By Aileen Leipprandt

The Sixth Circuit Court of Appeals recently affirmed that a surety did not act in bad faith when it settled the claim of its principal contractor against the State of Michigan related to disputes on a prison construction project. Great American Ins. Co. v E.L. Bailey & Co., et. al. (November 2016).

In this case, the State hired E.L. Bailey & Company to construct a kitchen in a prison in Ypsilanti. Great American Insurance Company (GAIC) provided performance and payment bonds ensuring Bailey’s performance and payment to subcontractors. In turn, Bailey agreed to indemnify GAIC for payments or expenses GAIC incurred under the bonds and to post sufficient collateral to protect GAIC from claims. The indemnity agreement between Bailey and GAIC also gave GAIC the right to settle on Bailey’s behalf any claim concerning the prison contract.

Disputes arose on the project and Bailey never finished the work. The State and GAIC agreed to have another contractor complete the project. The State withheld payment to Bailey asserting liquidated damages (“LDs”) for Bailey’s failure to timely perform. Bailey disputed the LDs, blaming delays on the State and its architect. The parties sued each other in the Michigan Court of Claims (Lawsuit #1). On the eve of facilitation, GAIC informed Bailey that it had settled Bailey’s claims against the State, with the State agreeing to pay GAIC $358,000 as final payment under the construction contract.

At about the same time, some of Bailey’s subcontractors sued Bailey and GAIC in state court under the payment bonds for amounts due for work (Lawsuit #2). GAIC demanded that Bailey provide collateral for those claims, but Bailey refused. GAIC ultimately settled the subcontractor claims for $645,287.

In another separate proceeding (Lawsuit #3), GAIC sued Bailey in federal court seeking indemnity for Bailey’s failure to provide collateral for the subcontractor claims and requesting a declaratory judgment that GAIC had the right to settle Bailey’s claims against the State. Bailey raised a “bad faith” defense, arguing that GAIC’s settlement with the State was in bad faith because GAIC concealed its negotiations with the State until the eve of facilitation.

While the federal court generally agreed that GAIC’s undisclosed settlement negotiations raised concerns because it might deprive Bailey of the opportunity to consider its options appropriately, that fact alone did not establish bad faith. Rather, Bailey had to prove that GAIC was motivated by a selfish purpose or a desire to protect its own interest at the expense of Bailey. Bailey offered no evidence as to GAIC’s state of mind. The Court sided with the surety concluding that GAIC had a right to settle Bailey’s claims under the parties’ indemnity agreement and that GAIC had not acted in bad faith in doing so, particularly where communications between GAIC and the State established that GAIC pushed the State for a higher settlement amount.

Lesson learned – a surety’s rights under the general indemnity agreement with its principal contractor are expansive. A contractor should carefully evaluate its course of action on project disputes in the face of its broad reaching indemnity obligations.