The General Agreement Of Indemnity Collateral Security Provision: If You Try Sometimes, You Might Find, You Get What You Need

The General Agreement Of Indemnity Collateral Security Provision: If You Try Sometimes, You Might Find, You Get What You Need

Surety bonds are a primary, if not mandatory, component of every-day construction projects.  While commercial insurers on a construction project expect losses and adjust insurance rates to cover such losses depending on many factors, sureties do not expect to pay out-of-pocket for bond losses and, instead, require principals and indemnitors to exonerate, indemnify, and often defend sureties in the event of a loss or anticipated loss.  As such, a general agreement of indemnity in favor of the surety usually goes hand-in-hand with the issuance of construction surety bonds.  Sureties have carefully crafted the general indemnity agreement language to offer bargained-for protection to the surety in case of loss or anticipated loss.  The question typically is, will the courts uphold the intended iron-clad language of the general agreements of indemnity in favor of the surety?   The United States District Court for the Eastern District of Louisiana recently affirmatively answered that question – – well, for the most part.

In Fucich Contracting, Inc. v. Shread-Kuyrkendall & Assocs., Inc.[1] the surety issued payment and performance bonds (collectively, “Bond”), with the penal sum in excess of $5 million, on behalf of the general contractor (“GC”) on the Lake Borgne Basin Levee District Pump Station #1 and #4 Pump Upgrade project (“Project”). The general scope of the work was to enhance certain levee/flood protections. As a condition precedent to issuing the Bond, the surety required the GC and various indemnitors to execute a General Agreement of Indemnity in favor of the surety (“GAI”).  The GAI contained typically onerous provisions in favor of the surety. One such provision was the “collateral security” provision, which provided:

5. Collateral Security: indemnitors agree to deposit with [the surety], upon demand, an amount as determined by [Surety] sufficient to discharge any Loss or anticipated Loss. Indemnitors further agree to deposit with [the surety], upon demand, an amount equal to the value of any assets or Contract funds improperly diverted by any initial Indemnitors. Sums deposited with [the surety] pursuant to this paragraph may be used by [Surety] to pay such claim or be held by [the surety] as collateral security against any Loss or unpaid premium on any Bond. [the surety] shall have no duty to invest, or provide interest thereon, the deposit. Indemnitors agree that [the surety] would suffer irreparable damage and would not have an adequate remedy at law if Indemnitors failed to comply with the provisions of this paragraph.[2]

The GAI also specifically defined “Loss” as:

[a]ll loss and expense of any kind or nature, including attorneys’ and other professional fees, which [Surety] incurs in connection with any Bond or this Agreement, including but not limited to all loss and expense incurred by reason of [Surety]:… (b) prosecuting or defending any action in connection with any Bond;… (e) enforcing by litigation or otherwise any provision of this Agreement; and (f) all interest accruing thereon at the maximum legal rate.[3]

On the whole, a surety hopes that it will not have to judicially test the strength of its GAI provisions. But, the Fucich surety was not so lucky. Instead, the GC, engineer, and public owner became embroiled in a dispute over alleged design defects in engines supplied for the Project. The GC retained the purportedly defective engines and equipment and refused to finish the work.  After the public owner failed to pay the GC and the GC filed suit against both the public owner and its engineer, the public owner terminated the GC’s contract for its failure to perform. You can guess what happened next: the public owner made demand on the surety under the (performance) Bond.  The surety rejected the public owner’s demand to complete, independently confirming the GC’s engine design defect defense.  The public owner sued the surety for the penal sum of the bond: in excess of $5 million.

The parties engaged in unsuccessful settlement negotiations.  In the process, the surety made formal demand on the indemnitors to deposit collateral in the amount of the penal sum, plus its costs and attorney’s fees through the date of demand. In the demand for collateral, the surety noted the GC’s default of the GAI (declaration of default by an obligee) and that its demand was based at least in part on the GC’s refusal to participate in some of the settlement negotiations. As of the date of the Fucich opinion, the indemnitors had not posted any collateral. The surety filed for a preliminary injunction to enforce the collateral security provision of the GAI.

Considering the preliminary injunction, the court analyzed the four necessary elements: (1) the substantial likelihood of success on the merits; (2) the substantial threat that the movant will suffer irreparable injury if the injunction is not granted (3) the balance of hardships of granting the injunction versus not granting the injunction; and, (4) determining whether granting the injunction would serve the public interest.[4]  The court analyzed each of these elements separately.

(1)      The Substantial Likelihood of Success on the Merits

While the parties did not dispute that the collateral security provision of the GAI was unambiguous or that the GC was obligated to indemnify the surety for losses under the bond, the parties disagreed as to (1) what triggered the surety’s ability to make a collateral demand and (2) how much the surety could demand. Applying Louisiana law,[5] the court looked to the plain language of the GAI, specifically Section 5 and the definition of “Loss,” respectively.

In somewhat of an about-face from its collateral demand letter, the surety argued that the right to demand collateral was triggered by the owner’s claim made on the Bond and not the GC’s default under the Bond or the GAI. The GC responded that it was not in default as defined by the GAI, and that the surety was in bad faith  – – both in demanding an arbitrarily high amount of collateral far exceeding what would be sufficient to discharge a Loss or anticipated Loss and in breaching the Bond.

As for the trigger to demand collateral, the court noted that the plain language of the GAI did not require a default before the surety could demand collateral. Instead, the court found that only a claim need be made against the Bond, which the owner made in this case.

As for the amount the surety could demand, the court determined that the definition of “Loss” allowed the surety to demand payment for “an expansive range of debts, including monies it could expend in completing the Project or in responding to the Parish’s lawsuit or its demand against [the surety] under the Bond.”[6]  The same broad relief would apply to future losses, damages, and attorney’s fees, without the necessity for the surety to prove actual liability. The court based its reasoning, at least in part, on the collateral security provision’s purpose: protecting the surety from “experiencing post-judgment uncertainty by providing pre-judgment security.”

More specific to the amount that the surety could demand, the court applied a “reasonableness” standard (i.e. that the amount demanded is reasonably related to the surety’s loss or anticipated loss).[7] Significantly, the court held that the reasonableness of the collateral demand did not depend on a finding of the GC’s actual liability.

The court also dispelled the GC’s “bad faith” assertions, particularly using the language in the GAI, finding that under the GAI:

  • subject to “reasonableness,” the surety had the right to determine the amount demanded; and,
  • the surety had the right, at its sole discretion, to settle any claims made in relation to the Bond.

Thus, the surety’s demand may very well have been appropriate at the time it was made.  However, the court noted that since the original demand, negotiations and resolutions had occurred.  So, the court ordered additional memoranda concerning the present sufficiency of amounts needed to protect the surety from losses.

(2)      Substantial Threat of Irreparable Injury

While the court often enforced the plain language of the GAI, this was not always the case.  As to demonstrating irreparable injury, the GAI contained typical surety language whereby the indemnitors stipulated that the surety would suffer irreparable injury in the event collateral was not provided upon demand. However, the court pointed out that in the Fifth Circuit there is a split as to whether a contractual stipulation alone may satisfy the irreparable harm element.[8] Instead, the court noted that a “surety must show that the inability to collect amounts that may become owed by an indemnitor is imminent, including, for example, showing that the indemnitor faces dire financial straits or bankruptcy, thereby increasing the likelihood that damages may not be recovered upon a later judgment awarding specific performance.”[9] Significantly, the court noted that the injunctive relief protects:

three interest of the surety: the bargain for benefit of collateral security, avoidance of present exposure to liability during pending litigation against indemnitors, and avoidance of risk that, should the [i]ndemnitors become insolvent, the surety will be left as a general unsecured creditor, frustrating the purpose of the indemnity agreement.[10]

 

 

After requiring more than the indemnitors’ GAI stipulations, the court found that the evidence supported that that the indemnitors would be unable to pay the amount demanded by the owner, thus, satisfying this element.

(3)      The Balance of Hardships

The court found that the hardships of the surety would face outweighed the potential injury to the indemnitors. After all, if the preliminary injunction was granted, the indemnitors would “merely be forced to perform an obligation they agreed to perform under the [GAI].”[11] Whereas, if the preliminary injunction was denied, the surety’s bargained-for security likely would be gone and it would face the possibility of indemnitor insolvency upon a judgment.

(4)      The Public Interest

Advocating its position as to public interest, the surety advocated:

“[t]he indemnity agreement literally represents the foundation of modern suretyship, and its enforcement is essential to the procurement of contract surety bonds to guarantee performance on construction projects,” and that the failure to enforce the [GAI] would “undermine the entire surety industry.”[12]

The court did recognize “[i]n less sweeping terms” the public interest in upholding clearly written contracts and specifically the surety’s interest in enforcing its bargained-for collateral security provision. However, the court noted that the Project itself served a vital public service: namely, flood protection. As such, the public would benefit in granting the injunction to be sure that funds were secured to complete the Project.

In finding that the elements mandating a preliminary injunction were primarily met, the court granted the surety’s request for an injunction, in part. The court specifically reserved its decision as to the amount of collateral that would be needed to protect the surety. In its order, the court gave the parties almost an additional month to brief, and for the court to hear, arguments as to the amount of collateral sufficient to discharge the surety’s loss or anticipated loss. Thus, while the surety may have succeeded on its motion, its bargained-for collateral security remains in the balance without substantial protections – – for now.

[1]   No. CV 18-2885, 2019 WL 1755525 (E.D. La. Apr. 19, 2019).

[2]   Id. at *1.

[3]   Id. at *6.

[4]   Id.at *3.

[5]   The court applied Louisiana law after a brief choice of law analysis.

[6]   Id. at *6.

[7]   Id. at *7 (citing, Cincinnati Ins. Co. v. Savarino Constr. Corp., 2011 WL 1068022, at *7-13 (E.D. La. Mar. 21, 2011).

[8]   Id. at *10 (Comparing Dickey’s Barbecue Restaurants, Inc. v. GEM Inv. Grp., L.L.C., 2012 WL 1344352, at *4 (N.D. Tex. Apr. 18, 2018) (stipulation “is merely one factor to be examined in making the irreparable harm determination”) (citing Dominion Video Satellite, Inc. v. Echostar Satellite Corp., 356 F.3d 1256, 1266 (10th Cir. 2004)), with Hartford Fire Ins. Co. v. 4-H Ventures, Inc., 2008 WL 11389579, at *3 (S.D. Tex. June 25, 2008) (under “the plain language of indemnity agreements,” which defeats all “arguments to the contrary,” indemnitors “expressly agreed that the failure to provide the requested collateral constitutes irreparable harm”).

[9]   Id.

[10]   Id. (citing Travelers Casualty & Surety Company of America v. Padron, 2017 WL 9360906, at *10 (W.D. Tex. Aug. 2, 2017)(quoting Int’l Fidelity Ins. Co., 2016 WL 8814367, at *7)). Emphasis in original

[11]   Id. at 11.

[12]   Id. at *12.