Schneider Electric in the Court of Appeals – So Much for Efficient Resolution of Surety Bond Disputes and Policies Favoring Arbitration over Litigation

By Alan B. Sternstein

Deciding in favor of litigation over arbitration, the Court of Appeals, in Schneider Elec. Bldgs. Critical Systems, Inc. v. Western Surety Co., 454 Md. 698, 165 A.3d 485 (2017) (“Schneider Electric”), affirmed a decision of the Court of Specials Appeals, discussed in this blog on June 26, 2017.

Schneider Electric Buildings Critical Systems, Inc. (“Schneider”), a contractor, had been given a performance bond by NCS, its subcontractor.  Despite their Master Subcontractor Agreement requiring dispute resolution by arbitration, and the performance bond, issued by Western Surety Company (“Surety”), binding NCS and the Surety “jointly and severally . . . to [Schneider] for the performance of the Construction Contract, which is incorporated herein by reference[,]” the Court of Appeals followed the intermediate appellate court in ruling that the Surety could choose litigation and need not participate with NCS in the arbitration that Schneider brought.  Both courts ruled that the term “performance of the Construction Contract,” used in the performance bond, was limited to describing NCS’s construction work and did not extend to other aspects of contract performance.

 

Pertinent Contract and Bond Form Provisions

Schneider’s Master Subcontractor Agreement included terms for resolving disputes between Schneider and its subcontractors.  These terms and others were incorporated by reference into the Construction Contract between Schneider and NCS.  In pertinent part, the dispute resolution terms provided:

19.2 Disputes between Contractor and Subcontractor.  In the event that … such dispute is only between the Contractor and Subcontractor, … then the parties shall resolve the dispute following procedures set forth below.

* * * * *

19.2.2 If the parties are unable to resolve the dispute through good faith negotiations and settlement, then the dispute shall be submitted to binding arbitration within thirty (30) days after demand for arbitration and conducted in the locale of the project before a single arbitrator, unless the parties mutually agree otherwise ….

The performance bond, which NCS obtained in accordance with the Construction Contract and furnished to Schneider, stated:

Contractor and the Surety, jointly and severally, bind themselves … to [Schneider] for the performance of the Construction Contract, which is incorporated herein by reference.

The performance bond further stated:

If there is no [default by Schneider], [the surety’s] obligation under this Bond shall arise after … [Schneider] has notified [NCS] and [the surety] … that [Schneider] is considering declaring a [default by NCS] and has requested and attempted to arrange a conference with [NCS] and [the surety] … to discuss methods of performing the Construction Contract.  If [Schneider], [NCS,] and [the surety] agree, [NCS] shall be allowed a reasonable time to perform the Construction Contract ….

 

Summary and Analysis of the Court’s Reasoning

The Court of Appeals’ opinion essentially adopted the reasoning of the Court of Special Appeals.  First, referencing the second paragraph quoted above from the performance bond, the Court of Appeals believed that that paragraph’s language and tenor showed that “performance” was limited to NCS’s work under the Construction Contract.  It is not so clear, however, and somewhat question begging to argue that “performance” in the context of a paragraph itself limited to circumstances concerning a default in construction work necessarily means that “performance” as used elsewhere in the performance bond, including in the Surety’s undertaking “performance of the Construction Contract” (as opposed to “performance of the Construction Contract work”), was limited to matters of construction.

The Surety, after all, is just that, a surety, not a construction contractor.  Certainly, therefore, the parties never contemplated that, if NCS defaulted, the Surety itself would do the construction work NCS was to do.  Indeed, indulging the court’s reasoning, the Surety could not satisfy its obligation under its bond to perform NCS’s work by making a payment to Schneider to cover Schneider’s costs in the event of an NCS default.  Rather, it would have to arrange for actual performance of the work.  Yet, what Schneider, in fact, did when NCS defaulted was arrange itself for the completion of NCS’s work and then sought reimbursement of its costs from the Surety, under its bond, resulting, of course, in litigation with Schneider, instead of the arbitration for which Schneider believed it had also contracted if NCS defaulted.  See Schneider Electric, 454 Md. at 703, 165 A.3d at 488.  If contract performance extends to paying for the work needed to be done rather than doing the work or even arranging for the work to be done, there is no stretch in reading “performance of the Construction Contract” to include all obligations of that contract, including arbitration.

Second, the Court of Appeals rejected the argument that the Surety, by incorporating into its bond the Construction Contract, including the arbitration clause of the Construction Contract, had bound itself to arbitrate matters of NCS’s default.  Looking at the language of the arbitration clause, the Court of Appeals reasoned that, because the arbitration clause appeared in a section of the Construction Contract titled “Disputes between Contractor and Subcontractor” and because “Contractor” and “Subcontractor” are defined elsewhere in that contract to mean “Schneider” and “NCS”, respectively, “[t]he language within the clause unambiguously limits its application to disputes between Schneider and NCS.”  Id. at 708, 165 A.3d at 491.  Really?

Why does the definition of the dispute to be arbitrated under the Construction Contract mean that the Surety did not obligate itself to participate in and be bound by the arbitral resolution of that dispute, whose subject matter NCS and Schneider were contractually obligated to arbitrate, particularly where the Surety had elsewhere in its own form of bond undertaken with NCS to “jointly and severally, bind themselves … to the Owner [Schneider] for the performance of the Construction Contract, which is incorporated herein by reference?”  (Emphasis added.)  In other words, given that the Surety had bound itself generally and without any express limitation to performance of the Construction Contract “severally,” as if it were NCS, by what logic would the Surety be excused from performing one of NCS’s obligations under that contract, that is, proceeding in arbitration?  It was not a dispute between the Surety itself and NCS, its principal, or a dispute between the Surety and Schneider unrelated to NCS’s work that the Surety was being asked to arbitrate but a dispute between NCS and Schneider, in which Schneider sought to require the Surety’s participation.[1]

The Court of Appeals then adverted to the remedial provisions in the Surety’s bond form, in an effort to buttress its conclusion that the Surety’s undertaking severally to perform a contract, without any further express limitation, meant only performance of its principal’s primary obligation under the contract, construction work.  The bond’s remedial provisions state:

Any proceeding, legal or equitable, under this Bond may be instituted in any court of competent jurisdiction in the location in which the work or part of the work is located and shall be instituted within two years after the Contractor ceased working or within two years after the Surety refuses or fails to perform its obligations under this Bond, whichever occurs first.

According to the Court, allowing Schneider to insist on arbitration, rather than requiring it to proceed against the Surety in court, would contradict the remedial provisions of the bond.  Obviously, of course, that is true only if the Surety’s undertaking elsewhere in its bond to assure “performance of the Construction Contract,” not just performance of the work of the Construction Contract, is ignored, despite the meaning of that provision being at the center of the controversy.  In fact, Schneider was proceeding consistently with the terms of the remedial provision, for it sought judicial relief to compel the Surety “to perform its obligations under this Bond,” to wit, arbitration.[2]

 

Take Aways – Context and a Presumption Favoring Arbitration Should Have Been Considered.

Any effort to resolve this controversy concerning contract construction by looking just to the language of the Master Subcontract Agreement and just to the language of the Surety’s bond form, at best, collapses in circularity, if it is not simply question begging.  Instead, what is warranted in these circumstances is regard for the context in which the transaction giving rise to the legal relationships of the parties occurred and trade custom relevant to the transaction.  See Calomaris v. Woods, 353 Md. 425, 436, 727 A.2d 358, 363 (1999) (“[W]hile evidence of prior intentions and negotiations of the parties is inadmissible [parol evidence], the parol evidence rule would not bar a court from considering the context of the transaction or the custom of the trade in a determination of ambiguity.”).[3]

Schneider, like, presumably, any contractor, required a surety bond for protection, as surely, expeditiously and economically as possible, against any subcontractor default.  To this end, it obligated any and all of its subcontractors, like NCS, to proceed in arbitration for the conclusive resolution of any issues involved in such a default.  Likewise, it did not seek to expose itself to the increased costs, frustration and delay that, as discussed below, would be occasioned by the conflicting resolution of a material issue common to two separate proceedings, one litigation and the other arbitration.  For its part, the Surety, regardless of the remedial terms of its bond form, effectively bought onto the subsequent and more specific obligations of any contract it subsequently bonded with that form and incorporated into that form.[4]  It is not surprising that, as the Court of Special Appeals acknowledged, in circumstances similar to that before it and the Court of Appeals, the majority of courts in other jurisdictions have decided in favor of arbitration.  Schneider Electric, 231 Md. App. 50-51, 149 A.3d 791-92.

Finally, the Court of Appeals also should have considered that, as evidenced by Maryland’s adoption of the Uniform Arbitration Act, arbitration is a judicially sanctioned mode of dispute resolution in Maryland, because it generally tends to be more expeditious and less costly than litigation and because it reduces the burdens on court dockets.  Md. Code Ann., Cts. & Jud. Proc. § 3-201 et seq.; see Questar Homes of Avalon, LLC v. Pillar Const., Inc., 388 Md. 675, 684, 882 A.2d 288, 293 (2005) (Maryland Uniform Arbitration Act “expresses the legislative policy favoring enforcement of agreements to arbitrate”); Allstate Ins. Co. v. Stinebaugh, 374 Md. 631, 641, 824 A.2d 87, 93 (2003) (same); Falls v. 1CI, Inc., 208 Md. App. 643, 653, 57 A.3d 521, 527 (2012) (“Maryland’s public policy favors arbitration of disputes.”); Letke Sec. Contractors, Inc. v. United States Surety Co., 191 Md. App. 462, 470, 991 A.2d 1306, 1311 (2010) (“public policy of the State, as reflected in [the Uniform Arbitration Act], is for the resolution of disputes through arbitration”).  To be sure, favoring arbitration does not mean that arbitration may call into question clear and certain contract language precluding arbitration or even that arbitration rules the day in all cases of uncertainty.  See, e.g., Cheek v. United Healthcare of MidAtlantic, Inc., 378 Md. 139, 149-50, 835 A.2d 662-663 (2003) (unilateral, as opposed to bilateral, arbitration provisions are unenforceable in Maryland, no matter how clear the unilaterality or obligation to arbitrate); Noohi v. Toll Bros., Inc., 708 F.3d 599, 609-14 (D. Md. 2013) (same).  Favoring arbitration does, however, require a more careful and indulgent analysis of the contract documents than the Court gave them.

Here, the Court of Appeals sidestepped consideration of any presumption in favor of arbitration.  The court viewed arbitration as a favored subject under the Federal Arbitration Act, codified at 9 U.S.C. § 1 et seq., but ruled that the Act required application of only state-law principles relevant to contract formation in determining whether parties had agreed to arbitrate a dispute, not any federal law presumptions.  See Schneider Electric, 454 Md. at 490, 165 A.3d at 705-06.  And, even though longstanding precedent under state law also favors arbitration, the court, in construing the bond before it, did not acknowledge the favored status for arbitration independently under Maryland law, including in assessing whether the bond’s language, unambiguously, did not require arbitration or, instead, unambiguously allowed litigationSee id. at 707-08, 490, 165 A.3d at 490-91.

Instead, having avoided any presumption favoring arbitration and finding that the contract documents before it did not unambiguously require arbitration, the court held that the surety did not bind itself to participate in the arbitration of any dispute between Schneider and NCS.  The court, however, also did not find that the contract documents unambiguously allowed litigation over arbitration.  See id.  Nor could it, given the discussion above.  Surely, then, if the tie in the certainty of the language for arbitration vel non was not to be resolved by a presumption in favor of arbitration, the court all the more should have examined the circumstances giving rise to the transaction that created the parties’ legal relationships, rather than indulging, as it effectively did, a presumption in favor of litigation.[5]

Not only does the court’s decision unduly fail to heed the values that undergird favoring arbitration but also it does particular disservice in this case to the economical and expedient resolution of disputes.  It is longstanding law in Maryland, reconfirmed as recently as last year, that in a dispute between a surety’s principal and the principal’s obligee (whom the surety undertakes, by its bond, to protect), the privity of contract between the surety and its principal does not result in the resolution of disputes between the principal and its obligee being conclusively binding on the surety.  See Watkins v. State, 162 Md. 609, 161 A. 173 (1932) (“There is a privity in contract between principal and surety, but a judgment or decree against the former is not ordinarily a conclusive, but only a prima facie, estoppel against the latter.”), quoting Taylor v. State, 73 Md. 208, 221, 20 A. 914, 915 (1890); Hartford Fire Ins. Co. v. Estate of Sanders, 232 Md. App. 24, 44-47, 155 A.3d 915, 927-28 (2017) (same).

Thus, where the surety does not participate in the resolution of such a dispute, even though it has notice of the proceedings, judicial or arbitral, to resolve the dispute, it will not be conclusively bound by all findings and decisions in such proceedings.  Instead, to the extent such matters go to the liability of the principal to its obligee, the surety will be free to attack such matters in any proceedings by the obligee to proceed on the surety’s bond after the principal has been found liable to the obligee.  Hartford Fire Ins., 232 Md. App. at 45, 155 A.3d at 927 (“[W]hen the liability of the principal has been established in a proceeding to which the surety was not party, the liability finding is binding on the surety in a subsequent action against the bond unless the surety rebuts it.”)

For example, in Schneider Electric itself, Schneider terminated its subcontractor, NCS, for failure to proceed, after a payment dispute arose between Schneider and NCS and NCS abandoned the job, contrary to contractual obligations to proceed.  Schneider thereafter claimed $1,500,000 in damages, being Schneider’s cost of completing the work that NCS allegedly and wrongfully failed to perform.  Schneider commenced arbitration proceedings against NCS and sought to compel NCS’s surety to join in those proceedings.  The Court of Appeals’ decision ended those efforts.  As a result, and in view of the longstanding surety law in Maryland, any award in favor of Schneider against NCS in the arbitration proceedings would be subject to plenary attack by the Surety in any effort by Schneider to execute on the Surety’s bond.  Schneider could be forced to prove in separate proceedings its losses occasioned by the conduct of NCS, including not just the liability of NCS to Schneider but also the amount of the losses NCS caused.[6]

A counter argument to this untenable situation for Schneider, of course, is that Schneider should have protected itself by explicitly requiring in the Construction Contract that the bond that NCS obtained provide explicitly for the Surety’s obligation to arbitrate any disputes about the work to be performed under that contract.[7]  This argument, however, is nothing more than also a sub silentio presumption favoring litigation and against arbitration, for, at best, the contract language relevant here is as equivocal to any privilege to litigate as it is to any obligation to arbitrate.  Moreover, the law works best when its principles are clear and predictable.  If there are to be limitations as to what has heretofore been understood as a policy favoring arbitration, absent contract language clearly providing for litigation or language ambiguously allowing litigation, those limitations, too, should be explicit in their scope and should be determined and announced in transparent argument rather than being left to be intuited, as in Schneider Electric, from the results of often complex litigation involving surety bonds.


[1] The error of the court’s ways in construing or apprehending the import of undertaking to be “jointly and severally” liable is evident from the court’s formulation of the task central to its decision:  “Accordingly, we apply Maryland law to determine whether [the Surety] has agreed to arbitrate its dispute with Schneider.”  Schneider Electric, 454 Md. at 706, 165 A.3d at 490.  The correct issue, however, was not whether the Surety had agreed to arbitrate “its” dispute with Schneider but whether it had agreed to participate in and be bound by arbitration of NCS’s dispute with Schneider.

[2] In this connection, the Surety argued that because its obligations only arose if NCS defaulted in performing the work of the Construction Contract, the arbitration provisions incorporated into the Construction Contract did not apply to it.  Id. at 707, 165 A.3d at 490.  The logic of this argument, if any, however, is unclear and certainly not definitive.  Once NCS defaulted, then, if it disputed its construction obligations, the Construction Contract obligated it to arbitrate those disputes.  Likewise, if the Surety disputed NCS construction obligations, which also became the Surety’s construction obligations once a default was alleged, the Surety, having undertaken performance of the Construction Contract “jointly and severally,” became obligated to arbitrate its dispute as to the construction obligations under the Construction Contract.

[3]Under the objective view of contract construction, a written contract is ambiguous if, when read by a reasonably prudent person, it is susceptible of more than one meaning. Heat & Power Corp. v. Air Prods. & Chemicals, Inc., 320 Md. 584, 596, 578 A.2d 1202, 1208 (1990); Truck Ins. Exch. v. Marks Rentals, Inc., 288 Md. 428, 433, 418 A.2d 1187, 1190 (1980).  Accordingly, even if the parol evidence rule did preclude consideration of the context of a transaction or trade custom relevant to the transaction, the contract documents here, read together are at least ambiguous (and, frankly, more clearly require arbitration, rather than permit litigation), permitting the consideration of extrinsic evidence to construe the parties’ intentions.

[4] As the Court of Special Appeals stated in Hartford Accident & Indem. Co. v. Scarlett Harbor Assocs., 109 Md. App. 217, 292, 674 A.2d 106, 142-43 (1996), aff’d, 346 Md. 122, 695 A.2d 153 (1997), “[a]bsent an indication of a contrary intention, the incorporation of one contract into another contract involving different parties does not automatically transform the incorporated document into an agreement between the parties to the second contract.”  (Emphasis added.)  Here, the Surety’s undertaking to perform not just the “work” of the Construction Contract but also and more broadly the contract itself is such an indication.  To be sure, in the Scarlett Harbor appeals, the courts rejected a surety’s attempt to require the obligee of its bond to arbitrate claims against the surety, where, as here, the bond incorporated by reference the underlying contract between the surety’s principal and the obligee that contained an arbitration provision.  Although the Court of Appeals relied on its Scarlett Harbor decision in Schneider, neither its Scarlett Harbor decision nor its opinion there dictates the result here.  In the Scarlett Harbor appeals, the surety had sought to compel arbitration by person with whom it was not in privity, the obligee under its bond, whereas, in Schneider, the surety sought to resist arbitration that was already the obligation of a person with whom it had become in privity, its principal, NCS.  In addition, the courts’ opinions in the Scarlett Harbor appeals do not indicate the scope of the arbitration provision language in the contract between the obligee and its contractor, and the opinion certainly did not consider the distinction between the “performance of the work” and the “performance of the contract.”  They did acknowledge, however, that their decisions were contrary to the weight of authority.  Scarlett Harbor, 346 Md. at 129 n.7, 695 A.2d at 156 n.7.

[5] It may be that the court’s decision reflects a view that arbitration is to be favored only when there is a clear agreement to arbitrate, for, at the outset of its reasoning, the court adverted to Maryland’s adherence to the objective approach to contract construction and its impression that the parties had not clearly agreed to arbitrate.  According to the court:

 

[I]f “the language of the contract is unambiguous, we give effect to its plain meaning and do not delve into what the parties may have subjectively intended.”  Rourke v. Amchem Prod., Inc., 384 Md. 329, 354, 863 A.2d 926 (2004) (citation omitted). As to arbitration clauses in particular, we have explained, “Arbitration is a process whereby parties voluntarily agree to substitute a private tribunal for the public tribunal otherwise available to them.” Hartford Accident & Indem. Co. v. Scarlett Harbor Assocs., 346 Md. 122, 127, 695 A.2d 153 (1997) (emphasis in original)….

 

Schneider, 454 Md. at 706, 165 A.3d at 490.  Given that the objective approach to contract construction strictly regards not what the parties, in fact, intended but what they said (and what, in the circumstances, would have been meant by the language they used), regardless of what they actually intended, the source for the court’s preference for litigation absent a clear and uncertain  agreement to arbitrate is hardly apparent.

[6] In fact, shortly after the parties’ presentation of oral argument before the Court of Special Appeals, arbitration proceedings between Schneider and NCS concluded with a determination that NCS had breached its subcontract with Schneider, and Schneider was awarded a total of $1,653,924.21 in damages, attorneys’ fees, arbitrator’s fees, and other costs that Schneider had incurred.  Schneider Electric, 231 Md. App. at 38, 149 A.3d at 784.

[7] In Scarlett Harbor, 109 Md. App. 294, 674 A.2d 143-44, the Court of Special Appeals offered just such a reason for rejecting the same argument based on the prospect for conflicting results.

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