What If You Want To Avoid Arbitration?
October 3, 2023
In this Surety Today blog post, we will continue with the theme of the last three blog posts and focus on arbitration. In the first two posts, we discussed recent case law addressing arguments raised by sureties to avoid arbitration and in the third post, we discussed arbitration in general. In this post, we will discuss the issue of what arguments to make if you want to avoid arbitration. If you are in a jurisdiction that, generally speaking, mandates a surety to arbitrate based upon an arbitration clause in a bonded contract that is incorporated into the bond by reference, but you would prefer not to arbitrate the dispute, you may wish to consider some of the following potential arguments.
First, consider the language of the bond. In Dunn Industrial Group, Inc. v. City of Sugar Creek, 112 S.W.3d 421 (Mo. 2003), the court held that a guarantor on a construction contract performance guarantee was not bound to arbitrate because the clause in the underlying contract was only “referenced” in the guaranty but not “incorporated” into the guaranty. 112 S.W.3d at 436. Although Dunn Industrial did not, technically speaking, involve a bond, it was a performance guaranty on a construction project – something very similar to a performance bond. In Dunn Industrial, the underlying contract was attached to the guaranty and the guaranty even stated that the guarantor “guarantees prompt and satisfactory performance of the attached Contract in accordance with all its terms and conditions.” Id. The court stated that “[m]ere reference to the construction contract in the guaranty is insufficient to establish that [the Guarantor] bound itself to the arbitration provision of the construction contract.” Id.; see also Case Int’l Co. v. T.L James and Co., Inc., 907 F.2d 65, 66-67 (8th Cir.1990); U.S., ex rel. Lighting & Power Servs., Inc. v. Interface Const. Corp., No. 4:07 CV 1144 DDN, 2007 WL 2710030, at *3 (E.D. Mo. Sept. 11, 2007), aff’d sub nom. U.S. for use of Lighting & Power Servs., Inc. v. Interface Const. Corp., 553 F.3d 1150 (8th Cir. 2009)(“Mere reference to the prime contract or a “flow-through” clause in the subcontract, are each insufficient to bind a subcontractor to an arbitration clause contained within a prime contract.”); Grundstad v. Ritt, 106 F.3d 201, 204 (7th Cir. 1997)(mere reference to an agreement does not demonstrate an intent to incorporate the referenced agreement).
Second, review the language of the arbitration provision. Arbitration is a consensual and contractual dispute resolution process. A party cannot be compelled to arbitrate unless it has agreed to do so. A corollary to that rule is that the scope of the arbitration will be governed by the language of the arbitration provision. This principle can manifest itself in a variety of ways, which may include:
- The arbitration provision may state that it is only applicable to the parties to the contract. If the provision is expressly limited to the contracting parties, then an argument can be made that even if the underlying contract is incorporated into the bond it is limited to just those parties and should not include the surety.
- The arbitration provision may also limit the scope of disputes to which it applies. For example, look to determine if the provision is limited to issues relating to disputes concerning the performance of the work. The surety may have an argument that its dispute with the claimant relates to suretyship defenses (such as a failure to meet a condition precedent, overpayment, etc.) and not performance of the work. Thus, the argument can be raised in that situation that the arbitration provision is inapplicable because the dispute does not arise from the “performance of the work.” See Trans-Vac Sys., LLC v. Hudson Ins. Co., No. 08-22-00232-CV, 2023 WL 4146295 (Tex. App. 6/23/23).
- Look to see if the arbitration provision in the bonded contract contains an exclusion for claims arising under federal law. For example, paragraph 6.5 of the AIA 1987 version of the A401 Standard Agreement between a Contractor and Subcontractor provides that arbitration “shall not be deemed a limitation of rights or remedies which the Subcontractor may have under Federal law . . .” A court in the Eastern District of Virginia addressed this contract provision in S. ex rel. Am. Sheet Metal Corp. v. Travelers Ins. Co., 222 F. Supp. 2d 789, 791 (E.D. Va. 2002), and noted that since the Miller Act is federal law, and the claimant was pursuing a Miller Act claim, the arbitration provision did not apply because the scope of the provision excluded claims arising under federal law. Id.
Third, if the claim is on a Miller Act bond, some courts have held that such claims are not subject to arbitration because they are within the exclusive jurisdiction of the federal courts pursuant to the terms of the statute. In Lee & Rua Co. v. Great Am. Ins. Co., 2008 WL 1868633 (W.D. Wash. Apr. 23, 2008), the court observed that the Miller Act provides an exclusive federal cause of action. The Miller Act permits waiver only under three conditions: (1) in writing; (2) signed by the person whose right is waived; and (3) executed after the person whose rights are waived has furnished labor or material for use in the performance of the contract. In Lee, the arbitration provision did not meet any of the three conditions. Thus, the court treated the arbitration provision as an attempt to waive rights under the Miller Act, and without a proper waiver, the court held that the arbitration clause did not apply.
Fourth, review the terms of the underlying contract. The underlying contract serves as the basis for the decisions ordering or compelling the surety to arbitrate. In some cases, the contract itself will say that it is not intended to create any kind of contractual relationship between any other parties other than those to the contract. This was the case in Excavating Engineers, Inc. v. Nat’l Fire Ins. Co. of Hartford, 524 So. 2d 1112, 1112 (Fla. Dist. Ct. App. 1988) where the surety attempted to enforce an arbitration provision in the underlying contract. The contract provided: “[t]his Subcontract, or any part of it, shall not give third parties other than the owner any claim, demand or right of action against contractor or subcontractor beyond those that exist in the absence of this subcontract.” (Emphasis added). The court held that the surety could not enforce the arbitration provision because it was not an intended beneficiary of the arbitration provision by virtue of the contract terms. In another case, the underlying bonded contract provided:
13.2 Except by written consent of the person or entity sought to be joined, no arbitration arising out of or relating to the Contract Documents shall include, by consolidation, joinder or in any other manner, any person or entity not a party to the Agreement under which such arbitration arises, unless it is shown at the time the demand for arbitration is filed that (1) such person or entity is substantially involved in a common question of fact or law, (2) the presence of such person or entity is required *38 if complete relief is to be accorded in the arbitration, (3) the interest or responsibility of such person or entity in the matter is not insubstantial, and (4) such person or entity is not the Architect, his employee or his consultant.
Aetna Cas. & Sur. Co. v. Jelac Corp., 505 So. 2d 37, 37–38 (Fla. Dist. Ct. App. 1987).
In Aetna the court held that the arbitration provision did not apply to the surety because of the contract provision and the fact that the court found that the surety did not satisfy any of the conditions. So, an argument can be made that a provision in the underlying contract excluding any intent to benefit any third parties indicates that the parties did not intend to include or bind the surety to the arbitration provision.
Fifth, look at the facts to see if they give rise to an argument that the claimant waived any right to arbitrate. City of Savage v. Varey, 358 N.W.2d 102, 106 (Minn. Ct. App. 1984)(“A party may waive an arbitration clause if it commences litigation over arbitrable claims * * * or defends such claims in a court action * * *.”); Hennepin Cnty. v. Ada-Bec Sys., 394 N.W.2d 611, 613 (Minn. Ct. App. 1986); Hosp. Serv. Dist. No. 3 of Par. of Lafourche v. Fid. & Deposit Co. of Maryland, 1999-2773 (La. App. 1 Cir. 1/16/01), 809 So. 2d 145, 148 (Louisiana courts have held that arbitration rights given by contract may be waived, by express words or by necessary implication); MicroStrategy, Inc. v. Lauricia, 268 F.3d 244, 249 (4th Cir. 2001)( A party waives its right to insist on arbitration only when it “so substantially utilizes the litigation machinery that to subsequently permit arbitration would prejudice the party opposing the stay.”). Waiver can be challenging to prove, particularly in a jurisdiction that binds the surety to arbitrate and that favors arbitration; however, generally speaking, the more a party engages in litigation before demanding arbitration, the more likely a court will find that the claimant has waived its right to arbitrate. A waiver may also exist where a party expressly waives its right to arbitrate in writing.
Sixth, in Great American Insurance Company v. Oxnard Unified High School District, No. CV 22-8780-JFW(AFMX), 2023 WL 5504967 (C.D. Cal. June 22, 2023), the California court held that an arbitration provision was unconscionable because it allowed only the government, and not the contractor or surety, to elect to arbitrate disputes under a circumstance where there was unequal bargaining power. As with waiver, arguing unconscionability is an uphill battle and difficult to prove in most jurisdictions. However, under the Oxnard case the court’s interpretation of the procedural and substantive elements of the unconscionable defense in a government contract scenario makes the argument more attainable. See our Surety Today blog post September 12, 2023.
Deciding whether to arbitrate must be made on a case by case basis, but if you decide that you do not want to arbitrate, the issues raised herein may provide some arguments.
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.