When a Surety’s Damages Might Exceed the Value of their Bond: When is a Surety Liable for the Tort of Bad Faith?
August 1, 2023
Nearly every contract made in the United States subjects the parties to a duty of good faith and fair dealing to one another. Even where there is no written term requiring that the parties operate in good faith, the Uniform Commercial Code and many state statutes hold that the term is implied in every written and oral contract. While there is no universal definition for “good faith,”, the UCC defines good faith as “honesty in fact in the conduct or transaction concerned.” Va. Code § 8.1-201(19).
As with any other contractual term, a violation of the duty of good faith and fair dealing by either party will constitute a breach of contract. Generally, such a violation amounts only to a breach of contract, not an independent tort. Charles E. Brauer Co., Inc. v. NationsBank of Virginia, N.A., 251 Va. 28, 33 (1996). This recognition is nearly universal. This rule is extraordinarily important in contract cases because the damages available for a breach of contract differ substantially from the damages available in tort. Contract damages are generally limited to “actual damages,” meaning that the aggrieved party is entitled to receive only the sum of money that would put them in the same position it would expect to be in if the contract was not breached.
For example, a contractor agrees to pay a subcontractor $500,000 to provide construction services on a large project. After the subcontractor satisfactorily completes its duties, the contractor refuses to make payment. When the subcontractor sues for breach of contract, its damages are likely going to be limited to the $500,000 it is owed unless there are specific provisions in the contract saying otherwise (e.g. attorneys’ fees, late payment fees, liquidated damages, etc.). If the lack of payment caused the subcontractor to lose other jobs because it could not maintain its payroll, the subcontractor would have no ability to claim those losses as damages, substantially limiting the breaching contractor’s liability.
Damages in tort cases are far less defined. In a tort case, the aggrieved party has a right to seek all damages that would make them whole, which allows them to claim both direct and indirect damages, including difficult-to-define categories such as emotional distress or inconvenience, which oftentimes means that only a judge or jury can determine the amount to which the aggrieved party is entitled. Most importantly, tort damages related to a contract will not be limited by provisions of the contract. In the surety context, contract damages cannot, as a matter of law, exceed the value of the bond. Tort damages, on the other hand, are not so limited.
While alleging a breach of the duty of good faith will not generally give rise to tort damages in a contract claim, courts have recognized an important exception to this rule. As the California Supreme Court explained, courts recognize “only one exception to that general rule: tort remedies are available for a breach of the covenant [of good faith] in cases involving insurance policies.” Cates Constr., Inc. v. Talbot Partners, 980 P.2d 407, 416 (Cal. 1999).
A surety lawyer will respond immediately to this exception by pointing out, correctly so, that sureties are not insurers and a surety contract is fundamentally different from an insurance contract. While surety litigators understand this simple fact, courts and legislatures have a habit of conflating surety with insurance. As a result, there is disagreement among the courts on whether a party may pursue a tort claim against a surety for the violation of the duty of good faith.
For example, the Arizona Supreme Court held that because sureties are defined as “insurers” under Arizona’s insurance statute, a surety is liable for the tort of bad faith in the same manner as an insurance company. Dodge v. Fidelity and Dep. Co. of Md., 161 Ariz. 344 (1989). Even without the benefit of a guiding statute, the Alaska Supreme Court followed the reasoning of Dodge and held, without citing to any state statute, that “the relationship of a surety to its obligee – an intended creditor third-party beneficiary – is more analogous to that of an insurer to its insured.” Loyal Order of Moose, Lodge 1392 v. Int’l Fid. Ins. Co., 797 P.2d 622, 628 (Ak. 1990). The Colorado Supreme Court reached a similar result in Transamerica Premier Ins. Co. v. Brighton Sch. Dist., 940 P.2d 348 (1997).
Other state supreme courts have recognized the substantial difference between a surety and an insurer and therefore reached the opposite conclusion. In California, where suretyship is “listed in the Insurance Code as a class of insurance,” the California Supreme Court held that in spite of this statutory classification, “it does not follow that a surety bond equates to a policy of insurance under the common law or common law theories of liability.” Cates Constr., Inc. v. Talbot Partners, 980 P.2d 407, 421 (Cal. 1999). Put simply, “a construction performance bond is not an insurance policy.” Id. at 427. Analyzing various conflicting opinions on the liability of a surety for bad faith, the South Carolina Supreme Court ultimately sided with sureties, holding that “the surety’s presence in a regulatory scheme does not render common law duties of an insurer applicable to a surety.” Masterclean, Inc. v. Star Ins. Co., 347, S.C. 405, 410 (2001). The most recent decision on this issue similarly sided with the sureties, as the Indiana Supreme Court found that the legislature defining sureties as “insurance companies” did not subject them to the tort of bad faith. Posterity Scholar House, LP v. FCCI Insurance Company, 205 N.E. 3d 1018 (2023).
Clearly, the availability of tort damages against a surety is inconsistent throughout the United States. Additionally, not every state supreme court has reached the issue of whether a surety may be held liable for the tort of bad faith. See e.g. U.S. v. Fed. Dep. Co. of Md., 875 F. Supp. 803 (M.D. Ala. 1995) (recognizing that the question of bad faith claims against sureties is a “novel and complex issue of state law” that had not been answered by Alabama state courts). Accordingly, a surety litigator may be required to argue the issue of bad faith as a matter of first impression for the court. To do so successfully, the lawyers will need to be well-versed in the logic underlying the conflicting decisions on this issue.
If you have any questions regarding the issues addressed in this blog post please contact me (cbleakley@wcslaw.com) or any member of the Surety and Fidelity Practice Group.