by: Anthony Sallah
On November 7, 2016, the Sixth Circuit Court of Appeals affirmed a judgment in favor of a surety on a Michigan public construction project as against the general contractor. In affirming, the Sixth Circuit held that the general contractor failed to present sufficient evidence of bad faith on the part of the surety, who settled the general contractor’s claims with the State of Michigan allegedly without the contractor’s knowledge.
In Great American Insurance Company v. E.L. Bailey & Company, Inc., E.L. Bailey & Company (“Bailey”) entered into a contract with the State of Michigan to construct a prison kitchen. After various delays on the project, Bailey and Michigan sued each other in the Michigan Court of Claims. Michigan argued that Bailey had not achieved timely substantial completion under the parties’ contract and it was therefore was entitled to withhold liquidated damages of $1,000 per day. Bailey never completed the project, so Bailey’s surety, Great American Insurance Company (“GAIC”) stepped in and negotiated another contractor to replace Bailey. After litigation in the Court of Claims and two stages of mediation, GAIC, litigating on behalf of Bailey, settled with Michigan for $358,000 in lieu of a release of all claims.
Additionally, subcontractors brought suit against Bailey and GAIC in separate litigation under Bailey’s payment bond for amounts due in connection with the project. GAIC demanded collateral from Bailey for the subcontractor claims, to which Bailey refused. Ultimately, GAIC settled the subcontractor claims for $645,287.55 and incurred over $260,000 in expenses and attorney’s fees.
Subsequently, GAIC brought suit in federal court seeking indemnification under the parties’ agreement for failure to provide collateral for subcontractor claims. GAIC also sought a declaratory judgment that it was entitled to settle Bailey’s claims against Michigan. Bailey’s affirmative defense was that GAIC settled Bailey’s claims in bad faith, in secret, without Bailey’s knowledge. The district court ultimately granted summary judgment to GAIC, holding that Bailey’s bad faith claim was based merely on a disagreement as to settlement amount, which does not rise to the level of bad faith.
The Sixth Circuit agreed. In an opinion addressing myriad surety-related issues, the Sixth Circuit first answered in the affirmative the question of whether bad faith can be raised as a defense in a surety’s declaratory judgment action regarding its right to settle claims involving the principal. Bailey argued to the district court that his bad faith claim was not yet ripe for review, because the district court was first required to determine whether GAIC had a right to settle Bailey’s claims in the first place pursuant to its indemnification claim. The Sixth Circuit held that Bailey’s bad faith defense was ripe for review, because GAIC did bring a simultaneous indemnification claim (in connection with the subcontractor claims) and because GAIC’s settlement required Michigan to pay GAIC, making a follow up indemnity action by GAIC unnecessary. Ultimately, the Sixth Circuit held that whether a principal can raise bad faith as a defense to a surety’s declaratory judgment claim depends on “fairness”; where a “declaratory judgment claim is already joined with an indemnification claim,” adjudicating the defense of bad faith is appropriate.
Second, the Sixth Circuit grappled with whether the definition of “bad faith” under Michigan law as used in the insurer/insured context was applicable to the surety context. The Sixth Circuit held that “bad faith” in a surety relationship may not incorporate all of the duties outlined in traditional insurance cases. However, “bad faith,” the Sixth Circuit stated, is “a state of mind,” and “offers of compromise” or “honest errors of judgment” are not sufficient to establish bad faith.
Third, the Sixth Circuit held that Bailey presented no evidence of GAIC’s state of mind or any reason why GAIC’s interest in settling would be different from Bailey’s. The Sixth Circuit did have concerns regarding GAIC’s concealment of its settlement negotiations with Michigan. However, Bailey did not have any evidence that GAIC had engaged in settlement negotiations “for months” with the State, as he alleged. And Bailey had the opportunity to take control of the settlement negotiations at one point, but failed to do so.
Finally, Bailey argued that GAIC failed to sufficiently investigate Bailey’s claims against Michigan regarding liquidated damages. Specifically, Bailey argued that liquidated damages provisions are unenforceable if the parties are mutually responsible for project delays (the mediator in GAIC’s litigation against the State determined that the State was partly at fault for project delays). The Sixth Circuit outlined cases utilizing the “non-apportionment” approach, which hold (albeit strictly) that liquidated damages cannot be apportioned, and “apportionment” cases, holding that liquidated damages could be apportioned based on each parties’ contribution to project delays. Ultimately, the Sixth Circuit declined to predict how the Michigan Supreme Court would rule and instead held that Bailey’s argument was one of settlement amount, which does not rise to bad faith.
The case is Great Am. Ins. Co. v. E.L. Bailey & Co., Inc., No. 15-2149 (6th Cir. Nov. 7, 2016).