The Surety and Arbitration
September 26, 2023
In this Surety Today blog post we will continue with the theme of the last two blog posts and focus on arbitration.
Arbitration is a form of alternative dispute resolution in which the parties contractually agree to submit their dispute to an arbitrator, or panel of arbitrators, for resolution. Because arbitration is a consensual dispute resolution method, the form of the arbitration can be dictated by the parties. Many contracts specify the rules and procedures that have been developed by the American Arbitration Association (“AAA”) and in particular the Construction Industry Arbitration Rules and Mediation Procedures. The AAA is a public service, non-profit organization that offers a range of dispute resolution services to many industries, including the construction industry. The format of an arbitration is more like a trial court proceeding, but depending on the rules adopted by the parties, can be substantially less formal than a court trial proceeding, especially with respect to the application of the rules of evidence.
In the early days, arbitration was disfavored by the courts and was viewed as an interference or an infringement on the jurisdiction of the courts. However, in more modern times, the pendulum has swung to the opposite extreme with courts sometimes stretching and straining to uphold arbitration agreements wherever possible and even finding agreements where it appeared none existed.
The majority of the states have enacted some version of the Uniform Arbitration Act. The Uniform Act provides for the validity and enforceability of arbitration agreements, gives arbitrators the authority to issue subpoenas, compels witness testimony and generally addresses such issues as (i) the process for challenging whether an agreement to arbitrate exists; (ii) the appointment of arbitrators; (iii) hearings; (iv) awards; (v) fees; and (vi) vacating awards, etc. Generally, an arbitration award under the Uniform Arbitration Act can only be vacated where:
(1) The award was procured by corruption, fraud or other undue means;
(2) There was evident partiality by an arbitrator, corruption or misconduct by any of the arbitrators;
(3) The arbitrators exceeded their powers or authority; or
(4) The arbitrators unjustifiably refused to postpone a hearing or refused to hear evidence material to the controversy or otherwise conducted the hearing so as to substantially prejudice the rights of a party.
In Rhode Island the statute permitting arbitration expressly includes the surety in the arbitration if the claimant under a payment or performance bond is a party to a written contract with a provision for arbitration. The Rhode Island Arbitration Act provides that:
[i]f a contractor principal on a bond furnished to guarantee performance or payment on a construction contract and the claimant are parties to a written contract with a provision to submit to arbitration any controversy thereafter arising under the contract, the arbitration provisions shall apply to the surety for all disputes involving questions of the claimant’s right of recovery against the surety.
R.I.G.L. § 10-3-21(a).
In some other states, statutes can expressly exclude from arbitration contracts of “insurance,” which can be defined to include sureties. Thus, the argument could be made that such statutes exclude compelling the surety to arbitrate. The federal government enacted the Federal Arbitration Act – 9 U.S.C.A. § 1 et seq. (the other “FAA”). The FAA applies to any written contract involving “commerce” in which the parties agree to arbitrate and provides that such agreements shall be “valid, irrevocable, and enforceable.” 9 U.S.C.A. § 2. “Commerce” is defined in the FAA very broadly to include all international or interstate commerce. 9 U.S.C.A. § 1. The Supreme Court has held that when state law directly prohibits the arbitration of a claim otherwise subject to the FAA, the FAA preempts the conflicting state law. Marmet Health Care Ctr., Inc. v. Brown, 565 U.S. 530, 533, 132 S. Ct. 1201, 1203–04, 182 L. Ed. 2d 42 (2012).
The proponents of arbitration contend that arbitration is faster, cheaper and more streamlined than litigation. Further, they point to the fact that the case is decided by an arbitrator or panel of arbitrators that are knowledgeable about the construction industry, as opposed to judges or juries who typically have no knowledge or experience with the industry. For sureties, the negatives relating to arbitration include: (1) the fact that the legal rules and defenses protecting sureties may be loosely applied and/or ignored in arbitration; (2) the arbitrators are perceived to allow personal concepts of fairness to override the facts/law; (3) the very limited appellate review to vacate an award; (4) limited discovery and disclosure of defenses/claims which can lead to last minute surprises or ambushes at the hearing; and (5) limited explanation of awards.
According to federal court statistics and information from the AAA, the median length of a jury or bench trial in civil cases is typically in the range of 27 months. In comparison, the AAA contends that in construction cases the median time from filing of a case with the AAA to award was approximately in the range of 232 days, less than 8 months. If there is an appeal, court cases required at least 21 months longer than arbitration to resolve (33.6 months vs 11.6 months). Notwithstanding such numbers, we can all point to cases where the arbitration, for one reason or another, has dragged on for longer periods of time and we can point to court cases that were resolved on summary judgment or motions to dismiss relatively quickly. Also, there is not a lot of publicly available data on arbitrations to compare and the arbitration data may be somewhat suspect because of inclusion of small streamlined or expedited disputes.
In response to the concerns that people have regarding the limited grounds to vacate an arbitration award, the major arbitration providers now offer parties an optional appeal within the arbitration process. CPR published its Arbitration Appeal Procedure in 1999; JAMS issued its Optional Appeal Procedure in 2003; and in 2013 the American Arbitration Association created its Optional Appellate Arbitration Rules. Under the AAA appeal procedure the parties must agree in their contract up front or stipulate after the fact to submit an arbitration award for review by a AAA arbitration panel. The parties or the AAA can appoint the arbitration panel and the appeal will be determined based on the record and briefs submitted in accordance with a schedule and page limits. Oral arguments are permitted, but only based on request and at the discretion of the panel. After 30 days, the panel must either (i) adopt the underlying award, (ii) substitute its own award or (iii) request additional information and time to render a decision. The entire appeal process is designed to take less than three months. There is of course an administrative fee for the filing. The appeal may be based on the grounds that the underlying award is based on: (1) an error of law that is material and prejudicial; or (2) determinations of fact that are clearly erroneous. So, the grounds for appeal under the AAA appeal rules are much broader than the traditional grounds for a court to vacate an arbitration award.
IS THE SURETY BOUND TO ARBITRATE?
The issue that comes up the most in the area of arbitration and suretyship is whether the surety can be bound to arbitrate when there is no arbitration provision in its bonds. There is a split of authority as to whether an arbitration provision in the bonded contract that is incorporated by reference into the bonds is enforceable as to the surety and compels the surety to arbitrate. The majority view is that the surety is bound to arbitrate under such circumstances. See e.g. Commercial Union Ins. Co. v. Gilbane Bldg. Co., 992 F.2d 386 (1st Cir. 1993); Choctaw Generation Ltd. P’ship v. Am Home Assurance Co., 271 F.3d 403 (2nd Cir. 2001); Great Am. Ins. Co. v. Hinkle Contracting Corp., 497 Fed. Appx 348 (4th Cir. Nov. 28, 2012); J.S. & H. Constr. Co. v. Richmond Cty. Hosp. Auth., 473 F.2d 212 (5th Cir. 1973); Exch. Mut. Ins. Co. v. Haskell Co., 742 F.2d 274 (6th Cir.1984); U.S. Fid. & Guar. Co. v. W. Point Constr. Co., 837 F.2d 1507 (11th Cir. 1988); Ansari v. Qwest Commc’n. Corp., 414 F.3d 1214 (10th Cir.2005); Hoffman v. Fid. & Deposit Co. of Md., 734 F. Supp. 192 (D.N.J. 1990). Thus, the majority of federal jurisdictions in the country hold that where the bond incorporates by reference a bonded contract that contains an arbitration provision, the surety is bound to arbitrate.
The minority view takes a more restrictive view of the significance of an incorporation by reference clause and focuses more on the intent of the parties, emphasizing the consensual nature of arbitration. See e.g. AgGrow Oils, L.L.C. v. Nat’l Union Fire Ins. Co. of Pittsburgh, PA, 242 F.3d 777 (8th Cir. 2001); Portland Gen. Elec. Co. v. Liberty Mut. Ins. Co., 862 F.3d 981 (9th Cir. 2017), as amended (Aug. 28, 2017); Schneider Electric Buildings Critical Systems, Inc. v. Western Surety Co., 454 Md, 698, 165 A.3d 485 (Md. 2017); Devs. Sur. & Indem. Co. v. Carothers Constr., Inc., No. 17-2292-JWL, 2017 WL 3674975 (D. Kan. Aug. 24, 2017).
The courts in the majority view generally cite three rationales in support of their view that incorporation by reference is sufficient to bind the surety.
- The first reason is that there is a public policy established by the FAA and the Uniform Arbitration Act adopted by many states favoring arbitration. Such Acts were designed to abolish the common law rule that arbitration agreements were not, generally speaking, enforceable. They were also enacted to establish a policy favoring arbitration.
- A second rationale identified by the majority view is found in the language of the contract itself. Courts often point to the fact that the contract language that requires arbitration generally speaking tends to be very broad. The clauses often require that all claims “arising of or relating to” the contract be subject to arbitration. If these clauses do not identify the parties who are bound to arbitrate, courts in these majority jurisdictions often hold that the surety falls within the broad language and must be bound to arbitrate.
- Finally, a third factor cited by courts in the majority is how they view sureties generally and what role they believe sureties should play. In these jurisdictions, if a court views a surety as one who guarantees to do what its principal has promised to do, then the court is more likely to bind the surety to arbitrate, because these courts believe that sureties should have the same rights, duties, and obligations as their bond principals. Thus, if the principal must arbitrate, then surety should have to arbitrate, too.
The minority view takes a different approach. Although the reasoning identified by these minority jurisdictions is more fractious, the one thing that these minority jurisdictions hold in common is that in order to bind the surety to arbitrate where there is an incorporation by reference, there must be some clear indication that the surety intended to bind itself to arbitration; something more than simply incorporating the bonded contract by reference. In Maryland, for example, our highest court held that merely incorporating another contract is not clear enough to show that the surety consented to arbitrate. The court stated that “the incorporation of one contract into another contract involving different parties does not automatically transform the incorporated document into an agreement between parties to the second contract.” In other words, incorporation by reference is not enough to bind the surety. In the next blog post we will explore some of the arguments that a surety can use to avoid being compelled to arbitrate.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (firstname.lastname@example.org) or any member of the Surety and Fidelity Practice Group.
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