Exoneration and Quia Timet

Jay M. Mann

This writing is an update of the author’s writing which appeared as Chapter 28 in the first edition of the Law of Suretyship, and a compilation of prior writings by the author on the topics of exoneration and quia timet. The author has also borrowed citations and ideas liberally from other well-written articles regarding enforcement of the surety’s collateral rights.

This web-formatted version of the article does not include citations or other footnotes. You can view the original footnoted article in PDF.

I. Introduction

According to Black’s Law Dictionary, “quia timet” is a Latin phrase meaning “because he fears or apprehends.” In fact, quia timet is the technical name of an equitable remedy which can be extremely valuable to the surety practitioner. Although bills quia timet date back to ancient Common Law, until the 1990s their modern applications were not generally known or sufficiently used by the surety industry.

Quia timet has long been the subject of discussion by legal scholars. From the modern surety’s prospective, the landmark writing was a comprehensive study of quia timet prepared by Walter W. Downs, entitled “Quia timet as a Preventor of Anticipated Mischief,” and presented to the 1956 Annual Convention of the American Bar Association. But as recently as 1982, two separate articles were published in which the authors (Charles A. Meeker and John R. Baylor) bemoaned the rare use of quia timet by the surety industry.

The decade of the 1990s witnessed a resurgence of exoneration and quia timet actions by the surety industry. The author believes this is primarily due to the special attention given to this area of surety law by the Second Circuit Court of Appeals in numerous reported cases, discussed below, and to the articulate opinion of the California Court of Appeals in a widely reported case known as Escrow Agents’ Fid. v. Superior Court (Abelman). With New York and California squarely on the quia timet bandwagon, the rest of the country will certainly follow this trend.

Also, it is very significant that the Restatement of the Law (Third) of Suretyship and Guaranty explicitly recognizes the surety’s exoneration and quia timet remedies. Section 21 of the Restatement reads, in pertinent part, as follows:

§ 21. Principal Obligor’s Duty of Performance

(1) If the principal obligor is charged with notice of the secondary obligation (§ 20), the principal obligor has the duty to the second obligor

(a) to perform the underlying obligation to the extent that failure to do so would leave the secondary obligor liable for performance that would entitle the secondary obligor to reimbursement by the principal obligor, and

(b) to refrain from conduct that impairs the expectation of the secondary obligor that the principal obligor will honor its duty of performance.

(2) Upon breach by the principal obligor of a duty set forth in subsection (1), the secondary obligor is entitled to relief that will properly protect its rights with respect to the principal obligor’s duty of performance.

Comments (i), (j) and (k) to Section 21(2) above specifically approve of exoneration and quia timet relief for the surety under appropriate circumstances (“Among the courses open to a court are to direct performance by the principal obligor, to require that a sum due the obligee by the principal obligor be paid into court for the obligee, or to require that the principal give the secondary obligor adequate security for its ultimate reimbursement.”).

II. Historical Background

A bill quia timet is a bill in equity to protect a party against the occurrence of some future injury which he fears he may suffer, and which he cannot avoid by a present action at law. It is a remedy of particular importance to the surety of a construction contractor because it may be utilized, under appropriate circumstances, prior to the time that the surety’s liability has become fixed. Quia timet is not, however, restricted to use by sureties. For example, quia timet may properly be used to seek cancellation of a negotiable instrument which is voidable while in the hands of a present holder, but which may be enforced against the maker if it is transferred to a bona fide purchaser for value.

Quia timet was originally enforced as a writ of prevention. There were six writs at ancient Common Law (all of which are now obsolete) that could be maintained quia timet before “molestation, distress or impleading.” These were called Brevia Anticipantia – anticipatory relief to accomplish the ends of precautionary justice. The common thread underlying these six ancient writs was that quia timet should be applied “so as to prevent wrongs or anticipated mischiefs, and not merely to redress wrongs after they were done.”

Many courts have taken the Latin phrase literally and applied bills quia timet in unexpected “fearful” contexts. These include the following:

(1) Suit to determine plaintiff’s status as the wife of defendant;

(2) Suit by wife to declare that Mexican divorce decree was invalid;

(3) Suit for cancellation of execution upon judgment;

(4) Suit to determine title to shares of stock;

(5) Suit to determine liability insurer’s duty to defend;

(6) Suit to remove cloud on title;

(7) Suit to establish easement upon real property;

(8) Suit to quiet title to vessel;

(9) Suit by property owner to determine that he had never been the owner of a supper club and therefore not liable for cabaret taxes;

(10) Suit to determine patent infringement;

(11) Suit to perpetuate testimony of severely injured person in action thereafter commenced;

(12) Suit to set aside antenuptial agreement due to fraud and misrepresentation.

These cases are representative of the many factual situations to which quia timet may be applicable. All of these cases involved an absence of actual present injury, a reasonable apprehension of future injury, and danger that irreparable harm would result if the relief prayed for was not granted. The combination of these essential elements made quia timet appropriate relief under the disparate factual circumstances of the above cases.

III. Surety’s Use of Exoneration and Quia timet Remedies

It has been said that “no principle in equity is more familiar or more firmly established than that a surety, after the debt for which he is liable has become due, without paying or even being called on to pay a debt, may file a bill in equity in the nature of a bill quia timet to compel the principal to exonerate him by its payment, provided no rights of creditors are prejudiced thereby.” This oft-repeated statement demonstrates the importance of quia timet in surety law. Nevertheless, the courts and legal scholars have frequently confused exoneration and quia timet remedies of the surety. An understanding of the distinction between exoneration and quia timet is essential to proper representation of the surety. Exoneration is an equitable remedy available only to a surety. The general definition of exoneration is “the removal of a burden, charge or duty – particularly the act of relieving a person or estate from a charge or liability by casting the same upon another person or estate.” In the context of a bonded construction contractor, exoneration is the surety’s right to require that contract proceeds be used to pay contract obligations of its principal which, if unpaid, shall become the obligation of the surety. Also, exoneration includes the surety’s right to require its principal to use his own funds to discharge the primary obligation for payment, even in the absence of the surety having made any payment itself in discharge of its secondary bond obligation. The goal of exoneration is to compel the principal, after the debt has matured, to honor his debt and thereby discharge the surety’s obligation. To invoke the exoneration remedy, a surety must demonstrate that the liability is absolute and that the liability ultimately rests with the principal.

Quia timet is much broader than exoneration. As stated above, the term quia timet is a Latin term meaning “because he fears or apprehends.” A surety may seek quia timet relief when it has reasonable grounds for fearing that its rights are being jeopardized in a potential loss situation, particularly in the diversion of contract proceeds from bonded contract obligations or in the principal’s failure to post collateral for probable bond liability. A quia timet suit by the surety is anticipatory and preventive, before the obligation to the obligee has become enforceable. A surety is under no obligation to file a quia timet suit, although the failure to promptly do so at the time of anticipated liability may result in substantially increased losses at a later date.

Thus, quia timet is more readily available to the surety than exoneration because quia timet may arise before the surety’s obligation has matured. Quia timet is also a more flexible remedy – it can be tailored to fit the particular circumstances facing the surety. The importance of quia timet to the surety was best expressed by Downs in his 1956 presentation to the American Bar Association:

The surety need no longer wait until it has paid claims and is subrogated or to wait until the “obligation has become due” in order to obtain exoneration, or to be limited to the security of the retained percentage before it has a right to protect itself against a diversion of the contract price by the contractor to purposes other than paying his contract creditors.

From the inception of its obligation to the complete discharge of its obligation the surety now has a right to control the entire price through quia timet, including all additional compensation awarded the contractor in connection therewith, whenever it has reasonable cause to be apprehensive about the contractor's use of that money at the expense of the surety or his laborers and materialmen.

This writing will explore how sureties, particularly sureties for construction contractors, may use exoneration and quia timet relief to prevent the diversion of contract funds and to require the posting of collateral to cover anticipated bond losses. The author does not, however, intend to imply that these are the only kinds of relief that may be obtained by sureties in exoneration and quia timet actions. It is submitted that these equitable remedies may in future cases be used in a variety of other situations, depending upon the resourcefulness of surety practitioners and their ability to persuade courts of the sureties’ need for equitable relief in particular “fearful” situations.

IV. Preventing the Division of Bonded Contract Funds

A. Legal Requirements to Protect Contract Funds

Upon the principal contractor’s default of the bonded construction contract (including default in obligations to laborers and materialmen), the surety is entitled to have contract proceeds applied to contract obligations. Alternatively, the surety is entitled to be reimbursed from contract proceeds to the extent of payments made in discharge of bond obligations. In the early stages of a claim matter, the practical problem facing the surety is how to preserve the contract funds until its obligations are dearly defined.

The United States Supreme Court first recognized the surety’s subrogation rights to bonded contract funds in the 1896 case known as Prairie State Nat'l Bank of Chicago v. United States. The surety’s rights were confirmed twelve years later by the Supreme Court in Henningsen v. United States Fidelity & Guar. Company. The Prairie State and Henningsen cases were decided at the time of the Heard Act, the predecessor of the Miller Act. Any doubts as to the continuing validity of the surety’s rights in unpaid contract proceeds under the Miller Act were resolved in the 1962 United States Supreme Court case of Pearlman v. Reliance Insurance Company. In this contest between the surety (who had paid claims pursuant to its Miller Act payment bond obligations) and the trustee for the bankrupt contractor, the Supreme Court ruled that the surety was entitled to the contract balances. Mr. Justice Black, writing for the majority, stated:

We therefore hold in accord with the established legal principles stated above that the Government had a right to use the retained fund to pay laborers and materialmen; that the laborers and materialmen had a right to be paid out of the fund; that the contractor, had he completed his job and paid his laborers and materialmen, would have become entitled to the fund; and that the surety having paid the laborers and materialmen, is entitled to the benefit of all these rights to the extent necessary to reimburse it. Consequently, since the surety in this case has paid out more than the amount of the existing fund, it has a right to all of it.

The right to have contract funds applied to contract obligations is meaningless unless the surety may take protective actions to prevent dissipation of the funds. Before actually making any bond payments, the surety does not technically have subrogation rights in the contract proceeds. If, however, it has a reasonable basis for fearing dissipation, the surety may bring a quia timet suit to compel exoneration by the principal contractor.

Cases which have granted quia timet relief to prevent the diversion of bonded contract proceeds include Morley Constr. Co. v. Maryland Casualty Co. (contractor’s insolvency provided the surety with a reasonable apprehension of diversion), National Surety Corp. v. Barth (right of surety to have contract funds paid to payment bond claimants was held superior to right of contractor to such funds, and superior to right of United States to which contractor owed income taxes), Western Casualty and Surety Co. v. Biggs (court seized contract funds due to contractor who had failed to pay subcontractors at the bonded project), and Lambert v. Maryland Casualty Co. (surety of an insolvent contractor entitled to take action to “freeze” contract funds for subsequent payment of bond claims).

Frequently, quia timet requests are not readily accepted by judges who are unfamiliar with this doctrine of law. For example, in Escrow Agents Fid. v. Superior Court (Abelman), the continuing viability of quia timet was questioned by a California trial court. Indeed, that court denied quia timet relief to the surety and ruled that quia timet is “a concept that pre-dates movable type, and has virtually no application in modern society.” The Court of Appeals strongly disagreed with the trial court’s analysis and its reported opinion affirmed the modern case of quia timet, as follows:

Although a surety may file an action at law to compel its principal to perform the obligation on a bond when due (Civ. Code, § 2846), the fact that it may eventually obtain a judgment against the principal is of little comfort to the surety if, in the interim, the principal has absconded with the very funds which could have been used to satisfy the bond. Quia timet allows the surety to prevent the principal from dissipating those funds if the surety knows it will be called upon to “pay the debt or perform the obligation” on the bond, suspects that the principal has some or all of the necessary funds to do so, and fears that the principal may abscond with those funds.

Morley Constr. Co. v. Maryland Casualty Co. is another case in which quia timet relief was originally denied but later granted following an appeal. In Morley, the Eighth Circuit originally ruled that the surety of an insolvent contractor was not entitled to exoneration because its bond liability had not matured. After reversal and remand by the Supreme Court, the Eighth Circuit then decided that the surety had made out a valid claim for quia timet relief. Although the record failed to disclose any indication that the contractor intended to voluntarily divert contract funds, the court ruled in the latter opinion that the contractor's insolvency provided the surety with a reasonable apprehension of diversion.

The remedy of quia timet is not unlimited, as shown by the Tenth Circuit’s opinion in Fireman's Fund Ins. Co. v. S.E.K. Constr. Co. This case involved a dispute between a surety and a contractor’s assignee-bank to a progress payment owed on a bonded highway project. The contractor had admitted to the surety that it owed $140,000 in outstanding bills, many of which were past due, but maintained that it was not insolvent because credit arrangements had been made with its creditors. No claims had been made against bonds issued by the surety, and the contractor was not in default in its work at the bonded project. The court ruled that the surety should not have instructed the State Highway Department to withhold the progress payment which the contractor intended to endorse to the assignee-bank. The court’s reasoning for refusing the surety's quia timet request was that the surety’s rights to exoneration and subrogation could not be asserted unless and until a default by the contractor occurred; only when the contractor was in default under the bonded contract, according to the court, would the surety prevail over the contractor and the contractor’s bank. The Morley case was distinguished as follows:

The Morley case applied the identical rules we have heretofore set out, and reached the decision that a bill in the nature of quia timet permitted the surety's exoneration, only because of facts which do not exist in the instant suit. First, the construction company was insolvent when the bill of complaint was filed. Second, the creditors were demanding payment on past due bills. Third, an agreement had been entered into between surety and principal whereby the former loaned the latter large sums of money to keep the company operational, in exchange for which the principal agreed to first apply the construction contract proceeds to bills for labor and materials furnished.

The S.E.K. Construction case illustrates the danger of a surety seeking to enforce its quia timet and exoneration rights without a sufficient showing of probable bond liability. While the S.E.K. Construction decision may be criticized for taking an overly restrictive view of when a contractor is in default, nevertheless the surety should definitely have waited to file suit until it had a better factual foundation upon which to seek relief.

B. Procedural Considerations

The common law right of a surety to control contract funds of its principal was first confirmed by the United States Supreme Court in Martin v. National Surety Co. Quia timet relief, in the form of an injunction, was granted to prevent the diversion of contract proceeds before paying claims of laborers and materialmen. Actually, the court based its injunctive relief on two grounds. One, an assignment in the indemnity agreement with the surety, effective upon default by the contractor, to the extent needed to pay bond claimants. Two, under common law, the failure to pay laborers and materialmen was a sufficient default to require the contractor to turn over payments to the surety upon appropriate demand. The progress payments were deposited with the court for the benefit of unpaid laborers and materialmen.

The Martin decision required the deposit of contract funds into court for distribution to bond claimants, with the surplus (if any) distributed to the principal contractor, contractor's assignee-bank and others according to an established priority formula. Other courts have followed this approach, including Fidelity & Deposit Co. of Maryland v. McClintic-Marshall Corp. and Glades County, Florida v. Detroit Fidelity & Surety Co. These cases resemble interpleader suits in which the surety’s superior right to the contested fund is recognized by the court.

The problem with this procedure is that it is too cumbersome for an ongoing construction project. Dynamics of keeping laborers and material suppliers paid and the work going forward according to schedule do not permit the time-consuming deliberation often required by the judicial process. It is suggested that a better approach is to establish a joint control trust account to which progress payments are deposited and, after verification by the surety, from which project bills are paid. Court approval for establishment of a joint control trust account will be needed unless the principal will agree to share control of project receipts and payments with the surety. Even if the principal will so agree, court approval must be obtained if the principal is a debtor-in-possession in a pending Chapter 11 bankruptcy proceeding.

Included in Appendix A to this chapter is a form trust account agreement, which is adapted from an actual agreement approved by a bankruptcy court for completion of a project by a debtor-in-possession principal. When this trust agreement was executed, the principal was behind in payments to project creditors, but the surety had not yet paid any claims and the extent of its bond obligations were not known. Court approval was obtained for the trust agreement on the basis of the surety's reasonable fear of bond losses, under the doctrine of quia timet, unless project funds were strictly applied to project expenses incurred by the debtor in the course of its bonded contract.

If the principal cannot or will not agree to a joint control account, the surety should file a suit for immediate relief. Among other things, the suit should request specific enforcement of the trust fund provision of the standard surety form of indemnity agreement. The trust fund provision typically provides that contract funds are held in trust “for the benefit and payment of all persons to whom the principal incurs obligations in the performance of such contract, for which the surety would be liable under the bond.” There are no reported cases directly enforcing the trust fund provision, although there is no logical reason why the provision should not be so enforced.

It is submitted that the best way for the surety to protect bonded contract funds, in the absence of cooperation from the principal, is to proceed expeditiously to court. A two-prong position should be taken by the surety in support of its request for relief (which may include an application for temporary restraining order and/or preliminary injunction), based upon common law exoneration and quia timet rights and further based upon a right to specific performance of the indemnity agreement. Precious time can slip away while the court considers the surety's pleadings. Accordingly, it is suggested that even before going to court, the surety should put the bond obligee on notice that contract funds may not be disbursed, thereby effectively freezing the contract funds until the court can enter an appropriate order compelling use of these funds for potential bond obligations of the surety.

V. Requiring Collateral for Anticipated Bond Losses

A. Legal Requirements to Obtain Collateral from Indemnitors

In addition to the all-inclusive indemnification clause, the standard form indemnity agreement between surety, principal contractor and indemnitors (individuals or companies, including the principal, who have agreed to be responsible for obligations owed to the surety) provides that the indemnitors must post collateral, upon demand, to secure anticipated bond liabilities. The contractual right of the surety to be placed in funds or collateralized by its indemnitors is independent of, and in addition to, the common law. Under the doctrine of quia timet such common law right may be exercised, before the bond obligation becomes due, under appropriate circumstances of anticipated losses.

The leading common law case addressing the surety’s quia timet right to be collateralized is a 1958 Alabama case called Doster v. Continental Casualty Co. This case involved a contractor, Doster, who declared to his surety, Continental, upon completion of a school construction project, that he was unable to pay approximately $24,000 owed for materials used at the project. Doster had $21,000 on hand, the bulk of which consisted of progress payments received from the school, but refused to pay the material suppliers whose accounts were past due. The surety brought a quia timet suit, and prayed that the court order Doster to use all available funds to pay project bills and, if such funds were not sufficient, then that Doster “be required to protect and secure and indemnify Continental by a transfer of all his assets not subject to exemption over to Continental.” The trial court granted the surety a temporary injunction consistent with its prayer for relief, which injunction was later made permanent.

Although Doster had signed a written indemnity agreement which included a provision for transferring assets to the surety as collateral, the court’s affirmance of the trial court’s injunctive relief was decided on common-law principles. In particular, the court rejected the argument that fraudulent disposition of property, or any other special reason for fearing a loss, had to be shown before a surety could invoke its quia timet rights. The following essential elements were set forth in the Doster opinion for requiring a contractor to transfer assets as collateral to the surety:

The requirements of our cases for a bill of exoneration are more than met in the bill in the instant case in that:

(1) The relationship of surety and principal is alleged.

(2) It is averred that the respondent had, in substance, declared himself in default under his bond by reason of his inability and failure to make payment of the bills of materialmen who had furnished material and supplies for the construction of the North Roebuck School on which the complainant was the contractor’s surety.

(3) It is averred that numerous of the materialmen who had furnished the project had made demand upon the complainant, Continental Casualty Company as surety, for payment under the terms of the performance and labor and material payment bond which the surety had executed on the respondent as principal pursuant to the provisions of § 16 of Title 50 of the Code of Alabama of 1940.

(4) Averments are made concerning the financial status of the respondent, including his possession and control of substantial funds collected as earnings off of the construction of the job bonded by the complainant, and the refusal of the respondent to use the same for the payment of the material bills incurred on the project.

(5) The Complainant in the bill offers to do equity and avers that it makes no effort to avoid its secondary liability to the materialmen for the reasonable value of materials and labor furnished for the construction of the North Roebuck School, for which the materialmen would be entitled to recover from the complainant as surety pursuant to the aforesaid public works statute, and further avers that equity, good conscience and simple honesty dictate and require that the respondent be made to fulfill his obligations to the extent that he is reasonably able, and that the complaint, as his surety, be permitted exoneration to the extent that the materialmen and obligee under the bond for the construction of the North Roebuck School will not be prejudiced on any valid and legitimate claims possessed by them.

Doster is not the only case to rely upon common law rather than the indemnity agreement to provide quia timet relief to the surety. Due to a dispute as to the efficacy of a subsequent indemnity agreement, the New York district court in Northwestern Nat'l Ins. Company of Milwaukee, Wis. v. Alberts also chose to base its decision upon common law principles. Also see a 1998 unpublished opinion of the United States Court of International Trade entitled U.S. v. Almany, in which a contractual indemnity agreement did not exist but the surety was still granted exoneration on common law principles. Nevertheless, most courts prefer to couch their decision in terms of specific performance of the written indemnity agreement, sometimes without reference to the equitable quia timet and exoneration remedies.

No reported decision known to this author has outright rejected the argument that the surety is entitled to collateral under appropriate quia timet circumstances. There are, however, instances in which the requested quia timet relief has been rejected due to the particular factual situation presented to the court. One example is Transamerica Premier Insurance Company v. Cavalry Constr., Inc., a 1989 decision from the Florida Court of Appeals.

In the Transamerica Premier case, the surety moved for a temporary injunction and quia timet relief, essentially asking that a receiver be appointed to take over the assets of the principal Cavalry and the individual indemnitors. The surety had issued $1,187,000 performance and payment bonds on behalf of Cavalry in connection with an underground piping contract. Cavalry and the owner became embroiled in a dispute during the course of construction, and eventually Cavalry was defaulted and forcefully removed from the project. Cavalry admittedly owed approximately $250,000 to suppliers and subcontractors, but claimed to be owed in excess of $350,000 by the owner. The surety demanded that Cavalry and the indemnitors furnish it with collateral equal in value to the total amount of its obligations under the bonds, $1,187,000. When the demand for collateral was refused, the surety filed suit.

The problem with the surety’s presentation in court was that, other than the bare claim from the project owner, no evidence was offered to show that the surety had a reasonable basis to apprehend bond liability. The evidence admitted at the injunction hearing totally supported Cavalry's position against the owner. Even the surety's own experts could not justify the surety’s collateral demand, other than to note that Cavalry planned to auction its equipment in an upcoming liquidation sale. The trial court refused the surety’s request for a receiver, but did grant partial quia timet relief by restricting the first $250,000 from Cavalry’s liquidation sale to pay outstanding project debts covered by the payment bond. The appellate court affirmed, as follows:

Transamerica asserts that under these circumstances it was entitled to enforcement of its collateral security clause. While we agree that such clauses are enforceable in equity, the party seeking quia timet relief must clearly establish a basis for it. As the trial court noted at the hearing, the issue was not whether Transamerica actually feared a $1,187,000 loss, but whether there was any rational basis for such a fear.

We agree that Transamerica failed to flesh out the nature and approximate amount of the claims and liabilities it might reasonably anticipate under the bond from Timberleaf’s claims. The claims of the unpaid subs, laborers and materialmen owed by Cavalry under the project were sufficiently established to permit the trial court to (in effect) grant quia timet relief, which was granted. However, without proof that the surety realistically faces loss under the performance bond and is in jeopardy, the trial court correctly determined that additional quia timet relief was not appropriate.

Despite the fact that the surety lost in Transamerica Premier, the decision is extremely instructive for surety practitioners because it helps define the limits of a quia timet suit. The court in Transamerica Premier explicitly recognized the cause of action, but denied the surety’s quia timet request due to an inadequate evidentiary showing at the injunction hearing. The lesson to be learned from Transamerica Premier is that the surety must prove in court that its fear of bond liability is reasonably based on objective facts – in some jurisdictions, including Florida, it is simply not enough for the surety to merely show that a bond claim has been made and the principal is insolvent.

Transamerica Premier is similar to Fireman's Fund Ins. Co. v. S.E.K. Constr. Company, discussed above, in that both cases involved sureties who were denied quia timet requests because they made an insufficient showing of anticipated bond liability. In re Gas Reclamation, Inc. Securities Litigation, a 1990 decision from the Southern District of New York, is different because the surety’s anticipated liability under a financial guarantee bond was well-founded. Nonetheless, the surety's quia timet request to have collateral posted by the indemnitors was rejected due to the indemnitors’ affirmative claims against the surety for fraud, negligence and securities violations. It was important to the court that the surety's motion for summary judgment on the indemnitors’ claims had previously been denied; thus, according to the court, the affirmative claims were proved to be more substantial than mere allegations. Three other cases involving similar facts, in which quia timet requests were granted by the courts, were distinguished because the investors in In re Gas Reclamation made “a more significant showing of the merits of their claims against [the surety].” In other words, the surety made an insufficient showing of likelihood of success on the merits (which is discussed, in detail below, to be a requirement for quia timet injunctive relief).

Furthermore, the surety in In re Gas Reclamation waited too long to bring the quia timet request. The court commented that in the other three similar suits, the sureties had all moved at an earlier stage in the litigation proceedings. The litigants in In re Gas Reclamation had spent over three years in discovery matters, and the court had twice ruled favorably upon the merits of the investors' claims in pretrial motions. Quia timet is an extraordinary remedy that requires exigent circumstances to justify the drastic relief sought – lengthy delay such as in the In re Gas Reclamation case severely undermines the surety’s contention that extraordinary measures are needed to preserve the status quo pending final resolution of the case. After all, the indemnitors argued against the surety, if the surety felt comfortable waiting three years before asking that the indemnitors post collateral, why should the surety feel less secure while the litigation proceeds to trial over the next several years? The In re Gas Reclamation surety could not answer this question, resulting in the surety’s request for collateral security being denied by the court.

Interestingly, most cases which have been decided since the 1989 Transamerica Premier case have disagreed with its holding. Several recent cases have determined that, if the collateral deposit clause in an indemnity agreement is properly drafted, the obligee’s demand on the bond is sufficient to trigger the surety’s right to have collateral deposited. Of course, if the collateral deposit clause is not properly drafted, the opposite result may occur. See, e.g., Fidelity and Deposit Co. of Maryland v. Rosenmutter, in which the surety was denied collateral relief because the indemnity agreement provided that the indemnitors were required to post collateral “as soon as Fidelity shall be liable therefor” – which the court interpreted to mean when the surety’s liability had become fixed and certain. As the triggering event had not occurred, according to the court, the surety was unable to obtain collateral to protect its interests.

Courts agree that if the surety is otherwise entitled to collateral from the bond principal and indemnitors, the fact that the liability is disputed by the bond principal does not adversely affect the surety’s collateral rights. Otherwise, the surety would not have the collateral, for which it bargained at the time of issuance of the bonds for its principal, while the principal’s defenses to bond liability are being litigated.

Assuming that the surety is entitled to be collateralized, the issue then becomes the amount of collateral that must be provided to the surety. Some courts take the view that the amount of collateral should be equal to the amount of the bond claim against the surety. Other courts permit the amount of collateral to exceed the bond claim, as long as the amount demanded is reasonable in the sole discretion of the surety. To avoid possible problems associated with the surety having too much restriction, most indemnity agreements condition the right to collateral with the creation of a liability reserve. As reserves serve a purpose unrelated to collateral issues – to cover anticipated claims in accordance with regulatory requirements – and are treated as liabilities on the surety’s balance sheet, abuse by the surety in setting reserves for the purpose of demanding collateral is unlikely.

Revenue Markets, Inc. v. Amwest Surety Ins. Co. addressed what the surety may properly do with the collateral which it receives from indemnitors. In this interesting case, the bonded contractor eventually won its litigation against the bond obligee Dade County and was awarded approximately $3.5 million in damages. But previously when the project was outstanding, Dade County had submitted its claim on the surety’s performance bond and the surety had liquidated a collateral letter of credit posted by the contractor in order to pay claims-related expenses. The Florida district court ruled that (notwithstanding the fact that contractor eventually won its dispute with Dade County) the contractor was in “default” under the surety’s indemnity agreement, and the surety’s rights were triggered as soon as Dade County declared the contractor to be in default. The surety was explicitly authorized by the indemnity agreement to liquidate the collateral “for expenses incurred or expected without first having paid any amounts to Dade County.”

One additional case to consider herein, in which the surety was denied quia timet relief, is the Ninth Circuit’s unpublished opinion in United Pacific Ins. Co. v. Gregory Timber Resources, Inc. In this case, the obligee U.S. Forest Service made demand upon the surety’s performance bond, but the court determined that the Forest Service’s claim against the bond principal was barred by the federal statute of limitations. Although the surety’s indemnity agreement provided for the posting of collateral should the surety set up a reserve “for any reason whatsoever,” the court held that the surety’s discretion was not unlimited – the surety’s potential liability had to arise from the bond which is the subject of the indemnity agreement. Although the surety was being pressured with debarment from federal contracts unless it paid money that it did not owe, the court still characterized its status as a volunteer had it decided to make payment. Since the surety had no reason to fear liability on its bond, it was not entitled to quia timet relief in the form of collateral from its bond principal and indemnitors.

B. Procedural Considerations

Probably even more so than when trying to prevent dissipation of contract funds, there is a great need for the surety to take prompt action when seeking collateralization from indemnitors. Injunctive relief to prevent transfers of assets is required. However, to have any real benefit for the surety, the injunction must be entered at the commencement of the lawsuit against the indemnitors, and must be in effect during the pendency of the litigation. Otherwise, the assets may be gone by the time that the surety can have final judgment entered against the indemnitors.

The standards for preliminary injunctive relief in a quia timet and exoneration case are no different than in other injunction cases. These standards are:

1. Whether the movant will suffer irreparable injury unless the injunction issues, and a concomitant absence of an adequate remedy at law;

2. Whether there is (a) a substantial likelihood that the movant will ultimately prevail on the merits, or (b) sufficiently serious questions going to the merits of movant’s claims to make them fair ground for litigation;

3. Whether the threatened injury to movant outweighs damage to the opposing party if the injunction is granted (i.e., a balancing of hardships in favor of the movant); and

4. Whether the injunction would be adverse to the public interest.

No single factor on this list is dispositive. A balancing of all the elements in required, but frequently the balancing focuses upon the irreparable harm in the absence of injunctive relief and the harm to the opposing party as a result of the injunctive relief. Furthermore, as a practical matter, a strong showing of likelihood of success on the merits may diminish the proof required for the other three elements. Frequently the surety in a quia timet and exoneration case will request a “mandatory” injunction, i.e., an injunction which commands a positive act that alters, rather than preserves, the status quo. A mandatory injunction requires a higher standard of proof than ordinarily required for a preliminary injunction. The surety-movant must show a “clear” entitlement to relief or that “extreme or very serious damage” will result from denial of the requested injunction.

Turning first to the requirement of irreparable injury and concomitant absence of an adequate remedy at law, the court in United Bonding Ins. Co. v. Stein stated, without further discussion, that a legal remedy for subsequent damages would not suffice when an indemnitor refuses to voluntarily comply with a surety's demand for collateral. The Ninth Circuit in Milwaukee Constr. Co. v. Glen Falls Ins. Co. seemed inclined to rule that inadequacy of remedy and irreparable injury could be presumed in these circumstances; also in that case, there was evidence that one of the indemnitors had transferred assets out of the country to avoid creditors. Also in Safeco Ins. Co. of America v. Schwab, the Ninth Circuit commented that “if a creditor is to have the security position for which he bargained, the promise to maintain the security must be specifically enforced.” In the Doster case discussed above, the court ruled that a showing of fraudulent disposition of property was not a prerequisite to quia timet relief against the indemnitors. Finally, in U.S. Fidelity & Guaranty Co. v. Feibus, a 1998 Pennsylvania case, the district court had no difficulty with irreparable injury and granted specific performance of a collateral deposit clause upon the surety’s showing that it had established a liability reserve, and the indemnitors had ignored its demands to be placed in funds for protection against future losses.

On the other hand, surety practitioners need to be aware of a 1977 case from the Ninth Circuit called Commercial Ins. Co. of Newark v. Pacific-Peru Constr. Corp. In that case, a surety was unable to require collateralization because the court believed it had an adequate remedy at law. The court was apparently impressed with the fact that the bond obligee’s claim had been reduced to judgment, thereby removing any uncertainty about the surety's liability. The surety’s remedy, according to the court, was for money damages rather than specific performance of the indemnity agreement.

More troubling for surety practitioners are certain Second Circuit cases which have distinguished between inadequacy of legal remedy for purposes of specific performance, and irreparable injury for purposes of preliminary injunctive relief, in collateralization situations. These cases, entitled Northwestern Nat. Ins. v. Alberts, Borey v. National Union Fire Ins. Co., and Abish v. Northwestern Nat. Ins. Co., all involve similar facts in which limited partnership investor notes were backed by financial guarantee bonds in favor of financing banks. When the investors defaulted in their notes, the obligee banks made demand upon the sureties. The sureties then made demand upon indemnitors for collateral to secure their bond obligations. According to these cases, quia timet and exoneration are final remedies, and there is not an automatic linkage between preliminary injunctive relief and final relief. In other words, the surety must demonstrate inadequacy of legal remedy to obtain collateral as the final outcome of the case, but must make an additional showing of irreparable injury to have a preliminary injunction entered during the pendency of the action.

The showing of irreparable injury required by the Second Circuit for a preliminary injunction is very difficult for the surety to meet in most cases. As explained in Abish v. Northwestern Nat. Ins. Co.:

In determining whether irreparable harm exists, the critical inquiry is not whether the surety's rights are lost, but whether the loss of those rights will cause serious or irreparable harm. Behind Northwestern’s claim for quia timet and exoneration relief, it is evident that both rights merely contemplate money payments during the pendency of the action. The nature of the relief sought being monetary compensation, there is no reason why Northwestern cannot be made whole upon resolution of the merits. We have often held that irreparable injury means injury for which a monetary award cannot be adequate compensation.

Abish and the other Second Circuit decisions do, however, recognize certain limited circumstances when irreparable injury may be shown by the surety. For example, irreparable injury may be shown when total bond losses and expenses exceed the indemnitor’s ability to pay, and thus the indemnitor will likely be forced to file bankruptcy. Another example of irreparable injury is when the likelihood of an extra-jurisdictional transfer or dissipation of assets can be proven by the surety. The key for the surety, according to the Second Circuit, is to present “evidence of damage that cannot be rectified by financial compensation.”

U.S. Fidelity & Guar. v. J. United Elec. Contracting, a 1999 Eastern District of New York case, is instructive of how the surety may meet the Second Circuit’s requirements for irreparable injury. In United, the surety sought to compel collateralization in a specific amount which was reasonable under the circumstances - $2,839,050, based upon $1,302,308 losses incurred to date, $73,323 expenses incurred to date, and $1,463,419 estimated to be the surety’s future net losses to meet its bond obligations. It was shown that while the indemnitor had assets that he could deposit as collateral security, the anticipated total amount of bond losses were beyond his financial ability. It was further shown that the indemnitor had engaged in misconduct in forging his wife’s signature on the indemnity agreement and then secretly transferring property to her. The Magistrate Judge, to whom this case was referred, found that the surety was in danger of irreparable injury and recommended a preliminary injunction (following issuance of a temporary restraining order) in favor of the surety. The Magistrate Judge’s recommendation was adopted in its entirety by the reported decision of the District Judge.

It is significant that other reported financial guarantee bond cases, not emanating from the Second Circuit, have taken a different view of irreparable injury in exoneration and quia timet suits. These cases, Northwestern Nat'l Ins. v. Barney and Wingsco Energy One v. Vanguard Groups Resources 1984, Inc., involve the same basic facts as did the Second Circuit cases. The Barney and Wingsco courts had no problem finding irreparable injury to support the surety’s request for a preliminary injunction during the pendency of the action against indemnitors.

This author believes that the Barney and Wingsco courts have adopted the correct approach in collateralization suits. Inadequacy of remedy and irreparable injury should be presumed from the indemnitors’ failure to voluntarily post collateral. When the issuance of bonds was first contemplated by the principal and surety, the indemnitors promised to provide collateral to the surety under appropriately described circumstances in the indemnity agreement. If such promise cannot be enforced at the inception of an equitable action for specific performance, but rather must await determination in a final judgment that will only be entered after adjudication on the merits, then the promise to collateralize is meaningless. It should be remembered that in another provision of the agreement, the indemnitors have already agreed to fully repay the surety for all bond losses and expenses. Unless the surety has recourse to obtain collateral while the lawsuit for damages is pending, then the promise to collateralize adds nothing to the surety’s rights under the indemnity agreement.

The Second Circuit’s position regarding irreparable injury led to a 1995 revision in the Model General Indemnity Agreement of the International Association of Defense Counsel, Fidelity & Surety Committee. The following was added to section I-B, the collateral deposit provision of the Model General Indemnity Agreement:

The Undersigned acknowledge that the failure of the Undersigned to deposit with the Company, immediately upon demand, the sum demanded by the Company as collateral security shall cause irreparable harm to the Company for which the Company has no adequate remedy at law. The Undersigned agree that the Company shall be entitled to injunctive relief for specific performance of the obligation of Undersigned to deposit with the Company the sum demanded as collateral security and hereby waive any claims or defenses to the contrary.

To the best knowledge of the author, this change has not yet been widely implemented by the surety industry. No reported cases have been published which have interpreted this provision, and so it remains to be seen whether this provision will be helpful to the surety seeking to establish irreparable injury for preliminary injunctive relief.

Parenthetically, the Second Circuit's overly-technical interpretation of the irreparable injury requirement in collateralization suits may lead the surety to more traditional prejudgment remedies. If indemnitors have identifiable assets which are presumably available to reimburse the surety upon final judgment (thereby negating irreparable injury to the surety, according to the Second Circuit), then in many jurisdictions the surety may be able to invoke statutory prejudgment remedies to garnish or attach the indemnitors’ assets. It has been held that these statutory remedies have not replaced quia timet, but rather are in addition to common law quia timet rights of the surety. The problem for the surety is that statutory prejudgment remedies are typically less flexible – and therefore less useful – than quia timet to meet the surety’s needs in a dynamic bond loss situation.

Regarding the remaining three requirements for a preliminary injunction, Barney and Wingsco are again instructive. These decisions applied the well-established standards to the surety’s request for a preliminary injunction. As stated above, in both cases the surety was found to be facing irreparable injury unless the injunction was granted. The surety was further found to have a likelihood of success on the merits. As to the balance of hardships and public interest standards, the decisions were “balanced” by ordering that the indemnitors’ assets be paid into court rather than to the sureties. The Barney court stated:

To satisfy the fourth element, serving the public interest, NNIC states the public's interest surely is served when the issuance of a preliminary injunction preserves inviolate the rights accruing to parties that cannot be preserved by a mere action for damages and that are mooted otherwise.

The shareholder-defendants counter that it is in the greater public interest that defendants in civil litigation not be stripped of money and assets before being given the full due process of a trial on the merits of their defenses.

The principals expressly assumed the risk of payment in the Indemnity Agreement and agreed to hold NNIC harmless. To ignore the express terms of this Agreement and the bargained for risks would not be in the public interest. Moreover, the shareholder-defendants specifically, in paragraph (4) of the Indemnity Agreement expressly agreed to subject their assets to a demand of their surety, NNIC. Additionally, the court is not ordering defendants' obligated assets to be turned over to NNIC, but, rather that the assets be paid into court, subject to further court order. To do so will also protect NNIC against the possibility, as claimed, that if injunctive relief is not ordered defendants' assets may be dissipated by the time defendants' securities claims are fully litigated. Under the totality of the circumstances, the fourth element has been satisfied.

Another case which balanced interests and applied injunction standards to a collateral demand by a surety is Safeco, Ins. Co. v. America v. Criterion Inv. Corp. The surety's request for collateral was granted, but the court would not enjoin the indemnitors from transferring assets to other persons before satisfying their collateral obligations. The court explained:

The Court will not award such injunctive relief, finding that the requisite showing of irreparable harm has not been made. The availability of means for the enforcement of judgments, such as the registration of judgments to create liens against judgment debtors' assets, provides the plaintiff in this case with adequate means by which to enforce the defendants' collateral security obligations.

Although not expressly stated, the author believes the Criteron court would have granted all of the requested injunctive relief had the surety been able to show any concealment or transfer of assets or other acts of wrongdoing by the indemnitors. The value of this type of evidence, in these proceedings, cannot be overstated.

Included in Appendix B to this chapter is a set of pleadings which were used in a case to obtain a temporary restraining order, without notice, from a federal district court. The order specifically provided the surety with a lien upon all assets of indemnitors and prohibited the indemnitors from transferring assets during the pendency of the order. Diversity jurisdiction was invoked to enable the district court to hear the case. The surety preferred to have an order from the federal court, rather than from the state court, because there was the possibility that out-of-state assets were owned by the indemnitors. Enforcement of injunctions, particularly affecting disposition of real property, is more easily accomplished across state lines with orders of the federal court.

Rule 65 of the Federal Rules of Civil Procedure governs issuance of temporary restraining orders. It provides that a temporary restraining order may only be entered if it clearly appears from specific facts shown by affidavit or by verified complaint that immediate and irreparable injury will result before the adverse party can be heard in opposition, and that the applicant's attorney must certify in writing the reasons why notice to the adverse party should not be required. The order only remains in effect for ten days, unless extended by agreement of the parties or for good cause shown for an additional ten days. The hearing on applicant’s motion for preliminary injunction, after notice to the adverse party, must be scheduled at the earliest possible time and take precedence over other matters before the court. The temporary restraining order must be supported by an injunction bond, in an amount to be determined by the court.

The pleadings included in Appendix B are a complaint for injunctive and other relief, and an application for temporary restraining order. In that case, a hearing on preliminary injunction was held four days after service of the temporary restraining order upon the indemnitors. The court sustained surety's request for quia timet relief, and a preliminary injunction was entered for the pendency of the litigation.

Obviously, these form pleadings must be adapted to the particular facts of the situation in which they are used. In particular, if the indemnitors are known to have transferred assets or done other things which give the surety special reason to be fearful, these facts should be specified in the pleadings. It is, however, noteworthy that in the case in which the pleadings were actually used, quia timet orders were entered by the court without such additional facts being shown – the surety’s reasonable anticipation of losses and the indemnitors’ refusal to collateralize the surety were held to be a sufficient basis for quia timet relief.

This author believes that sureties frequently wait too long before asking for exoneration and quia timet relief. At the inception of litigation, if warranted by the circumstances, the surety should seek a temporary restraining order to enjoin the transfer of assets by the indemnitors. If the TRO is granted, the assets will be preserved pending the preliminary injunction hearing that must be held shortly thereafter. The preliminary injunction, entered following an evidentiary hearing, will be a broader order that requires the posting of collateral to secure anticipated bond liability. It is not an exaggeration to say that these court orders, obtained at the earliest opportunity by the surety, can change the course of a bond loss matter. It may, indeed, be the difference between losses and full indemnification against losses for the surety.

VI. CONCLUSION

There is no question that extremely strict scrutiny is placed upon sureties requesting quia timet and exoneration relief. Because it is a drastic remedy, quia timet should only be used when the surety’s apprehension of bond losses may be proved by objective evidence admissible in court. Furthermore, a surety should expect to receive only the minimal equitable relief needed under the circumstances to protect its rights. An overzealous surety who brings a quia timet and exoneration action without reasonable anticipation of liability, or an overreaching surety who seeks a wide-ranging injunction against its principal and indemnitors, faces an uphill battle in court.

On the other hand, the recent cases unanimously confirm the surety's right to quia timet and exoneration relief under appropriate circumstances. As a practical matter, prompt use of quia timet and exoneration remedies may be the surety’s only hope to preserve contract funds or to obtain collateral to secure future bond losses. If the right situation is presented, the surety definitely should not wait until after payment of claims to bring suit against the principal and indemnitors. Rather, the surety should be aggressive and take appropriate action at the earliest possible time of anticipated bond liability. u