Court shields sureties from punitive damages but issues stark warning on arbitration participation
Pennsylvania's Supreme Court handed surety companies a major legal win on bad faith claims this week, but warned they must show up to arbitration proceedings.
The state's Supreme Court ruled that Pennsylvania's insurance bad faith statute does not apply to surety bonds, sparing the industry from potential punitive damages and enhanced penalties that insurers can face when they handle claims in bad faith. But in the same decision, the justices made clear that sureties can be held to arbitration awards entered against their principals, even when they choose to sit on the sidelines.
The February 18 decision settles a dispute that has dragged on for 15 years, stemming from a construction project at Penn State University that went sideways when the contractor ran out of money.
Back in 2008, Penn State hired Ionadi Corporation to erect steel for its Millennium Science Center Complex. International Fidelity issued a $10.125 million payment bond to guarantee the project. Ionadi brought in Eastern Steel Constructors to handle the steel reinforcing work. The subcontract spelled out payment terms, including 1.5 percent monthly interest on late payments, attorneys' fees recovery rights, and required arbitration through the American Arbitration Association for any disputes.
Eastern worked on the project from February 2009 through September 2010. Ionadi paid the first five months but then defaulted. By April 2010, Eastern notified Fidelity it was making a claim under the payment bond for $622,182.90. Fidelity paid the undisputed portion, leaving $253,788.08 outstanding.
Eastern filed for arbitration in November 2010, repeatedly notifying Fidelity and inviting its participation. Fidelity declined every time. When Ionadi filed for bankruptcy in October 2011, Eastern got the bankruptcy court to lift the automatic stay. The arbitration proceeded with neither Ionadi nor Fidelity defending. The arbitrator awarded Eastern $433,489.42, including the unpaid work, $68,299.08 in interest and penalties, and $111,404.62 in attorneys' fees. Neither party tried to vacate the award, and the Allegheny County Court of Common Pleas confirmed it in July 2012.
When Fidelity refused to pay, Eastern sued in Centre County, including a claim under Pennsylvania's insurance bad faith statute, Section 8371. After contradictory trial court rulings and appeals, the Superior Court in September 2022 ruled the arbitration award was binding on Fidelity but the bad faith statute did not apply to surety bonds.
Justice Wecht, writing for the Pennsylvania Supreme Court majority, examined Section 8371's text, which refers to insurance policies and actions by insurers toward the insured. It says nothing about surety bonds, sureties, or principals. The court emphasized the fundamental differences: insurance protects the party buying the policy, while suretyship protects third parties from that person's default. An insurer takes on risk and expects to absorb losses, while a surety steps into a debt temporarily with the right to get paid back by the principal.
The court concluded Section 8371 clearly and unambiguously applies only to insurance policies. If lawmakers wanted to include surety bonds, they knew how to do it, as other Pennsylvania statutes explicitly define insurance to include suretyship. The absence of similar language in Section 8371 was telling.
But the court had no sympathy for Fidelity on the arbitration issue. The payment bond obligated Fidelity and Ionadi jointly and severally to pay all sums due to subcontractors. The court said that phrase was key. What was due to Eastern came from the subcontract, which required arbitration to settle disputes.
The court pointed to a 1909 Pennsylvania case establishing that an arbitration award binds a surety that gets notice and opportunity to participate but does not appear. Fidelity was notified, had the opportunity to defend itself, and declined. It cannot complain now about the results.
Fidelity argued Eastern imposed unreasonable conditions on its participation, but the court found that later communications directly invited Fidelity to join with no conditions attached.
On what all sums due includes, the court relied on a 1968 case holding that interest was an integral part of the debt for material furnished, even when the bond did not specifically mention interest. The same logic applies here: every penny Eastern spent recovering damages from Ionadi's breach is a sum due under the payment bond. The subcontract's interest rate and attorneys' fees were integral to the debt.
However, the court drew a line. Fidelity was liable for fees and interest in the arbitration award for pursuing Ionadi, but not for additional attorneys' fees Eastern incurred suing Fidelity itself in court. Similarly, while the arbitration award properly included the 1.5 percent monthly contractual interest rate, interest on Fidelity's debt under the payment bond was the statutory 6 percent annually.
Chief Justice Todd and Justices Dougherty, Mundy, and McCaffery joined the majority. Justices Brobson and Donohue dissented in part.
For surety professionals, the decision offers a mixed bag. The industry dodged a bullet on bad faith liability, but the ruling on arbitration serves as a warning. Sitting out proceedings can mean getting stuck with whatever award comes down. In this case, Eastern's claim for unpaid work was around $254,000, but the final arbitration award reached over $433,000 once interest, penalties, and attorneys' fees were added.
The decision clarifies that all sums due language in payment bonds is not limited to the strict cost of labor and materials. Companies writing payment bonds may want to review their forms and consider whether more specific language is needed to limit exposure. When arbitration looms, showing up matters.