Exoneration Based on Fraud in the Inducement as a Surety Defense1
August 2002
With new business scandals unfolding daily,
improper business conduct is currently in the spotlight. Here, Marilyn Klinger
considers a surety’s exoneration defense based on fraud or material misrepresentation
in the inducement.
by Marilyn
Klinger
Sedgwick,
Detert, Moran & Arnold LLP
In the wake of a new business scandal unfolding virtually every day, fraud
and improper business conduct are currently in the spotlight. This article considers
a surety's exoneration defense based on fraud or material misrepresentation
in the inducement.
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:
- 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:
- 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
- has reason to believe that these facts are unknown to the secondary
obligor; and
- 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.
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