Article

Developers Sur. & Indem. Co. v. Carothers Constr., Inc., 2017 U.S. Dist. LEXIS 111021 (D.S.C. July 18, 2017);
Developers Sur. & Indem. Co. v. Carothers Constr., Inc., 2017 U.S. Dist. LEXIS 135948 (D. Kan. Aug. 24, 2017)

Two recent decisions from United States District Courts for the District of South Carolina and the District of Kansas, respectively, reached opposite conclusions when presented with the same issue: Is a surety bound to arbitrate claims against it when the surety’s bond incorporates its principal’s contract by reference, and the principal’s contract contains an agreement to arbitrate disputes. The District of South Carolina, applying South Carolina law, held that a surety is bound by the arbitration agreement in the incorporated contract, while the District of Kansas held that a surety is not so bound.

These cases both arise from an arbitration demand filed by the general contractor, Carothers Construction, Inc. (“Carothers”) against the surety, Developers Surety and Indemnity Company (“DSI”). DSI issued performance and payment bonds on behalf of subcontractors Liberty Enterprises Specialty Contractor (“Liberty”) and Seven Hills Construction, LLC (“Seven Hills”) in favor of Carothers for their work on Projects located in South Carolina and Kansas, respectively. Each subcontractor defaulted on its contractual obligations. Carothers initiated arbitration against DSI regarding both Projects. According to Carothers, the bonds incorporated by reference the subcontracts’ mandatory arbitration clauses and thus, DSI was subject to binding arbitration. In declaratory judgment actions before Federal District Courts in South Carolina and Kansas, DSI asked the courts to declare that the arbitration clause did not bind it to arbitrate Carothers’ claims. Each court reached the directly opposite conclusion. This article discusses the decision reached by each court in turn.

In this action, DSI sought a declaration from the District Court in South Carolina that the arbitration clause in the subcontract between Carothers and Liberty did not bind it to arbitrate Carothers’ claim. DSI argued that the arbitration clause had no application to the claim between it and Carothers because, by its own terms, the clause applied only to claims “between the Contractor and the Subcontractor,” and DSI, as surety, was neither. It similarly argued that Carothers’ claims fell beyond the scope of the arbitration clause, as the claims arose out of the bond, whereas the arbitration clause expressly applied only to claims arising from or relating to the Carothers – Liberty subcontract.

Applying South Carolina law, the court held that the subcontract’s arbitration clause bound DSI to arbitrate. The court found that South Carolina cases had previously concluded that a subcontract may incorporate an arbitration agreement in the prime contract by reference, and that the same result should obtain in the case of a bond. The court further found that DSI had guaranteed the performance of all of Liberty’s obligations under the subcontract and had incorporated all of the subcontract’s terms, including the agreement to arbitrate disputes. Reasoning that a bond is to be construed together with the agreement it incorporates in order to ascertain the parties’ intent, and that a surety obligates itself under a bond to the same liability as its principal, the court concluded that the parties intended to submit disputes against DSI under the bond to arbitration.

The District Court in Kansas reached the exact opposite result, finding that DSI did not consent to arbitration of Carothers’ claims on the bonds.

The court accepted the argument unsuccessfully advanced by DSI in the District Court in South Carolina – that the arbitration agreement expressly applied only to disputes between contractor and subcontractor, and DSI, as surety, was neither. In so finding, the court cited other provisions within the subcontract that supported its interpretation that the subcontract did not intend for “surety” and “subcontractor” to mean the same thing. Thus, the court held that the arbitration clause’s reference to disputes with subcontractor must not have been intended to include disputes with the surety. The court also reasoned that, although the bonds incorporated the subcontract (and its mandatory arbitration provision) by reference, DSI did not agree in the bonds to assume “any or all obligations” of subcontractor. Rather, it only agreed to undertake “certain” obligations in the event of subcontractor’s default.

The court said that it “respectfully disagreed” with the decision reached by the District Court in South Carolina, noting that that court had relied on the general principle of South Carolina law that “the liability of a surety is measured precisely by the liability of the principal.” The court noted that Kansas courts have not adopted such a rule. The court further found that even though a surety’s liability may be coextensive with that of the principle as a general rule, DSI’s liability in this case was defined by the terms of the bonds. Reading the plain language of the arbitration provision, other language in the subcontract, and the language in the bonds, the District Court in Kansas elected to disagree with the District Court in South Carolina’s conclusion that the parties clearly intended to submit disputes to binding arbitration.

https://www.lexology.com/library/detail.aspx?g=27162bc5-be73-4329-9e4f-c2669812846f

When Surety Bond Incorporates the Subcontract by Reference, Is the Subcontract’s Arbitration Clause Also Incorporated?