government Code applied and that a dispute regarding a Performance Bond issued under that Chapter for a public work project must be brought in a court in the county in which the project was located.
The appellate court held “[a]ccordingly, we find no language in either the Subcontract or the Performance Bond that convinces us that the parties intended to submit disputes between Hudson and Trans-Vac arising under the Performance Bond to arbitration. And in the absence of any such language, Hudson cannot be coerced into giving up its right to a judicial resolution of this dispute with Trans-Vac.” The court therefore affirmed the denial of the motion to compel arbitration.
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.