Payment Bonds and Arbitration:
Is the Surety Bound by the Result of a Claimant's
Arbitration with the Principal?

By John S. Mrowiec

Payment bonds are a frequent feature of construction projects. Labor and material payment bonds are universal on public projects because statutes mandate their use. Subject to the terms of the payment bond, the payment bond surety is to pay when the underlying principal fails to do so. Subject to the terms of the bond or the statute, the surety's liability for payment for the claimant's unpaid labor and materials is co-extensive with the liability of its principal, the contractor placing the bond.

Payment bond statutes and the bonds themselves usually require the filing of a lawsuit against the payment bond surety by a deadline provided by the statute or, sometimes, by the bond.
Otherwise, the payment bond claimant loses its rights. On private projects (and for bonds placed by subcontractors on public projects), the language of the bond itself typically requires that a lawsuit be filed by a deadline defined in the bond. But construction contracts and subcontracts often contain provisions mandating arbitration, not lawsuits, to enforce rights under the contract.

If there is such an arbitration provision in the subcontract, must a claimant both arbitrate with the principal and sue the surety? If the claimant must arbitrate with the principal and the claimant wins in arbitration, is that arbitration result binding on the surety? In other words, if the principal does not pay the arbitration award, must the court in the suit against the surety automatically declare victory for the claimant against the surety or is the arbitration result irrelevant to the surety's liability to the claimant?

If the surety is not bound by the results of the arbitration, then the claimant must prosecute two proceedings to conclusion - an arbitration and a lawsuit. Whether the surety will be bound by the results of the arbitration is sometimes a confusing legal question. A recent federal court decision discusses the question in the context of a contractor-principal on a federal construction project who failed to defend the arbitration in United States f/u/b Frontier Construction, Inc. v. Tri-State Management Co., 2003 U.S. Dist. LEXIS 6421 (N.D. Ill., April 16, 2003).

Tri-State Management Co. was the prime contractor for construction of a United States Postal Service building expansion. The prime contractor, as principal, posted a labor and materials payment bond as it was required to do under the federal Miller Act, 40 U.S.C. §270a et seq.
North American Specialty Insurance Co. was the surety.

Frontier Construction was a subcontractor to the prime contractor. The subcontract contained an arbitration provision that mandated all disputes arising under the subcontract be arbitrated. The subcontract also provided that a court judgment was to be entered in accordance with the arbitration award (a "consent to confirmation" clause).

The subcontractor claimed that prime contractor failed to pay. The subcontractor pursued two remedies: (1) a federal court lawsuit against the prime contractor and the surety under the Miller Act bond and counts against the prime contractor only for breach of the subcontract and quantum meruit; and (2) at the same time, arbitration with the prime contractor only for breach of the subcontract.

The Frontier Construction decision does not tell us whether the litigation was stayed pending the outcome of the arbitration. But an arbitrator held a hearing on the arbitration between the subcontractor and the prime contractor. The prime contractor failed to appear and to defend.
Accordingly, the arbitrator entered an award in favor of the subcontractor and against the prime contractor for $41,450 plus interest and $7,521 in attorneys' and arbitration fees.

In the litigation, after the arbitration award, the subcontractor moved to confirm the award and to enter judgment against both the prime contractor and the surety. Again, the prime contractor did not appear and defend. Thus, the Frontier Construction court granted that part of the subcontractor's request seeking confirmation of the arbitration award against the prime contractor.

The surety argued that there could be no judgment entered against the surety based solely on an arbitration award against its principal, the prime contractor. The subcontractor argued that as a Miller Act surety, the surety was bound by an arbitration award against the surety's principal.
Because the governing Seventh Circuit federal appeals court had never ruled on the issue, the subcontractor cited two federal appellate court decisions from outside the Circuit. The Frontier Construction court reviewed the cited cases and found those cases to be based on a theory of "preclusion." That is, those cases held the Miller Act surety was bound by a result in a proceeding against its contractor-principal "of which surety had full knowledge and opportunity to defend." (Frontier Construction, 2003 U.S. Dist. LEXIS 6421, at 5 quoting Frederick v. United States, 386 F.2d 481, 485 n.6 (5th Cir. 1967)).

The cases cited by the subcontractor for why the surety should be bound involved situations where the contractor-principal's lawyers also were defending the surety - the common situation when the contractor is solvent. In Frontier Construction, the prime contractor had no lawyer; the surety had to hire its own lawyers.

The Frontier Construction court noted that it was not clear whether a Miller Act surety (as opposed to a state statutory or non-statutory surety) ever may be bound by an arbitration award or court judgment against the surety's principal. The federal Miller Act provides "exclusive" federal court jurisdiction of actions on a Miller Act bond. Some cases, again from outside the Seventh Circuit, have held that the Miller Act's provision for exclusive jurisdiction means that a Miller Act surety may never be bound by an arbitration award or state court judgment against the surety's principal.

The court in Frontier Construction determined that, in this case, it did not matter whether one viewed the issue as one of "preclusion" or as one of "exclusive jurisdiction." Either the surety was entitled to defend in a federal court lawsuit under the terms of the Miller Act or, even if that rule did not apply, the surety cannot be bound by an arbitration award when the surety "did not have an opportunity to defend itself" (Frontier Construction, 2003 U.S. Dist LEXIS 6421, at 9).

The judge in Frontier Construction said that the default nature of the arbitration award in that case distinguished it from the usual "preclusion" case. Because the prime contractor-principal did not even bother to defend the arbitration demand, the Frontier Construction court held that the surety could not be bound by the default arbitration award.

The Frontier Construction court remarked that the subcontractor did not argue that the surety was bound by the agreement to arbitrate contained in the subcontract. Also, the arbitration award, on its face, was entered only against the prime contractor, not its surety. We do not know whether the Frontier Construction court was implying that the case might have been decided differently if the subcontractor had argued that the bond incorporated the subcontract, if there legally was such an argument available.

In another case, a prime contractor's performance and payment bond surety was held to be bound by an arbitration provision in the owner-contractor agreement regarding a dispute between the owner, contractor and contractor's surety (Bolingbrook Park District v. National-Ben Franklin Insurance Co., 420 N.E.2d 741 (Ill. 3d App. Dist. 1981)). But the Bolingbrook Park District case involved incorporation of the prime contract into the prime contractor's performance and payment bonds, not the question of whether a claiming subcontractor's subcontract is incorporated into a prime contractor's payment bond.

In Frontier Construction, the surety did have "notice of the arbitration." What is unclear about the decision is, once the subcontractor notified the surety about the arbitration, what extra step should the subcontractor have taken to ensure that the surety "had an opportunity to defend?"

To maximize the argument that the surety "had an opportunity to defend," a bond claimant can send to the surety copies of all of the arbitration papers, orders, notices of hearing dates and other correspondence that any participant in the arbitration would receive. Other times, the subcontractor might obtain the surety's agreement to be bound by the results of the arbitration.
(The "agreement to be bound" situation is much more common when the surety is comfortable with the principal being able to pay any arbitration award.)

John S. Mrowiec is a partner with Chicago-based Conway & Mrowiec, a construction and public contracts law and litigation practice. He may be reached at (312) 658-1100. For information, go to the firm's Web site at www.cmcontractors.com.