Basics of the law surrounding corporate surety bonds

We recently posted about probate bonds, which is a bit outside of our normal legal topic.  However, Our friends from Swiftbonds saw our posts and sent us the article below, which is just too good to pass up.

We promise that our next post will be something easier to understand, like whether a waterfall provision in a securitization document has precedence over a conflict sub-servicing agreement.  Or something like that.  Thanks, FLA.

The Law Surrounding Corporate Surety Bonds

The law of fidelity bonds is certainly not new.  The early 20th century saw a lot of litigation with regard to how surety bonds were interpreted by the court.  This litigation led to a prolonged period of certainty with regard to the underlying rights and liabilities of the parties.  Unfortunately, the recent financial downturn and the resulting pain suffered by construction companies, municipalities and other large institutions have led to a new set of litigation, which has resulted in some changes regarding how these contracts are ultimately viewed by the courts.

Financial Crisis

Theories of Interpretation

Strict Interpretation.  The most theory of construction is that of strict interpretation of the document.  That is, the document says exactly what it say and the court will interpret everything based upon the four corners of the document.    Thus, the intent of the parties are not relevant to any interpretation, but instead only the words on that document rule.  Anything that is not discussed would, therefore, be interpreted based upon state law or the UCC.

Uniform Commercial Code

This theory was the most prevalent in the early days.  However, given that most forms are preprinted forms created by the individual insurance companies (or bankers forms) with little to no negotiation, this rule has been largely overcome by newer rules of construction.  Still, it’s a good rule of thumb to remember that if the document actually specifies something and that something comes to pass, then the document will nearly always rule.

Insurance Contract.  The second major theory of construction is that a surety bond is the equivalent of an insurance contract.  Thus, the interpretation of that document should follow the general rules of construction found within the state regarding other insurance contracts.  This includes a large body of law on pooling and sharing of risk and, therefore, these rules are seen through that viewpoint.

Contract

The large problem with this viewpoint (which is the law in several states) is that fidelity bonds are not written like insurance contracts.  Instead, the underwriting process assumes no risk instead of a pooling effect.  We have fortunately not seen a spiking of rates in the states with these rules, so that is a good thing.

Indemnification.  The last major theory is that a corporate surety bond is basically an indemnification agreement and, therefore, the actual terms of the agreement are less important than the purpose for which it was given.  In these circumstances, the court takes a much more equitable approach in determining the liability.

Ambiguity sign

This is, of course, the most ambiguous of all the theories of construction.  How do you properly draft and structure the risk of an agreement if that contract can be interpreted in a way that is totally different than the words on the page?  The simple truth is, you don’t.  Instead, you create a business model that utilizes standard forms and agreements and then use the law of large numbers to nullify systemic risk.  And this is the world that we live in today.

Conclusion

The 21st century has seen a rebound in litigation with regard to corporate surety bonds.  This litigation has led us to review the old theories of construction on how these contracts are interpreted.  There are three main ways: 1) strict interpretation; 2) using insurance contracts as a guide; and 3) these agreements are similar to indemnification agreements.