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When Surety Bond Incorporates the Contract by Reference, Is the Contract's Arbitration Clause Also Incorporated? The Answer Varies by Jurisdiction

Authors: Robert E. Heideck and Stephen W. Kiefer

October 2017
When Surety Bond Incorporates the Contract by Reference, Is the Contract's Arbitration Clause Also Incorporated? The Answer Varies by Jurisdiction

This article was published in the October 2017 issue of AGC Law in Brief (Volume 3, Issue 5), Practical Construction Law & Risk Issues. It is reprinted here with permission.

Surety bonds commonly contain language broadly incorporating the principal’s contract by reference. In the event the principal’s contract contains a mandatory arbitration clause and the obligee makes a claim on the bond, the parties may face an immediate procedural dispute over the proper forum for the claim: Must the obligee sue the surety in court, or may it submit the claim to arbitration?

Recent cases from several jurisdictions have produced conflicting results. In fact, two federal courts recently reached opposite conclusions in cases involving the same contract language, the same obligee, and the same surety. Compare Developers Sur. & Indem. Co. v. Carothers Constr., Inc., 2017 U.S. Dist. LEXIS 111021 (D.S.C. July 18, 2017) with Developers Sur. & Indem. Co. v. Carothers Constr., Inc., 2017 U.S. Dist. LEXIS 135948 (D. Kan. Aug. 24, 2017). A survey of the case law suggests that the outcome in a given case may turn on the jurisdiction involved and the precise language used in the arbitration clause.

The decision by the district court in South Carolina in Developers Surety & Indemnity Co. v. Carothers Construction, Inc. is illustrative of those cases resolving the issue in favor of arbitration. There, general contractor Carothers Construction, Inc. (Carothers) made a claim on its subcontractor’s bond and demanded arbitration against the surety. The surety, Developers Surety and Indemnity Company (DSI), opposed Carothers’s demand for arbitration by filing a declaratory judgment action and seeking a declaration that the arbitration clause in Carothers’s subcontract with DSI’s principal did not bind DSI to arbitrate Carothers’s claim against it.

The arbitration clause in the subcontract required arbitration of “all claims, disputes, and other matters in controversy between the Contractor and the Subcontractor arising out of or relating to this Subcontract.” DSI argued that the arbitration clause had no application to the claim between it and Carothers because, by its own terms, the clause applied only to claims “between the Contractor and the Subcontractor,” and DSI, as surety, was neither. DSI similarly argued that Carothers’s claims fell beyond the scope of the arbitration clause because the claims arose out of the bond, whereas the arbitration clause expressly applied only to claims arising from or relating to the subcontract.

The district court in South Carolina rejected DSI’s argument. Focusing on the latter half of the arbitration clause, the court found that Carothers’s claim “arose out of the subcontract” because it was a claim to hold DSI responsible for a breach of the subcontract by DSI’s principal. The court further found that DSI had guaranteed the performance of all of the subcontractor’s obligations under the subcontract and had incorporated all of the subcontract’s terms, including the agreement to arbitrate disputes. Reasoning that a bond is to be construed together with the agreement it incorporates in order to ascertain the parties’ intent, and that a surety obligates itself under a bond to the same liability as its principal, the court concluded that the parties intended to submit disputes against DSI under the bond to arbitration.

A similar result obtained in Developers Surety & Indemnity Co. v. Resurrection Baptist Church. See 759 F. Supp.2d 665 (D. Md. 2010). The court in that case followed what it considered to be the majority rule that a surety is bound to arbitrate disputes related to its bond if the bond incorporates by reference a contract containing a mandatory arbitration provision. In support of this majority rule, the court cited cases from the First, Second, Fifth, Sixth, and Eleventh Circuits, which reached the same result. Id. at 669-70 (citing cases). Applicable Maryland state law might have compelled a different result, but the court found that the Federal Arbitration Act preempted Maryland law, as Maryland law was “hostil[e] to the enforcement of arbitration provisions incorporated by reference into other agreements.”1 Id. at 672 n.1. The court thus followed federal substantive law as reflected in the “majority rule.”

The dispute between Carothers and DSI in the district court in Kansas resulted in the opposite outcome, with the court holding that DSI did not agree to arbitrate. That court accepted DSI’s interpretation of the arbitration clause, holding that, even though DSI incorporated the subcontract and its arbitration clause by reference, the clause simply did not apply according to its own terms. Strictly interpreting the language of the arbitration clause, the court found that it expressly applied only to “claims, disputes, and other matters in controversy between the Contractor and the Subcontractor.” 2017 U.S. Dist. LEXIS 135948, at *14-16 (D. Kan. Aug. 24, 2017) (emphasis added). The claim between Carothers (contractor) and DSI (surety) thus did not fall within the scope of the clause, the court reasoned. The court distinguished the cases representing the supposed majority rule on the basis that none involved an arbitration clause that limited its scope to disputes between specified parties. Instead, the court followed cases from the Eighth Circuit, District of Columbia, and District of Hawaii, which it described as involving similar limiting language. Id. at 18-19.

The district court in Kansas buttressed its conclusion by noting that several provisions in the subcontract, including the section that contained the arbitration clause, referenced “subcontractor” and “surety” separately. The court interpreted these references as further evidence of the parties’ intent that the arbitration clause be limited to claims between the contractor and subcontractor, to the exclusion of the surety. Finally, the court distinguished the decision reached by the district court in South Carolina in the companion claim between Carothers and DSI. The court “respectfully disagreed” with the South Carolina court’s reasoning and found that Kansas law differed from South Carolina law concerning the extent of a surety’s liability. It found that, under Kansas law, a surety does not obligate itself to perform all of its principal’s obligations absent an express assumption of those obligations. Incorporation of a subcontract by reference thus did not result in an assumption of all of the principal’s obligations under the subcontract (including the principal’s obligation to arbitration) as a matter of Kansas law.

The Maryland Court of Appeals recently reached the same result as the district court in Kansas. See Schneider Elec. Bldgs. Critical Sys. v. W. Sur. Co., 2017 Md. LEXIS 482 (Md. July 28, 2017). There, the subcontract between the obligee and the principal included an agreement to arbitrate all “disputes between Contractor and Subcontractor.” The surety, Western Surety Company (Western), advanced the same argument that DSI had made, i.e. that the arbitration clause was limited to “disputes between Contractor and Subcontractor.”

Applying Maryland law, the Maryland Court of Appeals agreed, finding that the arbitration agreement expressly applied only to disputes between contractor and subcontractor, and Western, as surety, was neither. The court further noted that other provisions within the incorporated contract clearly referred to surety separately from subcontractor. As such, it found that the agreement did not intend for “surety” and “subcontractor” to mean the same thing. Thus, the court held that the arbitration clause’s reference to disputes with the subcontractor must not have been intended to include disputes with the surety. Finally, the court rejected the notion that a surety’s obligation for the principal’s performance includes the obligation to arbitrate claims. Rather, the court ruled that the surety agreed only to ensure the performance of the construction its principal agreed to complete, and not every other contractual provision incorporated by reference, such as the agreement to arbitrate disputes.

As the foregoing demonstrates, the issue of whether a surety will be bound by an arbitration clause in a contract that its bond incorporates by reference may depend on several factors, including the jurisdiction supplying the governing law and the precise language used in the arbitration clause. Given the variability of results, consider the following:

  1. Wording of the arbitration clause matters. If the clause includes language referencing “disputes between contractor and subcontractor arising out of or related to the subcontract,” the ability to compel arbitration in a dispute with the surety will be less likely.
  2. A choice of law clause could provide greater predictability on the ability to compel arbitration.

Endnote

1 Indeed, the “hostile” Maryland law cited by the district court in Resurrection Baptist Church was cited with approval by the Maryland Court of Appeals when it reached the opposite conclusion in Schneider Elec. Bldgs. Critical Sys. v. Western Sur. Co., discussed below. See 2017 Md. LEXIS 482 (Md. July 28, 2017).

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.