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Indemnifying Your Surety: What Have You Done?
08.01.06

“The Undersigned shall indemnify and keep indemnified the Surety against any and all liability, loss and expense of whatsoever kind or nature, including, but not limited to, court costs, attorneys’ fees, and interest, which the Surety may sustain or incur . . .” This provision, or something similar to it, is the crux of any general indemnity agreement. For contractors providing payment or performance bonds, this should be familiar language. However, when agreeing to indemnify the surety, did you fully understand the extent of your promises?

The payment or performance bond surety assumes an obligation of its principal with the understanding that either the principal or some third party, known as an indemnitor, will indemnify or hold the surety harmless if the principal fails to fulfill the underlying bonded obligation and the surety sustains a loss. The indemnitor may be the bonded principal itself (i.e. the contractor), an owner or one with a financial interest in the principal, or even the spouse of an owner. Distinguished from insurance, where the insurer assumes it will sustain a loss if a covered claim occurs, the surety has no expectation of a monetary loss.

Central to this surety relationship is the written indemnity agreement. Generally speaking, the indemnity provision in the agreement grants the surety the broad legal right to recover from the indemnitor whatever it pays on the principal’s behalf under the related bonds, as well as those amounts for which it remains liable. If the clause provides for indemnity to the surety against “liability” as well as against “loss,” the surety may be entitled to indemnification even before payment is made, so long as that liability is fixed.

Notwithstanding the surety’s broad rights of recovery, the indemnitor may have one or more defenses to a demand for reimbursement. Although these defenses historically have not met with much success, a few of the more commonly asserted ones are:

The principal was not liable for the surety’s payment.

In other words, if the principal had a valid defense to the claim against the bond, the surety may be barred from seeking reimbursement from the indemnitor. This defense may be your best bet. But be aware that most indemnity agreements grant the surety very broad discretion to pay and settle claims. Therefore, depending on the circumstances, any loss sustained by the surety may be a reimbursable loss.

The surety failed to mitigate damages.

Some courts have held that the surety must act reasonably to prevent or reduce its own losses in the performance of its contractual obligations.

The surety failed to provide notice to the indemnitor.

This defense may work if the indemnity agreement requires notification of intent to pay a claim. However, many if not most agreements specifically provide for waiver of these notices.

The surety engaged in improper conduct.

In some cases, the indemnitor has successfully argued that the surety’s conduct discharged the indemnity liability. Examples of improper conduct have included an unauthorized increase in the penal amount of the bond, interference with the principal’s underlying construction contract, and assuming work under a contract absent evidence of the principal’s default.

Given the rights of the surety under the indemnity agreement, and the potentially dim prospects for a defense to a reimbursement claim, a prudent contractor will take affirmative steps to avoid the surety’s involvement in a project. If, however, a claim is made, you may help yourself by helping your surety investigate and vigorously defend against the claim.

This article was originally published in the August 2006 issue of Dallas/Fort Worth Construction News, and is reprinted with permission.