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holding as a matter of first impression that, "[w]hile there may be differences in the form of the suretyship agreement and the obligations of the parties, its substance is essentially the same as insurance," and that "Colorado common law recognizes a cause of action in tort for a commercial surety's failure to act in good faith when processing claims made by an obligee pursuant to the terms of a performance bond."
Summary of this case from Liberty Mut. Ins. Co. v. Milender White Constr. Co.Opinion
No. 96SC227
June 9, 1997 Petition for Rehearing DENIED August 4, 1997
Certiorari to the Colorado Court of Appeals
JUDGMENT AFFIRMED
Quiat, Schlueter, Mahoney Ross, P.C., Laurin D. Quiat, Denver, Colorado, Attorneys for Petitioner.
Miller, DeLay Crabb, P.C., Thomas S. Crabb, Pauline A. Brock Westminster, Colorado, Attorneys for Respondent.
We granted certiorari to review the court of appeals decision in Brighton School District 27J v. Transamerica Premier Insurance Co., 923 P.2d 328 (Colo.App. 1996), to determine whether Colorado recognizes the existence of a common law tort claim against a commercial surety who fails to reasonably proceed with the payment of a claim under a performance bond. The court of appeals held that the trial court did not err in submitting an obligee's bad faith claim to the jury. We conclude that allowing this cause of action to proceed in the commercial surety context is justified by the special nature of the suretyship agreement and by the reasoning set forth in our prior decisions authorizing bad faith actions against insurers. For this reason, we affirm the court of appeals.
I.
On May 13, 1991, Brighton School District 27J (the school district) entered into a contract with Adco Mechanical Contractors, Inc. (Adco) to perform the mechanical work on a construction project at Brighton High School. Pursuant to section 38-26-106(1), 16A C.R.S. (1982), Adco provided the school district with a performance bond on which Transamerica Premier Insurance Company (Transamerica) agreed to act as commercial surety to guarantee Adco's performance under its contract with the school district.
Section 38-26-106(1) provides:
Every contractor who is awarded any contract for more than fifty thousand dollars for the construction, erection, repair, maintenance, or improvement of any building, road, bridge, viaduct, tunnel, excavation, or other public works for this state, or for any county, city and county, municipality, school district, or other political subdivision of the state, before entering upon the performance of any such work included in said contract, shall duly execute, deliver to, and file with the board, officer, body, or person by whom such contract was awarded a good and sufficient bond, or other acceptable surety, approved by such contracting board, officer, body, or person, in a penal sum not less than one-half of the total amount payable by the terms of the contract.
§ 38-26-106(1), 16A C.R.S. (1982).
Adco began work on the project in June of 1991 and soon fell behind schedule. The construction manager and the school district repeatedly advised Adco of the need to proceed on schedule, but Adco fell further behind and continued to miss deadlines throughout the winter of 1991-92. Adco was also notified both orally and in writing that various problems with its work had been discovered, but it failed to address most of these problems. On April 30, 1992, solder, wood chips, and rocks were discovered in a unit ventilator which controlled the temperature in one of the classrooms. Further inspection revealed numerous instances of Adco's incomplete or defective work as well as repeated failures to comply with the architect's drawings and specifications. Following its investigation, the school district gave Adco written notice on May 19, 1992, that it had been removed from the project. That same day, the school district filed a claim with Transamerica on the performance bond. Adco filed suit on June 8, 1992, in Adams County District Court, alleging that the school district violated the terms of the construction contract.
The construction contract between the school district and Adco provided that Adco's work was to be substantially completed by December 16, 1991.
The school district met with Transamerica representatives on June 10, 1992, to devise a remedial plan to correct the errors in Adco's work. At the meeting, the school district stressed the importance of completing the remedial project by the start of the 1992-93 school year. A Transamerica representative stated that the school district was proceeding properly and expressed Transamerica's desire to have the school district obtain between three and five bids for the remedial work.
On June 29, 1992, the school district filed an answer, counterclaim, and third-party complaint asserting breach of warranty, breach of contract, negligence, and fraud claims against Adco and asserting that Transamerica had breached the terms of the performance bond by not performing its commercial surety obligations.
Three bids for the remedial work were submitted by July 2, 1992, and the school district subsequently awarded the contract to a new contractor, APH Service Company (APH). On July 15, 1992, the school district sent a letter to Transamerica informing it that APH's bid had been selected and that the remedial work was proceeding on schedule. The next day, Transamerica responded to the school district's letter by stating that the remedial work concerned "nothing more than a detailed punchlist"; the new work contained several items that were not in Adco's original contract; the bids were "nonresponsive and extremely excessive"; and Adco should be returned to the project and allowed to complete the work. Thereafter, Transamerica made no progress payments for the remedial work and continued to assert that Adco had been wrongly terminated. Nevertheless, the remedial work was substantially completed by August 13, 1992. On January 15, 1993, a bill for the remedial work was sent to Transamerica and Adco. Three days later, the school district made a formal demand for payment which Transamerica refused. Adco subsequently declared bankruptcy.
The parties proceeded toward trial. On August 18, 1993, the school district was granted leave to amend its third-party claim against Transamerica to include a separate tort claim for bad faith denial of the school district's performance bond claim. On October 12, 1993, Transamerica filed a motion for summary judgment or dismissal of the third-party claim on grounds that the performance bond was not a contract for insurance that was subject to a bad faith claim. The trial court denied this motion and subsequent motions asserting the same argument. After an eleven-day trial, the jury awarded the school district $311,666.04 pursuant to the performance bond and an additional $10,000.00 on the school district's bad faith claim. The court of appeals held that the trial court did not err in submitting the school district's bad faith claim to the jury.
II.
In Colorado, every contract contains an implied duty of good faith and fair dealing. See § 4-1-203, 2 C.R.S. (1992); Amoco Oil Co. v. Ervin, 908 P.2d 493, 498 (Colo. 1995). Actions based upon a breach of this duty were traditionally limited to contract damages because the duty of good faith and fair dealing concerned the faithful performance of a contract's terms. See Amoco Oil, 908 P.2d at 498 (stating that "[t]he good faith performance doctrine is generally used to effectuate the intentions of the parties or to honor their reasonable expectations"). In Farmers Group, Inc. v. Trimble, 691 P.2d 1138 (Colo. 1984), we held that an insured could assert a cause of action apart from, and in addition to, contract damages for an insurer's breach of its implied duty to act in good faith. Id. at 1141-42. In so holding, we reasoned:
The basis for liability in tort for the breach of an insurer's implied duty of good faith and fair dealing is grounded upon the special nature of the insurance contract and the relationship which exists between the insurer and the insured. The motivation of the insured when entering into an insurance contract differs from that of parties entering into an ordinary commercial contract. By obtaining insurance, an insured seeks to obtain some measure of financial security and protection against calamity, rather than to secure commercial advantage. The refusal of the insurer to pay valid claims without justification, however, defeats the expectations of the insured and the purpose of the insurance contract. It is therefore necessary to impose a legal duty upon the insurer to deal with its insured in good faith.
Id. at 1141 (citations omitted).
In Travelers Insurance Co. v. Savio, 706 P.2d 1258 (Colo. 1985), we extended the "basic rationale" of Trimble to authorize actions in tort where an insurer was alleged to have handled a first-party workers' compensation claim in bad faith. Id. at 1272-76. We noted that, "[s]ince workers compensation serves the same purpose as insurance in general, the Trimble rationale demands that the provider of such compensation deal fairly and in good faith with an employee asserting a compensable injury." Id. at 1273. We also elaborated on the proper standard for evaluating such claims as follows:
[I]n the first-party context an insurer acts in bad faith in delaying the processing of or denying a valid claim when the insurer's conduct is unreasonable and the insurer knows that the conduct is unreasonable or recklessly disregards the fact that the conduct is unreasonable.
Id. at 1275.
Section 38-26-106(1), 16A C.R.S. (1982), provides that every contractor that is awarded a public works contract for more than $50,000 must submit a performance bond executed by a qualified commercial surety to the public entity in charge of the project. Under the terms of the performance bond, in the event the contractor (the principal) fails to fulfill its obligations to the public entity (the obligee) under the public works contract, the commercial surety must guarantee performance and/or satisfy debts resulting from unpaid labor and materials. See § 38-26-106(2), 16A C.R.S. (1982 1996 Supp.); see also General Ins. Co. of America v. City of Colorado Springs, 638 P.2d 752, 757 (Colo. 1981) (explaining that "[a] surety bond is a written contract guaranteeing performance of an obligation by another").
The issue in this case concerns whether we should extend our holdings in Trimble and Savio to include situations in which a commercial surety company fails to act in good faith when processing claims made by an obligee pursuant to the terms of a performance bond. We conclude that the rationale for providing insureds with a cause of action in tort for an insurer's bad faith in processing a claim applies with equal force in the commercial surety context.
We have previously explained that commercial sureties receiving consideration for the issuance of surety bonds serve a purpose similar to that of insurers:
"Generally speaking, a contract of suretyship by a surety company is governed by the same rules as the contracts of other sureties, but some distinctions are made by the courts in construing such contracts. The doctrine that a surety is a favorite of the law, and that a claim against him is strictissimi juris, does not apply where the bond or undertaking is executed upon a consideration by a corporation organized to make such bonds or undertakings for profit. While such corporations may call themselves `surety companies,' their business is in all essential particulars that of insurers."
Empire State Sur. Co. v. Lindermeier, 54 Colo. 497, 505, 131 P. 437, 440 (1913) (quoting 32 Cyclopedia of Law and Procedure Principal and Surety § 306 (1909) (footnotes omitted)).
The insurance statutes reflect a legislative intent to include sureties as part of the regulatory scheme governing insurance. Section 10-1-102(8), 4A C.R.S. (1994), defines the term "insurer" as "every person engaged as principal, indemnitor, surety, or contractor in the business of making contracts of insurance." Similarly, section 10-3-1102(2), 4A C.R.S. (1994), of the Deceptive Practices Statute, §§ 10-3-1101 to -1114, 4A C.R.S. (1994 1996 Supp.), defines the terms "insurance policy" and "insurance contract" to include suretyship agreements. The Deceptive Practices Statute expressly prohibits unfair claim settlement practices and lists a variety of penal measures available in the event a commercial surety engages in unfair settlement practices. See § 10-3-1104(h), 4A C.R.S. (1994); § 10-3-1108, 4A C.R.S. (1994). Furthermore, section 10-3-1113(1), 4A C.R.S. (1994), provides:
In any civil action for damages founded upon contract, or tort, or both against an insurance company, the trier of fact may be instructed that the insurer owes its insured the duty of good faith and fair dealing, which duty is breached if the insurer delays or denies payment without a reasonable basis for its delay or denial.
These statutes indicate persuasive legislative support for treating a commercial surety contract as a form of insurance agreement and for treating a commercial surety which fails to settle its obligations in good faith in the same way that our tort law treats insurers who process a claim in bad faith.
More specifically, most other jurisdictions that have considered this issue have recognized a separate cause of action in tort for a commercial surety's bad faith in processing claims made under a surety bond. See Loyal Order of Moose, Lodge 1392 v. International Fidelity Ins. Co., 797 P.2d 622, 626-28 (Alaska 1990); Dodge v. Fidelity and Deposit Co., 778 P.2d 1240, 1242 (Ariz. 1989); K-W Indus. v. National Sur. Corp., 754 P.2d 502, 504-505 (Mont. 1988); Szarkowski v. Reliance Ins. Co., 404 N.W.2d 502, 504 (N.D. 1987); Suver v. Personal Serv. Ins. Co., 462 N.E.2d 415, 417 (Ohio 1984). But see Great American Ins. Co. v. North Austin Util. Dist., 908 S.W.2d 415, 418-20 (Tex. 1995). We agree with the reasoning of those cases which authorize a bad faith cause of action in the commercial surety context and conclude that a similar result in the present case represents a logical extension of our holdings in Trimble and Savio.
A special relationship exists between a commercial surety and an obligee that is nearly identical to that involving an insurer and an insured. See Loyal Order of Moose, 797 P.2d at 626-27; Suver, 462 N.E.2d at 417; see also Trimble, 691 P.2d at 1141. When an obligee requests that a principal obtain a commercial surety bond to guarantee the principal's performance, the obligee is essentially insuring itself from the potentially catastrophic losses that would result in the event the principal defaults on its original obligation. See Dodge, 778 P.2d at 1242. When the principal actually defaults, the commercial surety must assume or correct any flaws in performance pursuant to the terms of the original contract, thereby eliminating the obligee's risk of loss in the venture.
Contrary to Transamerica's assertions, public entities such as the school district seek performance bonds to reduce or eliminate the risk of catastrophic loss. See Trimble, 691 P.2d at 1141. Besides operating on a not-for-profit basis, public entities are constrained by tight budgets that give them little, if any, financial flexibility. Additionally, the timing of a contractor's performance is especially important in constructing schools. Delays and shoddy work on critical infrastructure improvement projects are sure to result in profound consequences to both the public entity and the general public that uses the facilities.
Although the parties to a suretyship agreement are on equal footing in terms of bargaining power when they enter into the agreement, it is the commercial surety who controls the ultimate decision of whether to pay claims made by the obligee under the terms of the surety bond. For this reason, the commercial surety has a distinct advantage over the obligee in its ability to control performance under the secondary agreement. As with insurers, commercial sureties must proceed with the payment of claims made pursuant to a surety bond in good faith. Otherwise, the core purpose of the suretyship agreement, which is to insulate the obligee from the risk of a default, is defeated. See Trimble, 691 P.2d at 1141; Dodge, 778 P.2d at 1243.
Recognizing a cause of action in tort for a commercial surety's breach of its duty to act in good faith compels commercial sureties to handle claims responsibly. When the commercial surety withholds payment of an obligee's claim in bad faith, contract damages do not compensate the obligee for the commercial surety's misconduct and have no deterrent effect to prevent such misconduct in the future. As the Arizona Supreme Court explained in Dodge, contract damages
"offer no motivation whatsoever for the insurer not to breach. If the only damages an insurer will have to pay upon a judgment of breach are the amounts that it would have owed under the policy plus interest, it has every interest in retaining the money, earning the higher rates of interest on the outside market, and hoping eventually to force the insured into a settlement for less than the policy amount."
Id. at 1242-43 (quoting Wallis v. Superior Court, 207 Cal.Rptr. 123, 128 (Cal.Ct.App. 1984)).
Transamerica argues that the unique features of suretyship distinguish it from insurance and that the suretyship agreement is, in essence, a financial service. We disagree. As explained above, the suretyship agreement provides the obligee with financial security by eliminating the risk of default in the original agreement between the principal and the obligee. While there may be differences in the form of the suretyship agreement and the obligations of the parties, its substance is essentially the same as insurance. See Empire State, 54 Colo. at 505, 131 P. at 440.
We recognize that the commercial surety is put in an awkward position in handling simultaneous claims made by the principal and the obligee. The Supreme Court of Hawaii has explained the surety's dilemma as follows:
Clearly, the surety owes a duty of good faith and fair dealing to both the principal and the obligee on the bond. If the surety pays too quickly to the obligee, it may invite liability claims from the principal. Conversely, if it refuses to pay anything pending an arbitration or judicial proceeding to determine its liability on the bond, the surety may incur liability to the obligee for failing to act promptly on a valid claim.
Board of Dirs. of Ass'n of Apartment Owners v. United Pac. Ins. Co., 884 P.2d 1134, 1137-38 (Haw. 1994) (citations omitted). Although the commercial surety's obligations may be more complex than those of an insurer, this complexity does not authorize a commercial surety to disregard its obligation to act in good faith. See Dodge, 778 P.2d at 1243; Suver, 462 N.E.2d at 417.
In Suver v. Personal Service Insurance Co., the Supreme Court of Ohio elaborated on the differences and similarities between insurers and sureties as follows:
It is true that a financial responsibility bond is not the same as an insurance policy and that a surety is not an insurer and may therefore act in its own interest. But the nature of the differences between the two is neither complete nor absolute. Rather, the financial responsibility bond and the insurance policy differ primarily in whom they protect and to whom the duty runs. . . .
These differences are not so pronounced as to require the creation of a cause of action in one case and its denial in the other. Precisely the same policy arguments and rationale hold true in both settings. . . . Moreover, to insulate the issuer of a financial responsibility bond from liability for the deliberate refusal to pay its obligations arising from the bond is to encourage the routine denial of payment of claims for as long as possible. This court should not provide an incentive to act in bad faith.
Suver, 462 N.E.2d at 417 (citations omitted).
Accordingly, we hold that Colorado common law recognizes a cause of action in tort for a commercial surety's failure to act in good faith when processing claims made by an obligee pursuant to the terms of a performance bond. In evaluating these causes of action, we adopt the rule set forth in Savio that a commercial surety acts in bad faith when the surety's conduct is unreasonable and the surety knows that the conduct is unreasonable or recklessly disregards the fact that its conduct is unreasonable. Savio, 706 P.2d at 1275. By imposing this legal duty on the commercial surety, our holding ensures that the expectations of the obligee and the purposes of the suretyship agreement are given effect while recognizing the surety's right to refuse invalid claims. See id. at 1274-75; see also Trimble, 691 P.2d at 1141; Dodge, 778 P.2d at 1242-43.
In Savio, we noted that injured workers could be viewed as third-party beneficiaries of an insurance contract between the insurer and the employer. Id. at 1272. We further explained that the relationship between the employee asserting the workers' compensation claim and the insurance company was essentially that of a first-party claim. Id. Similarly, the obligee in a suretyship agreement is analogous to a third-party beneficiary because the suretyship agreement, in this case a performance bond, is designed solely for the obligee's benefit. See Loyal Order of Moose, Lodge 1392 v. International Fidelity Ins. Co., 797 P.2d 622, 628 (Alaska 1990) (explaining that an obligee in a suretyship agreement is an "intended creditor third-party beneficiary"). We therefore view a claim filed by an obligee under a suretyship agreement as a first-party claim that warrants application of the Savio standard. See Savio, 706 P.2d at 1274-75.
III.
The trial court properly submitted the school district's bad faith claim to the jury and gave the jury an appropriate instruction on the applicable standard. Therefore, we affirm the decision of the court of appeals.
JUSTICE KOURLIS dissents, and JUSTICE MARTINEZ joins in the dissent.