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This article was featured in Surety Claims Institute Newsletter 33, no. 3 (September 2019): page 11. To view/download the original article click here.
A performance bond is a type of contract generally subject to the principles of contract interpretation, and the liability of the surety issuing the bond is tied to the language of the bond. Traditionally, the language of the bond was considered to be strictissimi juris and would be interpreted strictly and not extended by construction or interpretation beyond its specific scope of coverage. While that principle of construction has been eroded somewhat in some jurisdictions, it remains the majority view. However, the four corners of the bond are often not the only source from which the liability of the surety may be derived. Typically, a performance bond contains language broadly incorporating the bond principal’s contract by reference with language such as the following: “subcontract between general contractor and subcontractor is hereby referred to and made a part hereof.” Commonly referred to as an “incorporation by reference” clause, these deceptively simple contractual provisions create an array of issues for courts that are tasked with interpreting the bond language and ascertaining the true intentions of the parties.
Including the incorporation by reference clause in the bond may not place the same benefits and burdens on the surety, obligee, and principal; there are limits. In 1992, the Florida Supreme Court decided the case of American Home Assurance Co. v. Larkin General Hospital.22 In that case, the court ruled that while a surety’s liability is coextensive with that of its principal, that liability is limited by the purpose and, more importantly, the terms of the performance bond; the surety’s liability cannot be extended beyond that purpose.23 While Larkin did not involve the application of an incorporation by reference provision, it is the best place to start an analysis as to surety liability. Larkin recognized the general rule that a surety’s obligation is controlled by the terms of the bond.
The question then becomes to what extent, if at all, is a surety’s obligation expanded when an incorporation by reference provision is involved? There is a large volume of case law concerning this very question, and those cases tend to fall into certain areas: categories of damages, statutes of limitations, notices of default, and mandatory arbitration provisions. This article will explore how courts have interpreted incorporation by reference clauses and applied them in those circumstances. Additionally, this article will be a guide for the surety that otherwise may be concerned that the inclusion of an incorporation by reference clause might amount to an automatic win for an obligee seeking damages allowable under the bonded contract.
I. Delay Damages
Not surprisingly, the type of damages to which a bond obligee is entitled may become a point of contention, and in particular, treatment of delay damages varies according to the jurisdiction. In Larkin, the Florida Supreme Court refused to enlarge a surety’s obligation under a performance bond to include both damages for costs of completion and delay damages.24 The obligee contracted to build a hospital, and the surety issued a performance bond. Eighteen months after the project was to have been completed, the obligee terminated the contract and gave notice to the surety, which elected not to complete the project and instead allowed the obligee to utilize another contractor. The obligee filed suit against the surety for breach of the performance bond, and the matter proceeded to arbitration resulting in a net award against the contractor for $1,860,545.00. The trial court confirmed the arbitration award, holding that the surety’s liability to the obligee, including delay damages, was $2,314,579.58.25 The trial court additionally assessed attorney’s fees incurred in the arbitration confirmation hearings against the surety.26
The appellate court affirmed the trial court, and in doing so certified conflict with another court of appeals case that held a surety of a performance bond could not be held liable for damages caused by delays in completing the contract.27
The performance bond at issue obligated the surety to cover the costs of completion and “other costs and damages.”28 On appeal to the Florida Supreme Court, the obligee argued that “other costs and damages” included delay damages. The court noted that while a surety’s liability is coextensive with the principal’s liability, a surety’s liability is limited by the terms of the bond.29 The court went on to state, “Florida courts have long recognized that the liability of a surety should not be extended by implication beyond the terms of the contract, i.e., the performance bond.”30
Ultimately, the court found that the purpose and terms of the performance bond made it clear the goal was to merely guarantee completion of the project and nothing more, and it denied the request to impose delay damages.31 The court held “a surety cannot be held liable for delay damages due to the contractor’s default unless the bond specifically provides coverage for delay damages.”32 Importantly, no incorporation by reference provision was included in the terms of the bond.
A California court revisited Larkin when a similar situation arose but when an incorporation by reference provision was in fact present. The California court found the Florida Supreme Court’s reasoning in Larkin unpersuasive. Based upon the language of the underlying contract incorporated into the bond, the California court awarded delay damages, reasoning as follows:
It long has been settled in California that where a bond incorporates another contract by an express reference thereto, the bond and the contract should be read together and construed fairly and reasonably as a whole according to the intention of the parties. To ascertain the nature and extent of the liability to which the surety has bound itself, courts must examine the language of the undertaking by the light of the [construction] agreement, faithful performance of the terms of which it guarantees. As a general rule, the obligation of a surety must be neither larger in amount nor in other respects more burdensome than that of the principal . . . . Even assuming, for purposes of argument, that the performance bond in American Home contained language substantially similar to the bond at issue here, we are not persuaded. The Florida court appears to have viewed the purpose of a performance bond narrowly and to have determined the surety’s obligations without reference to the underlying construction contract. While that may reflect the rule in Florida, firmly established California precedent holds otherwise.33
In 2003, the Eleventh Circuit, which includes Florida, revisited a performance bond surety’s liability for delay damages. The bond at issue in that case again contained an incorporation provision, but the contrary result was reached.34 The owner alleged that the surety was contractually liable for liquidated delay damages because the bonds incorporated the underlying subcontracts by reference, and those subcontracts, in turn, expressly provided for delay damages. The surety denied any responsibility for delay damages, arguing that such damages were unrelated to the completion of the bonded construction projects and that the performance bonds did not expressly recognize liability for delay damages. The court stated as follows:
[T]he purpose of the bond must be considered, which requires reference to the contract secured by the bond. Where a provision for liquidated delay damages is clearly delineated in the underlying contract and incorporated by reference into the bond, the surety is on notice of the time element of performance and the contractual consequences of failure to timely perform in accordance with the contract.35
This case makes it clear that an incorporation by reference provision can significantly impact the scope of a surety’s liability.
Though state and federal courts vary when it comes to an award of delay damages depending upon whether or not the bond contains an incorporation provision, all cases have a common thread, which is the consideration of the true purpose and intent of the performance bond. As such, a surety’s best defense to an award of additional damages that may have been inadvertently agreed upon through an incorporation provision is to specify the purpose of the bond and the intended scope of the guarantee.
II. Statutes of Limitation
An incorporation provision may also affect the applicable statute of limitation. In 1998, the Florida Supreme Court decided the case of Federal Insurance Co. v. Southwest Florida Retirement Center.36 In 1981, the obligee contracted with a contractor to build a retirement center. The surety issued a performance bond, which incorporated the construction contract by reference. In 1993, nearly ten years after the project was completed, the obligee sued the contractor and surety for latent defects that amounted to a breach of an express warranty provided by the contract. The obligee alleged a cause of action against the surety for breach of the performance bond for failure to cure the warranty violation. The trial court granted the surety’s motion for judgment on the pleadings, ruling that the claim on the performance bond was time barred by Florida Statute 95.11(2), which imposed a five-year statute of limitation on claims on written contracts.37
The appellate district court reasoned that “by incorporating the construction contract into the bond, the surety’s liability becomes coextensive with that of the general contractor. . .” and “a timely contractual claim against the general contractor would result in a valid claim against the surety’s bond.”38 The court concluded that because the contracts were coextensive, “the limitations period for an action against the surety did not begin to run until discovery of the latent defects constituting the breach of warranty.”39 The dissent, on the other hand, argued that the majority opinion “extends the liability on the bond by implication beyond the terms of the bond contract. . . .” and such an “additional burden” was contrary to the Florida Supreme Court’s holding in American Home Assurance Co. v. Larkin General Hospital.40
On appeal, the Florida Supreme Court reasoned that the intent of a performance bond is a financial guarantee of the general contractor’s completion obligations in compliance with the conditions of the contract, and, as such, a surety is liable for patent and latent defects whether or not discovered before or after substantial completion.41 The court then turned to the application of the statute of limitations and agreed—at least partially—with the dissent in ultimately holding that the statute of limitations on a performance bond begins to run on the acceptance date of substantial completion of the project, not from the date of discovery of a latent defect.42 As such, despite the presence of an incorporation by reference provision that arguably could have been grounds to bind the surety to the same extended timeframes as the contractor, the court declined to do so. The court’s holding, which specifically declined to extend Larkin beyond its application to delay damages,43 seems to be more strongly rooted in the fact that it found a tolling of the statute of limitation improper as opposed to the argument that the surety’s liability was being extended past the terms of the bond. Despite that, the Southwest case demonstrates that an incorporation by reference provision does not equate to an automatic extension of a surety’s liability and instead offers the surety a plausible position to take when arguing against an overly broad application of the incorporation provision. And again, we see that the courts look first and foremost to the true purpose and intent of the particular bond as a guide to determine how or when an incorporation provision will be applied rather than starting with the purported stronghold premise that an incorporation by reference clause makes a surety’s liability coextensive with that of its principal in every respect.
III. Notice Requirements
Although bonds come in different sizes and shapes, a performance bond will often give a surety several options from which to choose when the principal defaults. Many bonds provide that notice is a condition precedent to the surety’s obligation to perform one of these options. But what happens when there is an incorporation by reference provision, and the principal’s contract, unlike the bond, does not require notice? How do the courts read the documents together and apply the notice requirements?
In 2008, the Florida Third District Court of Appeal heard the case of Dooley & Mack Constructors, Inc. v. Developers Sur. & Indem. Co.,44 which addressed this exact issue. The trial court granted summary judgment in favor of the surety as it was undisputed that the bond obligee contractor had remedied the subcontractor’s default and brought suit against the surety without first notifying the surety. The bond at issue, which incorporated the subcontract by reference, provided that the surety’s obligation arose after notice. On the other hand, the subcontract, which was drafted by the contractor obligee, stated that the contractor could remedy the default itself and later sue the surety. It did not contain an explicit notice requirement.
The appellate court reversed the trial court and noted that all portions of the documents had to be read together.45 It concluded that the options were alternatives, and since the obligee chose the option as provided under the subcontract that contained no explicit notice provision, the surety was financially obligated for the costs of completion and was not entitled to notice.46 The dissent expressed frustration with the majority’s conclusion. Citing American Home Assurance Co., the dissent argued that its “analysis is consistent with the fact that in any dispute between the obligee and a surety, the bond is necessarily the primary determinant of surety liability.”47 The dissent went on to state that the reasoning for that proposition was plain. The contract preceded the bond. Renegotiation of the contract after issuance of the bond to assuage all of the surety’s concerns is impractical.48
Thankfully, the Dooley case appears to be an outlier. The Northern District of Alabama49 and the Southern District of Florida50 have since both rejected the logic of Dooley and have instead, specifically citing the reasoning of the dissent,51 held that the bond language is the primary determinant on notice. Stated otherwise, the lack of a notice requirement in the subcontract cannot override a notice requirement within the bond. Nonetheless, if a bond is going to contain an incorporation by reference provision, a surety issuing a bond in Florida may be wise to include language in the notice provision, such as “notwithstanding language to the contrary within the principal’s contract,” to avoid having its notice provision eviscerated.
IV. Mandatory Arbitration Clauses
Oftentimes the principal’s contract contains a mandatory arbitration provision. As such, when an obligee files suit with the principal, the matter proceeds from court to arbitration with little fanfare. However, if the performance bond contains an incorporation clause, and the obligee also makes a claim on the bond, a procedural dispute over the proper forum can quickly arise. Does the incorporation provision bind the surety to the mandatory arbitration clause included within the principal’s contract?
Unfortunately, jurisdictions continue to vary greatly on this particular issue. Notably, two federal courts recently came to completely opposite conclusions in cases that had the same surety, same obligee, and the same contract language.52 Both cases began with an arbitration demand filed by the contractor on claims of breach of a performance bond. The surety filed declaratory judgment actions in both cases seeking a determination that the incorporation by reference provision did not bind it to arbitrate. The surety argued that by its own terms, the arbitration clause would not apply because the claims were on the bond and the arbitration clause specified that it applied only to claims “between the Contractor and the Subcontractor.” The South Carolina court ultimately held the surety was bound by the arbitration provision.53 The court reasoned the bond should be construed together with the agreement it incorporates to determine the parties’ intent and that a surety clearly obligates itself under a bond to the same liability as the principal.54
The Kansas court reached the opposite conclusion, finding the surety did not consent to arbitrate the dispute despite the presence of an incorporation by reference provision.55 Unlike South Carolina, the Kansas court agreed that the language of the arbitration provision was limited to disputes between the subcontractor and contractor.56 The Kansas court also reasoned that even though there was an incorporation by reference provision, the surety had not agreed to assume “any or all obligations” of the subcontractor but only “certain” obligations in the event of a default by the subcontractor.57
In Florida, arbitration is favored as a matter of public policy, and as such it is no surprise Florida courts mandate arbitration when such obligation was deemed incorporated by reference.58 The District of Columbia also comes down in favor of arbitration.59
A Maryland court recently took a different approach to the incorporation by reference of arbitration clauses. In Schneider Electric Building Critical Systems, Inc. v. Western Surety Company, the Maryland Court of Special Appeals held that the mere incorporation by reference of a contract containing an arbitration clause did not obligate the surety to arbitrate, reasoning that the incorporation of one contract into another contract involving different parties does not automatically transform the incorporated document into an agreement between the parties to the second contract, unless there is “an indication of a contrary intention.”60 In short, there must be some indication that the surety was agreeable to being obligated to arbitrate. This analysis is similar to that of the Kansas court in the Developers case.
As the preceding opinions make clear, cases from around the country on this particular issue can be found both in favor of and against mandatory arbitration clauses binding the surety based upon the incorporation of the underlying contract by reference. Ultimately, if a surety desires to avoid such disputes arising in its claims, the surety may wish to consider whether the incorporation by reference clause specifically states which terms of the principal’s contract are or are not incorporated. Better yet, the provision might specifically state whether dispute resolution provisions are meant to be incorporated, the goal being to ensure that the language of the bond accurately reflects the intent of the bond with respect to the dispute resolution forum in which the surety’s obligations are to be determined.
It is common for a performance bond to incorporate by reference the terms of the principal’s contract, which may expose a surety to rights or obligations the principal and obligee have negotiated outside the presence of the surety. A deceptively simple incorporation provision can create disputes over an array of areas regarding the intent of the parties regarding the scope of the surety’s obligations. The courts, while recognizing that a surety’s liability is generally meant to be coextensive with that of its principal, will first and foremost look to the purpose and intent of the bond itself to determine the scope of the surety’s obligation where the bond includes an incorporation by reference provision.