Schneider Electric: The Surety’s Word Is Its Bond; Not So Its Incorporation of the Words of Its Principal

By Alan B. Sternstein

Language in a surety’s performance bond incorporating, without limitation, the provisions of its principal’s subcontract is not sufficient to bind the surety to the arbitration requirements of the subcontract, according to the Court of Special Appeals in Schneider Elec. Bldgs. Critical Systems, Inc. v. Western Surety Co., 231 Md. App. 27 (2016), cert. granted, 2017 Md. LEXIS 137 and 277 (Feb. 3 and Mar. 3, 2017) (“Schneider Electric”) (video of oral argument available here).

Clark Construction Group, LLC contracted on August 14, 2009 with the Army Corps of Engineers to build a facility for medical research in Harford County, Maryland. Clark, as general contractor for the project, retained the services of Schneider Electric Buildings Critical Systems, Inc. (“Schneider”). Thereafter, Schneider, pursuant to its Master Subcontract Agreement, subcontracted with National Control Services, Inc. (“NCS”), to perform equipment and electrical installation work for the project.

Schneider’s subcontract with NCS (the “NCS Subcontract”) incorporated, by reference and without limitation, the terms of its Master Subcontract, which included an arbitration provision. The NCS Subcontract also required NCS to obtain a performance bond, and NCS obtained that bond from Western Surety Company. The performance bond provided that Western Surety bound itself “for the performance of the Construction Contract [that is, the NCS Subcontract, incorporating the Master Subcontract].” The bond also provided that the “Construction Contract … is incorporated herein by reference.”

A payment dispute between Schneider and NCS resulted in NCS’s abandoning the Construction Contract, Schneider declaring NCS in default, and Schneider hiring others to complete the work at an increased cost to it of $1.5 Million, its damages. Schneider filed a demand for arbitration with the American Arbitration Association and named NCS and Western Surety as respondents. Western Surety then promptly filed a declaratory judgment action in the Circuit Court for Howard County (later transferred to Harford County), seeking a stay of the arbitration proceedings with respect to any claim by Schneider against it and a declaration that Western Surety was not a party to any arbitration agreement with Schneider or NCS or to any such agreement between Schneider and NCS. The arbitration nevertheless proceeded between Schneider and NCS and concluded before the end of the Circuit Court action.

The Circuit Court eventually ruled that Western Surety was not contractually bound to arbitrate any disputes arising from the performance bond. Schneider Elec. Bldgs. Critical Systems, Inc. v. Western Sur. Co., 2015 U.S. Dist. LEXIS 49320 (D. Md., Apr. 14, 2015). The Court of Special Appeals (“CSA”) affirmed in Schneider Electric. The Circuit Court and the CSA held that, regardless whether the Federal Arbitration Act[1] or the Maryland Uniform Arbitration Act[2] governed, the controversy involved a matter of contract formation, which, under either act, state law controlled.

The CSA held that a surety’s undertaking to assure the performance of its principal’s contract with an obligee only extended to the work to be performed by its principal, not to any other obligations or provisions of the principal’s contract with the principal’s oblige. In particular, Western Surety’s only obligation to Schneider was to assure that the work NCS had agreed to perform was performed. The court reasoned that the circumstances did not support the conclusion, under Maryland contract law, that Western Surety intended to undertake obligations of the principal, NCS, other than performance of the specifically agreed work (as opposed to intending to undertake all of NCS’s obligations and requirements under the NCS Subcontract). In other words, absent circumstances to the contrary, the express and mere incorporation by Western Surety’s performance bond of the obligations of the NCS Subcontract between NCS, the principal, and Schneider, NCS’s obligee, should not be construed, without more, literally to incorporate all NCS Subcontract obligations, including the obligation to arbitrate, but only the obligations to perform the work specified in the subcontract.[3]

According to this rationale, therefore, the potential arbitration obligations to which Western Surety did not bind itself through incorporation would include, in particular, not just (1) any obligation to join in any arbitration of a dispute between the principal, NCS, and the principal’s obligee, Schneider, including arbitration of a dispute concerning the work to be performed or payment for the work, but also (2) any (i) obligation of the surety to arbitrate disputes between it and its principal or any (ii) obligation of the surety to arbitrate disputes between it and the obligee based on the surety’s own defenses to any obligation the surety has to the obligee. In other words, the CSA’s decision conflates three materially different arbitration obligations. The CSA did not distinguish between the issue whether the surety was bound to join in the arbitration of the dispute between the principal and its obligee and the issue whether the surety was obligated to arbitrate disputes between the surety and its principal or between the surety and the obligee, such as the surety’s defenses to its obligations under the performance bond. No consideration was given to whether the differences among these various potential obligations should have affected the CSA’s decision or suggest a different outcome in circumstances other than those presented in Schneider Electric.

The CSA’s recitation of the basic Maryland contract law principles applicable here is not questionable, but its application of the principles is. As to the applicable law, the CSA stated:

“Maryland follows the objective theory of contract interpretation,” Nationwide Mut. Ins. Co. v. Regency Furniture, Inc., 183 Md. App. 710, 722 (2009), according to which a “court must, as its first step, determine from the language of the agreement what a reasonable person in the position of the parties would have meant at the time the agreement was effectuated.” Hartford Accident and Indemnity Co. v. Scarlett Harbor Associates Ltd. Partnership, 109 Md. App. 217, 291 (1996) (“Scarlett Harbor I”), aff’d, 346 Md. 122 (1997) (“Scarlett Harbor II”). Moreover, “[w]here the contract comprises two or more documents, the documents are to be construed together, harmoniously, so that, to the extent possible, all of the provisions can be given effect.” Regency Furniture, 183 Md. App. at 722-23 (quoting Rourke v. Amchem Prods., Inc., 384 Md. 329, 354 (2004)).

Schneider Electric, 231 Md. App. at 43-44.

It is hardly evident that, as the CSA determined, the objectively reasonable construction of Western Surety’s express performance undertaking was limited to the work specified to be performed in the NCS Subcontract. The CSA attempts to justify this construction by quoting a term from the Master Subcontract, by which Schneider “desires to engage the services of [a named subcontractor] necessary to perform work in connection with construction projects.” Id. at 45 (emphasis added). Western Surety’s express undertaking, however, was to bind itself to Schneider “for the performance of the Construction Contract,” the latter being indisputably the combined Master Subcontract and the NCS Subcontract. Id. at 34 (emphasis added).

The potential difference in meaning between “perform the work” and “perform the contract” should be evident. Quite apart from any regard for industry expectations and understandings in connection with surety bonds, “performing a contract,” unlike “performing the work,” may readily be understood to mean complying with all the terms of contract, including remedial or enforcement terms, such as an arbitration clause. Beyond the literal language, context here is also important. The CSA overlooks that its decision allows considerable room for unnecessary conflict and needless expenditure of judicial resources if the mechanism for determining and enforcing the principal’s duty to the obligee to perform “the work” is different from the mechanism by which the obligee may determine and enforce the surety’s duty to perform “the work.” According to Schneider Electric, the former is arbitration and the latter is litigation.[4]

If the surety is not a party to the arbitration determining the liability (including damages or other relief), if any, of the principal to the obligee and, instead, insists on its contractual right to have its liability (including damages or other relief), if any, for the same work to be determined in litigation, what then of the potential for conflicting, not to mention, delayed results? Although the CSA ruled that Western Surety was not obligated to arbitrate (and was, therefore, improperly brought into the arbitration), it did not address to what extent, if any, the award in the arbitration between the principal, NCS, and its obligee, Schneider, had a preclusive effect in the litigation of disputes between Western Surety and Schneider. Perhaps principles of privity of contract or estoppel might be brought into play to harmonize any conflict, but would not this be tantamount to saying that Western Surety was always bound by the arbitration and, therefore, was obligated to participate in the arbitration between the principal and the oblige to protect its interests, at least to the extent that the issue is and only is liability (including damages or other relief) between the principal and the obligee?[5]

The preceding caveat emphasized here is important, for, as noted above, there may be legal issues peculiar to the relationship between the surety and the principal or between the surety and the obligee involving matters other than the liability (in terms of damages or other relief) between the principal and the obligee. It is conceivable, for example, that the surety may have defenses to claims by the principal or obligee against it or that the surety may have its own claims against the principal, none of which are dependent on the primary liability between the principal and the obligee. In these circumstances, the Schneider Electric result, holding the surety free from an obligation to arbitrate, may well be the correct result, for, in such circumstances, there is little, if any, room for a conflict in results or a waste of judicial resources allocated to resolving disputes not involving the primary liability between the principal and the obligee. No doubt the practical considerations of avoiding conflicting results and unnecessary lawsuits motivated, expressly or otherwise, the majority of decisions in other jurisdictions that reached a result contrary to that in Schneider Electric, decisions which the court in Schneider Electric recognized but rejected. See cases cited id. at 50-51 & n.12.

Nor was the CSA’s result dictated to it by the reasoning and result in Scarlet Harbor II,[6] on which the CSA relied. In Scarlett Harbor II, the surety, Hartford Accident and Indemnity Co., sought to compel the obligee, Scarlett Harbor Associates Ltd. Partnership, to join with Hartford in an arbitration between Scarlett Harbor and Leonard A. Kraus, Inc. (“Kraus”), the subcontractor to Scarlett Harbor and Hartford’s principal, so that all claims among the parties could be arbitrated. In Schneider Electric, by contrast, the obligee sought to compel the surety to arbitrate. It is unclear from the opinions in Scarlett Harbor I[7] and II whether the issues between Hartford and Scarlett Harbor were coextensive with the primary liability issue between Scarlett Harbor and Kraus. If they were coextensive, then perhaps only Scarlett Harbor knows why it embarked on a course of action involving a second litigation and a potentially conflicting and preclusive result in the arbitration, instead of joining with Hartford in the arbitration between Scarlett Harbor and Kraus. If they were not coextensive, then the ruling that Scarlett Harbor sought, that it was not required to arbitrate with Hartford issues that it had not agreed to arbitrate, that is, issues other than the primary liability between Scarlett Harbor and Kraus, could be sensible.

Schneider Electric plunges all for whom it is pertinent into an Alice in Wonderland-like tour of the legal relationships among principals, obligees and sureties. If the Court of Appeals, which has granted certiorari in Schneider Electric, does not provide a pathway out of the rabbit hole, at least one takeaway is this: where a contractual relationship between two parties is the common denominator between or for relationships between either of those two parties and third parties or between third parties, it will be prudent to provide explicitly by contract that the means for determining the parameters of that initial contractual relationship is the same for and binds all parties.

[1] Codified at 9 U.S.C. §§ 1-16.

[2] Codified at Md. Code Ann., Cts. & Jud. Proc. §§ 3-201 et seq.

[3] It bears noting that the CSA so ruled, even though there was no provision in the incorporation clause carving out particular obligations from incorporation, such as obligations to arbitrate.

[4] Even assuming that determinations in arbitration may be used to collaterally estop determinations in litigation, principles of collateral estoppel do not resolve all potential conflicts. If it were determined first in arbitration that the obligee is entitled to but did not receive the principal’s performance, the surety would remain free in litigation to challenge the obligee’s claims against it for that deficient performance, notwithstanding that the obligee had already established in arbitration that it did not receive the performance by the principal to which the obligee was entitled. Were it determined first in litigation that the obligee is due performance by the surety, the surety would face the risk of a determination in arbitration that it has no claims against its principal, while still being obligated to perform for the obligee.

[5] Estoppel might be appropriate, for example, where the surety, having had and forgone the opportunity to participate in an arbitration and assert its interests affecting the determination of liability vel non between the principal and obligee, thereafter seeks to claim some sort of defect in the conduct of the arbitration between the principal and the obligee cognizable under the Federal or Uniform Arbitration Acts, such as evident partiality of the arbitrator or the arbitrator’s refusal to hear pertinent evidence or engaging in other actions prejudicial to a party’s rights. See 9 U.S.C. § 10. Such a defect would not involve rights and obligations peculiar to the relationship between the surety and principal or obligee.

[6] Hartford Accident & Indemnity Co. v. Scarlett Harbor Associates Ltd. Partnership, 346 Md. 122 (1997).

[7] Hartford Accident & Indemnity Co. v. Scarlett Harbor Associates Ltd. Partnership, 109 Md. App. 217, 291 (1996), aff’d, 346 Md. 122 (1997).