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Acting in Good Faith: A Condition Precedent to a Surety’s Right to Indemnification

When a federal government project requires it, a prime contractor must secure a bond to ensure payment for any concerns providing labor or materials in the event the prime fails to pay its subcontractors. In exchange for the surety’s issuance of the bond, the prime, as principal, must agree to indemnify the surety for any losses arising or resulting from a claim filed against the bond. This relationship is memorialized in an indemnity agreement executed by the surety and the prime. These agreements are severely in favor of the surety – to the extent that the principal has virtually no defense to indemnification of losses should such be incurred by the surety. However, an indemnity agreement will often have language indicating that the surety must make disbursements in good faith. In Texas, this “good faith” requirement has been determined to be a condition precedent to a right to indemnification.

The seminal case on this matter is Associated Indem. Corp. v. CAT Contracting, Inc., 964 S.W.2d 276, 285 (Tex. 1998). Here, the Texas Supreme Court held that if an indemnity agreement includes language that the surety act “good faith” in making disbursements, then such is a condition precedent to recovery under an indemnification theory. Texas courts have further defined the good faith term as follows: if an indemnity agreement requires a surety to act in “good faith,” then it must not willfully ignore the facts. Associated Indem. Corp. at 285 (Tex. 1998). Willful ignorance is equal to bad faith. Bobbora v. Unitrin Ins. Services, 255 S.W.3d 331, 337 (Tex. App.--Dallas 2008) citing Citizens Bridge Co. v. Guerra, 152 Tex. 361, 371, 258 S.W.2d 64, 69 (1953). And, bad faith in a surety setting may be shown by a willful disregard of and refusal to learn the facts when they were available and at hand. Id.

When facing a standard this high, the burden of proof becomes a critical element in the case. The pleading requirements for conditions precedent in Texas allow a plaintiff on a breach of contract cause of action to generally aver that it has met all of its conditions precedent. Upon doing so, a defendant must then specifically deny which conditions precedent are lacking. In doing so, the burden shifts back to the plaintiff to show that all of its conditions precedent have been satisfied. Meaning, if the principal has identified and denied certain conditions precedent, i.e., the surety failed to act in good faith, then the surety must demonstrate that it did not act in a manner that rose to the level of willful disregard when investigating and ultimately disbursing on a claim.

In government contracting alliances, this good-faith issue usually arises when a subcontractor has filed a claim on the bond, sues the prime and the surety under the Miller Act, and the surety settles or becomes liable on/pays a resultant judgment. The surety, if it has not already done so, will then file suit against the prime under the indemnity agreement for its losses. The prime’s best defense is going to be raising the good faith condition precedent argument, specifically denying it was met, and shifting the burden of proof to the surety. Importantly, though, particularly for the survival of summary judgment (or on cross-motion), the prime will want to ensure it has kept adequate records in the underlying proceeding of the surety’s conduct and engage in targeted discovery in the indemnification suit.

For example, the Miller Act requires the plaintiff in the underlying action to prove that it furnished labor or material in carrying out the work for which it claims it has not been paid. However, qualifying labor under the Miller Act has been judicially interpreted to be manual or physical. Meaning, it is not necessarily the case that simply because the subcontractor performed work that payment for that work is compensable under a Miller Act claim. Accordingly, it is incumbent upon a surety to determine to the extent possible, what, if any, work qualifies and is therefore viable under a Miller Act suit. Conversely, it is equally as important for the principal to determine what information the surety had and activities it undertook before disbursing to determine the extent of covered labor.

In sum, a lot can depend on three words in an indemnity agreement – at least in Texas. If the agreement requires the surety to make disbursements “in good faith,” then the principal has a possible defense in an otherwise ill-favored adhesion contract. Sureties are put in a position of meeting a condition precedent that triggers a right to indemnity – simply incurring losses is insufficient. While the “willful disregard” standard is high, it is not out of reach of the principal, particularly if the surety does not fully understand the nature of the claims against it and does not ensure that its underlying litigation activities demonstrate that it conducted itself accordingly.

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