Enforcing the Surety’s Rights Prior to Actual Payment of Claims

Jay M. Mann

From "The Pursuit of Subrogation and Indemnity Claims," Defense Research Institute, Volume 1991, Number 3

Please note that this web-formatted version of the article does not include citations and other footnotes. To view the original footnoted article with related appendices, please view the PDF version.

I. Introduction

There are well-established remedies available to the construction surety, prior to actual payment of claims, to enforce its rights and minimize bond losses. In the early stages of a construction bond loss situation, two primary objectives of the surety will often be: (1) preventing the diversion of bonded contract funds; and (2) requiring indemnitors to post collateral for anticipated bond losses. The remedies available to the surety to accomplish these objectives include exoneration and quia timet, based upon equitable, common law and contract principles. A suit for specific performance of the indemnity agreement by the surety may be required to implement these remedies, or a declaratory judgment action may be more appropriate under the circumstances. To bring these issues to the attention of a court for early resolution, the surety may seek a temporary restraining order or preliminary injunction against the principal contractor and indemnitors.

This article closely follows a 1985 paper co-written by this author that discussed these exoneration and quia timet issues. In that paper, sureties were encouraged to be more aggressive in their use of early remedies, particularly quia timet, to protect their rights. The authors of the 1985 paper concluded:

Whenever the construction surety is faced with potential bond losses and a recalcitrant principal contractor or indemnitor, the remedy of quia timet should be considered. It is not suitable for all situations, and the surety practitioner must determine, on a case-by-case basis, whether quia timet may properly be invoked and whether it will really be beneficial to the surety. However, under appropriate circumstances of default and reasonable apprehension of liability, quia timet may be the only practical means by which the surety may preserve funds or other assets for subsequent discharge of bond obligations or reimbursement to the surety. In other words, prompt use of available quia timet procedures may be the difference between losses and avoidance of losses to the construction surety.

It remains this author’s belief that sureties, and counsel representing sureties, are too reluctant regarding use of exoneration and quia timet remedies in the handling of their bond loss matters. The case law that has developed since the 1985 paper support the surety’s prompt invocation of these equitable remedies, and indeed these recent cases help define the practical limits of modem exoneration and quia timet relief. This article will review the law of exoneration and quia timet, and will give special emphasis to recently reported cases. Hopefully, with this update of the law, readers will be more inclined to bring exoneration and quia timet actions in their own construction surety claim files.

II. Distinguishing between Exoneration and Quia Timet

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 require the principal to discharge a liability of the surety that has already matured. 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. The term quia timet is a Latin phrase meaning “because he fears or apprehends.” A bill quia timet is a bill in equity, with origins back to the six writs at ancient Common Law, designed 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. The “fearful” contexts in which quia timet has been granted is not limited to surety situations -suits to quiet title, establish easements, determine title to stock and even determine marital status have all been covered under the quia timet umbrella.

The surety for a construction contractor may seek quia timet relief when it has reasonable grounds for anticipating 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. Quia timet suits by the surety are 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 Walter Downs in his landmark presentation at the 1956 annual convention of 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.

In the following two sections, this article will explore how the surety may use exoneration and quia timet 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.

III. Preventing the Diversion 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 clearly 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 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. (Emphasis added).

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).

The remedy of quia timet is not unlimited, as shown by the case of Fireman’s Fund Ins. Co. v. S.E.K. Constr. Co. This case involved 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 Construction 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, 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.

In this author’s 1985 paper, the Martin approach was criticized as follows:

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. These authors suggest that a joint control trust account be established to which progress payments are deposited and, after verification by the surety, from which project bills are paid.

Court approval for establishment of a trust account will be needed unless the contractor will agree to share control of project receipts and payments with the surety. Even if the contractor will so agree, court approval must be obtained if the contractor is a debtor-in-possession in a pending chapter 11 bankruptcy proceeding. Precious time can slip away while court approval is being obtained. Accordingly, it is suggested that surety’s counsel immediately place the bond obligee on written notice’ of its claim to unpaid contract proceeds upon learning of the default, and thereby freeze the funds until a trust account can be judicially approved.

In a later paper presented to the 1989 MidWinter Meeting of the ABA, TIPS Fidelity & Surety Committee, commentators Lawrence, Wright, Bachrach and Dolan (hereinafter collectively referred to as “Lawrence”) responded with a suggestion for handling this problem based on a standard form General Indemnity Agreement. According to Lawrence’s interpretation of the indemnity agreement, the principal and indemnitors have effectively granted control over the bonded contract funds to the surety. The trust funds provision of a standard General Indemnity Agreement states 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.” Lawrence contends that:

The surety does not need court approval for establishment of a trust account, nor does the surety have to rely on the principal’s agreement to share control of project receipts and payments with the surety because the principal and the indemnitors have already agreed to such control by the surety by their execution of the Agreement of Indemnity. If the principal and the indemnitors refuse the demand of the surety to establish the joint control trust account under the Agreement of Indemnity, the surety’s remedy is to seek specific performance of the Agreement of Indemnity and request that the court compel the establishment of the joint control trust account already consented to by the principal and the indemnitors by their execution of the Agreement of Indemnity. While there do not appear to be any reported cases directly enforcing the trust fund provision, the authors see no reason why it should not been forced for the reasons which follow.

This author agrees with Lawrence that specific performance of the indemnity agreement may lead to the same common law relief granted by the Martin court. Of course, the trust fund provision is not self-executing -he surety must still go to court for expedited relief to avoid substantial prejudice to its position. Further, the trust fund provision does not contain explicit joint control account language, and so a favorable interpretation of the parties’ intent underlying the General Indemnity Agreement must be made for the court to create a joint control account over the principal’s objection.

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 the litigation, based upon its common law exoneration and quia timet rights and further based upon its right to specific performance of the indemnity agreement. Even before going to court, the bond obligee should be put on appropriate notice not to disburse contract funds, 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.

IV. Requiring Collateral for Anticipated Bond Losses

A. Legal Requirements to Obtain Collateral from Indemnitors

In addition to the all-inclusive indemnification clause, a standard form General 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 following collateral security provision is the most common within the surety industry:

That if Surety shall be required or shall deem it necessary to set up a reserve in any amount to cover any claim, demand, liability, expense, suit, order, judgment or adjudication under or on any Bond or Bonds or for any other reason whatsoever, the principal and indemnitors shall immediately upon demand deposit with Surety an amount of money sufficient to cover such reserve and any increase thereof, such funds to be held by Surety as collateral, in addition to the indemnity afforded by this instrument, with the right to use such funds or any part thereof, at any time, in payment or compromise of any liability, claims, demands, judgment, damages, fees and disbursements or other expenses.

Note that the surety’s right to have collateral posted in the above provision is conditioned upon the establishment of a liability reserve. There may, however, be situations in which the surety needs collateral before the liability reserve is set, or needs collateral in an amount greater than the liability reserve. This author prefers the following, more flexible, collateral security provision:

In order to exonerate or indemnify Surety, the principal and indemnitors shall upon demand of Surety, place Surety in funds before Surety makes any payments; such funds shall be, at Surety’s option, money or property, or liens or security interests in property. (The amount of such money or property or the value of the property to become subject to liens or security interests, shall be determined by Surety.)

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 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:

(l) 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 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 complainant, 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. Que to a dispute as to the efficacy of a subsequent indemnity agreement, the district court in Northwestern Nat’l Ins. Company of Milwaukee, Wis. v. Alberts also chose to base its decision upon common-law principles. Nevertheless, most courts prefer to couch their decision in tenus of specific performance of the written indemnity agreement, sometimes without reference to the equitable quia timet and exoneration remedies. For example, in United Bonding Ins. Co. v. Stein, the operative provision of the indemnity agreement for collateralization was conditioned upon the surety’s establishment of a liability reserve. The indemnitors refused to comply with surety’s demand for funds equal to its established reserve, and so the surety brought suit to compel security. The court denied the indemnitors’ motion to dismiss in the following passage:

When stripped to its essentials, this action is simply one for the specific performance of a contractual agreement. Unlike the situations with which the cases cited by defendant petitioners were involved, the instant controversy concerns defendants’ promise to place funds in reserve should the plaintiff deem such precaution necessary. Hence consideration of instances of contracts to indemnify against actual loss is not relevant....

In the instant case the only conditions precedent to defendants’ obligation were the plaintiff’s estimate that a reserve was necessary and its demand upon defendants for current funds in the amount of such reserve. Once these conditions are fulfilled equity will specifically enforce such a promise where, as in the instant case, legal remedy for subsequent damages would not suffice, ...

Numerous cases have upheld the surety’s right to enforce the collateral security clause of the indemnity agreement. For example, see American Motorists Ins. Co. v. United Furnance Co., Inc., a 1989 Second Circuit case involving a customs bond, in which the court enforced a collateral clause because the surety “had specifically bargained to have access to collateral security under the circumstances it faced.” Also in the 1984 Ninth Circuit decision entitled Safeco Ins. Co. of America v. Schwab, the court specifically enforced the collateral security clause and 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.” Another noteworthy Ninth Circuit case is Milwaukee Constr. Co. v. Glen Falls Ins. Co., in which the court specifically enforced the provision in an indemnity agreement requiring indemnitors to post adequately security upon establishment of a liability reserve. The argument that such relief could not be given until after payment of bond claims was rejected, on the basis of the surety’s quia timet right to compel exoneration and obtain security against loss upon accrual of the bond liabilities. The Milwaukee Construction court explained the rationale for its holding in this oft-quoted passage:

Before maturity of the debt, or accrual of liability, for which he is surety, the surety has no right of action in equity to be indemnified against apprehended danger of loss by reason of his undertaking. After maturity, however, in the absence of a present remedy at law, although he has not paid and has not been troubled by the creditor, or asked by him to pay, he has the right, before payment, to go into a court of equity, at any time, to compel the principal to exonerate him from liability or to pay the debt, or to secure him against loss, provided no rights of the creditor are prejudiced thereby. The doctrine in such cases rests on the simple right, as between the principal and surety, that the surety has to be protected by the principal; a surety is awarded exoneration in order that mischief and circuity of action may be avoided; he is not obliged to make inroads into his own resources when the loss must in the end fall on the principa1.

No reported decision known to this author has outright rejected the argument that the collateral security clause of the indemnity agreement may be specifically enforced by the surety 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 Premium Insurance Co. v. Cavalry Constr., Inc., a 1989 decision from the Florida Court of Appeals.

In the Transamerica Premium 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, under the collateral security provision of the written indemnity agreement, that Cavalry and the indemnitors furnish it with collateral equal in value to the total amount of its obligation sunder 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 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 Timberleafs 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 Premium, the decision is extremely instructive for surety practitioners because it helps define the limits of a quia timet suit. The court in Transamerica Premium 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 Premium is that the surety must prove in court that its fear of bond liability is reasonably based on objective facts -it is simply not enough for the surety to merely show that a bond claim has been made and the principal is insolvent.

Transamerica Premium 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 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 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 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 courts.

One further caution for the surety -it should be sure that the conditions precedent set forth in the indemnity agreement have been strictly met. In Maryland Casualty Co. v. Straubinger, the appellate court reversed the trial court’s award of specific performance under the indemnity agreement. The reason for the reversal was that the indemnity agreement stated that funds had to be immediately deposited by the indemnitors upon the surety setting up a reserve “required by the State Insurance Department.” The appellate court strictly interpreted this provision; as there was no proof that the state had actually required establishment of the liability reserve in that case, the court held that the condition precedent had not been met.

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 to 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 substantial likelihood that the movant will ultimately prevail on the merits;

3. Whether the threatened injury to movant outweighs damage to the opposing party if the injunction is granted; 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.

Turning first to the requirement of irreparable injury and concomitant absence of an adequate remedy at law, the Stein court 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 Milwaukee Construction court 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. In the Doster case, the court ruled that a showing of fraudulent disposition of property was not a prerequisite to quia timet relief against the indemnitors.

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 specifically enforce the collateral security clause of the indemnification agreement 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 recent 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 the enforcement of collateral security clauses. 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 on 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 specifically enforce the collateral security clause as the final outcome of the case, but must make an additional showing of irreparable injury to obtain a preliminary injunction during the pendency of the action.

The showing of irreparable injury required by the Second Circuit is very difficult for the surety to meet in most cases to enforce collateral security clauses. 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 recent 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 is to present “evidence of damage that cannot be rectified by financial compensation.” Without such proof, a preliminary injunction apparently cannot be obtained by the surety in the Second Circuit.

It is significant that several other recent 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 suits to enforce collateral security clauses. 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.

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, supra note 2 at page 10. 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 recent case which balanced interests and applied injunction standards to a collateral demand by a surety is Safeco Ins. Co. of America v. Criterion Inv. Corp. The surety’s request to specifically enforce the collateral security clause of the indemnity agreement 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.

Finally, regarding the issue of collateral demands by sureties, this author believes that sureties generally wait too long before asking for quia timet relief. The surety is best served by applying for a temporary restraining order at the inception of litigation. In federal district 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.

If warranted by the circumstances, the surety should definitely 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 overstatement 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.

V. Declaratory Judgment Actions by the Surety

As discussed above, a surety cannot bring successful quia timet suit unless it has a reasonable and provable basis for anticipated liability. There are, however, situations in which sureties need protection even when they cannot meet the proof requirements for quia timet relief. The surety’s answer may be a declaratory judgment action which can be filed even earlier than a quia timet suit.

It has been said that “declaratory judgment and quia timet are similar in that both seek to prevent further harm.” According to Judge Learned Hand in the Second Circuit case of Meeker v. Baxter, declaratory judgment “is only a kind of expanded quia timet, meant to do in general what that suit did in its limited field.” An important difference is that declaratory judgment only requires a showing of actual controversy, rather than an apprehension of bond liability. Another difference is that a declaratory action, unlike a quia timet action, may determine the surety’s rights against the obligee and others who are not signatories to the indemnity agreement. It is significant that the surety does not need to chose between declaratory and quia timet; a lawsuit may be filed which combines the two by requesting specific performance and common-law relief against indemnitors and further requesting a determination of rights between interested parties.

In Fidelity & Deposit Co. of Maryland v. Sheboygan Falls, the Seventh Circuit approved the surety’s decision to file a declaratory judgment suit. This case involved a dispute between the principal contractor (Scotty) and the obligees (two Wisconsin towns) regarding a bonded contract to build a garbage-burning incinerator. When the obligees made demand upon the surety (Fidelity & Deposit), the surety responded with a declaratory judgment action brought in federal court under diversity jurisdiction. Fidelity & Deposit’s complaint sought a declaration that it was not liable to the towns on the performance bond because Scotty had not breached the bonded contract; however, if the court held otherwise, a declaration was sought that Scotty was liable to Fidelity & Deposit under the indemnity agreement. The district court, on motion for summary judgment, agreed with Scotty’s position arid ruled that Scotty had not breached the contract with the towns.

On appeal, Fidelity & Deposit was commended for finding a way to bring this case within the diversity jurisdiction of the federal court. As Scotty and the towns were both Wisconsin citizens for diversity purposes, a suit by one against the other [or breach of contract would have defeated diversity jurisdiction. Fidelity & Deposit, a Maryland corporation, was able to avoid this problem by naming both parties as defendants in the declaratory judgment litigation. The court stated:

Fidelity’s invocation of the Declaratory Judgment Act, 28 U.S.C. § 2201, was wholly proper. The indemnity agreement gave it a potential claim of some magnitude against Scotty, but a claim on which Fidelity could not realize unless and until it was found to have defaulted on its obligations under the performance bond. Fidelity may have been concerned lest passage of time prevent its recouping from Scotty any money it might have to pay the towns. Only by forcing the towns to bring their action on the bond could Fidelity crystallize its own rights under the indemnity agreement. This is the kind of interest that the Declaratory Judgment Act was intended to protect.

The opposite result was obtained by the surety in Travelers Indemnity Co. v. Midstate Constructors, a 1981 case from the Northern District of Texas. This case also involved a dispute between obligee and principal as to work performed at a bonded construction project. The principal’s contract was terminated by the obligee, but the principal denied default and charged the obligee with breach. The problem was exacerbated when the principal refused to pay numerous subcontractors based upon a pay-when-paid clause in the subcontracts. The surety’s decision not to immediately pay bond claims of these unpaid subcontractors was based, in part, upon a fear that a later judicial decision in favor of the principal and against the obligee could affect the surety’s ability to obtain indemnification from the principal. Instead the surety filed a declaratory judgment suit, invoking the federal court’s diversity jurisdiction, which named the obligee, principal and subcontractors as defendants.

At first blush, the declaratory judgment suit appeared to be properly based on diversity jurisdiction. Plaintiff (surety) was a non-Texas corporation, and defendants (principal, obligee and subcontractors) were all Texas citizens. Unfortunately for the surety, the Midstate court chose to realign the principal as a party-plaintiff with the surety for purposes of determining jurisdiction. The court reasoned that there were two primary issues: (l) whether the principal breached the bonded contract; and (2) whether the pay-when-paid clause of the subcontracts provided a good defense to the subcontractors’ claims. On both of these issues, the principal’s and surety’s interests were in harmony. Thus as a practical matter, the surety and the principal were on the same side, and they were opposite the obligee and the subcontractors. The suit was dismissed for lack of jurisdiction.

Despite the fact that Midstate is unreported, this author believes that Midstate is a better reasoned opinion than Sheboygan Falls because it considers the real interests of the parties to the dispute. Nonetheless, dismissal of the declaratory judgment suit in Midstate should not deter the surety from this remedy. The real impact of the Midstate rationale, if followed by the federal courts, is that sureties will need to file declaratory judgment suits in state courts unless there is diversity of citizenship between the principal and obligee and/or other bond claimants. Declaratory judgment relief is generally available in all state jurisdictions. When the circumstances confronting the surety do not even rise to the level of quia timet, then the early filing of a declaratory judgment suit in federal or state court should be strongly considered by the surety.

VI. Conclusion

Recent cases demonstrate the strict scrutiny 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