You’re a subcontractor working on a project that involves a performance and payment bond. The general contractor isn’t paying you for your work. What do you do? You sue the general contractor for breach of contract and the bonding company on the bond. Can you do anything else? Maybe.

Some states recognize a “bad-faith” claim on performance and payment bonds. A bad faith claim arises from the acts of the bonding company. Bad faith may consist of the bonding company: 1) misrepresenting material facts regarding coverage, 2) failing to reasonably respond to a claim, 3) refusing to pay a claim without conducting a reasonable investigation, 4) failing to settle a claim promptly once liability has become clear, 5) failing to provide reasonable explanation for denial of a claim, 6) appealing an adverse judgment for purpose of delaying or reducing payment, or 7) engaging in burdensome litigation for purpose of delaying or reducing payment.

Origin of the Bad-faith Claim

Bad-faith claims were first recognized in California against insurance companies. Most states have followed suit and accepted the bad-faith claim against insurance companies. Recently, however, some companies attempted to apply the insurance bad-faith claims against sureties. These companies argue that a surety providing a performance or payment bond is analogous to an insurance company providing an insurance policy, and, therefore, the same rules that apply to insurance companies may apply to sureties. They also argue that the same policy reasons California created the insurance claim also apply to sureties. Specifically, those reasons are: damages based on the breach of contract are not enough to compensate the injured party; the fact that the parties already have a duty to perform the contract in good faith; and the fact that the parties have a special relationship of trust.

This argument has only been made in a few states. Some states have rejected bad-faith claims as it applies to sureties. In contrast, some states have recognized the claim.

Reasons for Rejecting Claim

The California court gave four reasons for not allowing a bad-faith cause of action against a surety. First, the court listed several adverse consequences resulting from the state previously recognizing the cause of action against insurance companies. Those consequences included multiple litigation (an initial suit against the insured and a second suit against the insurer for bad faith); unwarranted settlement demands by claimants and inflated settlements by insurers; and higher insurance coverage costs.

Second, the court reasoned that the cause of action created a conflict of interest in that the surety must not only protect the interests of its principal but also its interests against the claimant. Third, the court stated no additional tort remedy was necessary since a regulatory scheme covering sureties was already in place. For example, California provided sanctions like license revocation for failing to properly perform bond obligations. The court also noted that no “special relationship” existed in the surety context like it does in the insurance context. No special relationship exists because the parties to a surety bond have equivalent bargaining power and they have the power to negotiate the terms of the bond. Finally, the court recognized some fundamental differences between sureties and insurers.

Reasons for Accepting the Claim

The Arizona court that recognized the bad-faith claim offered three reasons for its decision. First, although the court recognized the differences between sureties and insurance companies, the court found the state regulated sureties as if they were insurance companies. The court also found the special relationship that exists in the insurance context to apply to sureties. This special relationship exists if an insurance contract is for protection rather than commercial advantage and if allowing the claim creates a deterrent effect on insurers breaching agreements. Lastly, the court believed that limiting the surety’s damages to breach of contract defeated the purpose of an insurance contract.

States Where Issue is not Decided

Most states have not specifically answered whether a surety can be liable for bad faith in relation to a performance or payment bond. Some of these jurisdictions, however, have given indications that they would not recognize such a cause of action because they do not recognize a bad-faith claim against insurance companies. Some states could go either way on the issue. They all recognize a cause of action against an insurance company for bad faith, but have not yet decided on the availability of the cause of action against sureties. It may be possible in some states to allege bad faith as a basis of an unfair and deceptive trade practice.

The Bottom Line

With the majority of jurisdictions in the United States providing little or no guidance in this area, years of litigation on the issue are in the forecast. What you need to know is that you might have a new option when you are not paid on a project if the bonding company treated the claim improperly. Your chances of suing a surety on the basis of bad faith are better if:

1. Your state regulates sureties as if they were insurance companies, especially if the regulations do not adequately protect companies from the abuses of sureties

2. Damages based on breach of contract would not be enough to compensate for the injury caused by the surety

3. You can establish a special relationship of trust between your company and the surety

If you are fortunate enough to be in a state that recognizes the bad faith claim, use it as leverage against the surety to get your money faster.