Exoneration Based on Fraud in the Inducement as a Surety Defense

Fraud and/or Material Misrepresentation

There are at least three scenarios where fraud and/or material misrepresentation are committed against a surety. First, the bond obligee may be directly involved in acquiring the bond and misrepresents facts to do so. Second, the bond principal alone deals with and makes misrepresentations to the surety, but the obligee is aware of the misrepresentation. Third, the principal misrepresents material facts without the obligee's knowledge.

The third scenario is quickly and easily dismissed. If the obligee has no knowledge that the principal has engaged in fraud or a misrepresentation, the surety has no exoneration defense. [See, e.g., Mahoney v Founders' Ins. Co., 190 Cal App 2d 430, 438–439, 12 Cal Rptr 114, 118 (1961), and the Restatement of the Law Third, Suretyship and Guaranty, section 12 ("Restatement 3d").]

When the Obligee is Directly Involved in Obtaining the Bond

The Restatement 3d provides:

1. If the secondary obligor's [the surety's] assent to the secondary obligation [the bond] is induced by a fraudulent or material misrepresentation by the obligee upon which the [surety] is justified in relying, the [bond] is voidable by the surety.

Many courts refer to the Restatement 3d or have developed similar requirements to support a surety's fraud defense. [See, e.g., Banque Franco-Hellenique de Commerce International Et Maritime S.A. v Orestes Christophides, 1997 U.S. Dist. LEXIS 8189, 1997 WL 317398 (S.D.N.Y. 1997).]

Focusing on the Restatement 3d, there are a number of specific requirements. First, the misrepresentation must either be fraudulent or material. Fraud is an intentional perversion of truth for the purpose of inducing another to act in reliance on it. A material misrepresentation, in contrast, may occur either where the obligee deliberately represents or suppresses a material fact (a fact which the surety relies on in deciding to issue a bond) or where the obligee innocently omits to disclose a material fact. Notwithstanding the innocent mistake, if the fact represented or omitted is material, the surety may raise the exoneration defense. Conversely, if the information is unimportant in the surety's decision to issue the bond, then the surety cannot void the bond. [See, Comment (b) to Restatement 3d.]

Second, the misrepresentation must have induced the surety to issue the bond. In other words, had the surety known the information was false or had it known the undisclosed facts, it would not have issued the bond. For example, in Ground Improvement Techniques, Inc. v R.N. Robinson & Son, Inc. et al., 63 F Supp 2d 1272 (D Colo 1999), the principal applied for performance and payment bonds for excavation work already underway. When questioned as to the principal's bid and competency to perform the work, the obligee failed to disclose to the surety the existence of a dispute concerning the excavation work. The court held that a reasonable juror could find that had the surety known of the dispute, the surety may not have issued the bonds.

The final element in the fraud/misrepresentation defense is the surety's justifiable reliance.

If a surety fails to seek important information that is available to him, he cannot, in the absence of fraud, assert as a defense ignorance of facts which he should have known and considered prior to the execution of the contract. The law does not favor the indifferent, unseeing surety who fails to help himself. [St. Paul Fire & Marine Ins. Co. v Commodity Credit Corp., 646 F2d 1064, 1072 (5th Cir 1981); see also Iowa Concrete Breaking Corp. v Jewat Trucking, Inc., 444 NW2d 865, 868 (1989).]

A surety is expected to make reasonable inquiries before issuing a bond. If the surety fails in this respect, it will not prevail on the fraud/material misrepresentation defense.

In Ground Improvement Techniques, the surety did inquire about the subcontractor's bid and its competency. However, the surety could not have reasonably been expected to inquire about some unknown dispute.

The Silent Obligee

In most instances, the obligee is not involved in the bond transaction. Although the obligee may require a bond, obtaining it is left to the principal. An obligee's duty to disclose information is quite limited in this scenario as the obligees are often wholly unaware of the facts that the principal presents to the surety. Accordingly, an obligee, acting in good faith and without knowledge of any misrepresentation, is entitled to enforce the bond. [See Restatement 3d, § 12(2).]

By the same token, the Restatement 3d, section 12(3) provides that if, before the bond becomes binding, the obligee:

1. knows facts unknown to the secondary obligor ["surety"] that materially increase the risk beyond that which the obligee has reason to believe the [surety] intends to assume; and
2. has reason to believe that these facts are unknown to the secondary obligor; and
3. has a reasonable opportunity to communicate them to the secondary obligor; the obligee's nondisclosure of these facts to a [surety] constitutes a material misrepresentation.

The Ground Improvement Techniques court stated that the obligee had no obligation to inform the surety until the surety inquired. Indeed, some courts do give a certain degree of grace to the silent obligee resting the initial burden of inquiry on the surety. However, other courts and arguably the Restatement 3d hold that voluntary disclosure is required without requiring that the surety contact the obligee.

For example, in Sumitomo Bank of California v Iwasaki, 70 Cal 2d 81, 88-90, 447 P2d 956, 961-962 (1968), the California Supreme Court recognized the obligee's duty to disclose information to the surety at least in situations when it is patently clear to the obligee that the principal misrepresented facts affecting the risk and that the surety did not know the true facts. [See also Rachman Bag Co. v Liberty Mutual Insurance Company, 46 F3d 230 (2nd Cir 1995) (holding that a requisite element of a fraudulent concealment claim is that the obligee had a duty to disclose the material fact but not stating what creates that duty.)]

An obligee has no burden to investigate facts for the surety's benefit and is not required to confirm that the surety knows facts which the obligee reasonably believes are known to the surety. [See Restatement 3d, § 12, Comment on Subsection (3).] In that regard, the Restatement 3d, section 12(4), provides guidelines regarding the obligee's reasonable beliefs, including: (a) The nature of the surety's relationship to the principal, (b) The nature of the surety's business, and (c) The surety's ability to obtain independent factual knowledge using ordinary care.

Reasonable Opportunity

Case law has not yet addressed the issue of the obligee's opportunity to inform the surety. Since the opportunity to advise a surety regarding a material fact can be as simple as a telephone call, the burden to show the obligee had no reasonable opportunity likely falls on the obligee.

Conclusion

Exoneration based on fraud or material misrepresentation can be a viable surety defense. The Restatement 3d reveals the delicacy of prevailing on such a defense, however.