The Supreme Court of California holds that an obligee may not recover in tort for a surety’s breach of covenant of good faith and fair dealing implied in a performance bond.

Cates Constr., Inc. v. Talbot Partners et al.,
1999 Cal. LEXIS 4847 (Co. July 29, 1999)

In 1989, defendant Talbot Partners (“Talbot”) hired plaintiff Cates Construction, Inc. (“Cates”) to build a condominium project in Malibu, California. The construction contract required Cates to have the project ready for occupancy in eight months. The contract also required Cates to furnish a performance bond and a labor and materials bond, both of which were subsequently issued by Transamerica Insurance Company (“Transamerica”).

During construction, Cates submitted twenty-two payment requests, each of which was paid. Talbot rejected the twenty-third request because Talbot had already paid several hundred thousand dollars more than the cost of the work. On November 29, 1990, six months after the project should have been completed, Talbot advised Transamerica that Cates apparently intended to abandon the project and that Talbot had already paid everything it owed under the contract. Talbot demanded that Transamerica perform under the bond. In December, Cates abandoned the project and filed a Mechanic’s Lien in the amount of $645,367. Transamerica refused to intercede, claiming a legitimate dispute existed between Cates and Talbot. In March 1991, Transamerica, after having been assigned Cates’ rights against Talbot, began the process of completing the job pursuant to the performance bond.

Transamerica then sued Talbot, alleging causes of action for breach of the construction contract, foreclosure on the Mechanic’s Lien, and declaratory relief. Talbot cross-complained against Cates for breach of the construction contract and against Transamerica for breach of the performance bond and breach of the implied covenant in good faith and fair dealing in the performance bond. By stipulation of the parties, the contract claims were tried before a retired California Supreme Court Justice sitting without a jury. The Justice ruled against Transamerica and Cates on all their causes of action. Those rulings were not appealed.

Talbot then tried the tort causes of action against Transamerica before a jury. The jury found that Transamerica breached the implied covenant of good faith and fair dealing and awarded $28,000,000 in punitive damages. Although the California Court of Appeal reduced the punitive damages to $15,000,000, it affirmed the judgment in all other respects. Transamerica appealed and the California Supreme Court reversed the Court of Appeal.

The Supreme Court of California first addressed whether Transamerica was contractually liable under the performance bond for damages attributable to Cates’ failure to complete the project by June 1, 1990. Transamerica maintained that the performance bond merely assured completion of the condominium project in the event of Cates’ default, as opposed to timely performance. The Supreme Court viewed the issue as one of contract interpretation. The Court first looked to the obligations created under the contract between Cates and Talbot, which explicitly stated that all time limits were “of the essence of the contract.” The Court noted that the contract required Cates to obtain a performance bond “as security for the faithful performance of the Contract Documents” and that the bond expressly referred to the contract between Cates and Talbot.

Taken together as a whole, the Court found that the bond required Transamerica to answer for damages suffered by Talbot as a direct result of Cates’ failure to “promptly and faithfully” perform the contract. Although the bond did not explicitly mention the subject of delay damages, the Court reasoned that Transamerica knew from the contract, which had been “made a part” of the bond, that time was “of the essence” of the contract and that the bond’s purpose was to provide security for the “faithful” performance of the contract in the event of Cates’ default. The Court therefore held that Transamerica was contractually liable under the performance bond for damages attributable to Cates’ failure to complete the Project in a timely manner.

The Court then addressed whether Transamerica could be liable in tort for breach of the implied covenant in good faith and fair dealing. After reviewing the regulatory common law and public policy background, the Court held that tort remedies are not available to obligees under a performance bond. The Court initially noted that it had never recognized the availability of tort remedies for breaches occurring in the context of a construction performance bond or any other so called “contract of suretyship.” Thus, the Court framed the issue as whether the exceptional approach thus far reserved for breaches in the insurance policy setting should be extended to breaches in the context of a surety bond given to assure performance on a construction contract.

The Court first found that the mere inclusion of surety arrangements in the Insurance Code, as suretyship is in California, was not dispositive of the issue. In its analysis, the Court reviewed various policy considerations to decide whether tort remedies should be available for breach of a performance bond. California courts permitted tort recovery in the insurance setting because the courts found insurance contracts to be characterized by adhesion and unequal bargaining power. In contrast to insurance, the Court found that the surety relationship is not marked by adhesion and unequal bargaining power. Rather, the Court reasoned that if the obligee does not agree with the terms of the bond secured by the principal, it may consent to a modification of the underlying contract or may end bargaining altogether and seek a different principal whose financial resources and qualifications enable it to procure a bond with acceptable terms. Further, performance bonds typically incorporate the underlying construction contract, the terms and conditions of which have been negotiated by the principal and the obligee without any input from the surety. The Court then concluded that unlike insurance policy, the typical performance bond bares no indication of adhesion or disparate bargaining power that might support tort recovery by an obligee.

The Court then looked to a variety of public interest and fiduciary responsibility considerations. In distinguishing between insurance and suretyship, the Court found that whereas the typical insurance policy insures against accidental and generally unforeseeable losses caused by a calamitous or catastrophic event, a construction performance bond seeks merely to provide additional security to an existing contract with the principal. The Court also focused on the owner’s ability to hold retainage as additional security and thus reduce its vulnerability to a surety’s inaction.

The Court then reviewed the consequences of allowing tort recovery. The Court reasoned that unlike insurance, obligees such as owners possess sufficient bargaining power to negotiate terms to encourage timely performance of bond obligations and that provide for attorney’s fees and interest when breaches occur. Owners may also require liquidated damages clauses to discourage non-performance by sureties. Accordingly, the Court found that tort remedies were unnecessary to induce a surety’s performance or to fully compensate for surety’s breach of the covenant of good faith. The Court also predicted that allowing tort claims would increase the already complex nature of construction disputes. Last, the Court found that allowing tort recovery in the construction bond could foster increased litigation, which would result in increased costs to obtain bonds. Thus, the Court held that an obligee may not recover in tort for surety’s breach of the implied covenant of good faith and fair dealing.

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