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Fall 2006

Fraud in the Inducement as a Defense to Fidelity and Surety Claims

INTRODUCTION

Under general principles of contract law, contractual obligations may be avoided by a party whose assent was given under circumstances which vitiate its validity. Contracts induced by intentional, or even under some circumstances innocent, misrepresentations may be abrogated, provided that the party relying on such misrepresentations acts promptly upon discovery thereof to void the contract. The equitable remedy of rescission has been applied to both contracts of insurance and of suretyship to discharge, respectively, the fidelity insurer and the surety of their obligations on the basis of both affirmative misrepresentations or failure to disclose material facts which caused either to miscalculate the risk being assumed. When applicable, rescission results in a contract being voided in its entirety. The remedy, therefore, affords the fidelity insurer or the surety, as the case may be, a complete defense to the claim of an insured or obligee and is not limited to the extent of demonstrable prejudice.

In order to appreciate fully the application of common law principles of fraud in the inducement in the context of fidelity coverage or surety bonds, an understanding of those principles is helpful. Accordingly, a brief overview of them as set out in the Restatement (Second) of Contracts is presented in Part I of this article. Part II addresses issues raised by the fraud in the inducement defense to claims under fidelity policies, and Part III does the same with respect to surety bonds. Part IV explores the potential for waiver of the right to rescission by contractual disclaimer or by ratification from inaction.

I.          BASIC PRINCIPLES OF RESCISSION FOR FRAUD

Under the Restatement (Second) of Contracts a contract is voidable by a victim of misrepresentation under the following circumstances:

§ 164. When A Misrepresentation Makes A Contract Voidable

(1) If a party's manifestation of assent is induced by either a fraudulent or a material misrepresentation by the other party upon which the recipient is justified in relying, the contract is voidable by the recipient.

(2) If a party's manifestation of assent is induced by either a fraudulent or a material misrepresentation by one who is not a party to the transaction upon which the recipient is justified in relying, the contract is voidable by the recipient, unless the other party to the transaction in good faith and without reason to know of the misrepresentation either gives value or relies materially on the transaction.[1]

A “misrepresentation” is “an assertion that is not in accord with the facts.”[2] A misrepresentation is “fraudulent” if “the maker intends his assertion to induce a party to manifest his assent” and the maker (a) “knows or believes that the assertion is not in accord with the facts,” (b) “does not have the confidence that he states or implies in the truth of the assertion,” or (c) “does not have the basis that he states for the assertion.”[3] A misrepresentation is “material” if “it would be likely to induce a reasonable person to manifest his assent, or if the maker knows that it would be likely to induce the recipient to do so.”[4] Thus, although a contract is rendered voidable by a misrepresentation which is intended to deceive and is therefore fraudulent, an intent to deceive is not required so long as the misrepresentation is material. Conversely, although materiality is necessary if a misrepresentation is innocent, it is not necessary when there was an intention to mislead.[5] In either case, the recipient must have been justified in relying on the misrepresentation to enter into the contract. Overall, under the common law as set out in the Restatement of Contracts, one seeking to void a contract must establish the following four elements: first, there must be a misrepresentation; second, the misrepresentation must be either fraudulent or material; third, the misrepresentation must have induced the recipient to make the contract; and fourth, the recipient must have been justified in relying on the misrepresentation.[6]

II.        FIDELITY BONDS

Despite use of the word “bond” in the short-hand term “fidelity bond,” the phrase typically refers to “specialized insurance coverage”[7] by which financial institutions or commercial enterprises seek to protect themselves from the dishonest conduct of their employees.[8] As a species of first-party insurance, fidelity coverage creates a contractual relationship between two parties: the purchasing insured which seeks protection and the insurer which issues and underwrites the coverage.

In this context, common law rules governing rescission for fraud can be applied straight forwardly. Rescission, however, is a strong remedy and when applied to insurance can raise policy concerns about denuding insureds of insurance protection. Many states have enacted statutes which specify the grounds upon which rescission of insurance policies will be permitted; and, as insurance, fidelity bonds are subject to those statutes. The statutes typically do not depart significantly from common law principles; instead, they seek to regulate the application of common law rules in the insurance context. Materiality, for example, is usually defined in terms of the underwriting factors which go into the insurer’s decisions as to the issuance of coverage. One consequence of tying the definition of materiality so directly to underwriting decisions is that some courts conclude that reliance as a separate element is superfluous. The intent to deceive is also typically addressed in the statutes, though the majority allow rescission for innocent misrepresentations so long as the statutory materiality test is met and therefore are consistent with common law principles.  In a minority of states, however, the opposite is the case. In states which have not enacted such statutes, there is decisional law which requires an intent to deceive for some kinds of misrepresentation thereby limiting the category of innocent misrepresentations which will support rescission.

Fidelity insurance creates a two-party contract to which the parties are the insurer which issues the coverage and the business entity seeking the protection provided by it. A corporation, however, can only know that which is known to the persons who act on its behalf. When the person applying for fidelity coverage on behalf of a corporate entity is either himself engaged in dishonesty or has knowledge of the dishonesty of other employees, a third set of interests becomes involved in the process. The question then becomes whether, and to the extent to which, the knowledge of such a person should be imputed to the corporate applicant in determining whether the fidelity insurer may avoid liability because it was induced to issue coverage by the fraud of that person.

A.        Materiality of the Misstatement

1.         Statutory Definitions

Statutes governing rescission of insurance policies for fraud typically define materiality as a misrepresentation which, if the insurer had known the truth, would have caused the insurer to (i) not issue the coverage at all, (ii) not issue it at the same premium rate, (iii) not issue it in as large an amount; or (iii) not include coverage with respect to the particular hazard which ultimately resulted in the loss.[9] Whether the misrepresentation is, in fact, material and would have led to a different underwriting decision is usually judged from the subjective standpoint of the insurer[10] as opposed to an external standard of some kind. For example, California law provides that “[m]ateriality is to be determined not by the event, but solely by the probable and reasonable influence of the facts upon the party to whom the communication is due, in forming his estimate of the disadvantages of the proposed contract, or in making his inquiries.”[11] New York’s Court of Appeals stated that:

Any decision that a misrepresentation is not material must, of course, be based upon a holding, as question either of law or of fact, that the departure from the truth was not a factor which deprived a person of freedom of action and did not induce a choice which otherwise might not have been made. In no case which has been called to our attention has a court of this or other jurisdiction enforced a policy where information demanded by an insurance company ‘in order to decide whether it would issue a policy’ and which might reasonably be considered a factor in arriving at a choice has been withheld. The question in such case is not whether the company might have issued the policy even if the information had been furnished; the question in each case is whether the company has been induced to accept an application which it might otherwise have refused. ‘Any misrepresentation which defeats or seriously interferes with the exercise of such a right cannot truly be said to be an immaterial one.’[12]

Similarly, the Utah Supreme Court has held that the “materiality of a fact misrepresented or withheld is determined by the probable and reasonable effect that a truthful disclosure would have had upon the insurer in determining the advantages of the proposed contract,” basing this analysis on the concept of a “reasonable and prudent insurer.”[13] Some states have utilized a mixed standard, requiring the information to be such that the insurer would deem it material and the insured would have reason to believe the information important to the insurer.[14] In either case, the issue is generally a question of fact which revolves around the impact, actual and/or perceived, of the misrepresentation on decisions regarding issuance of the coverage.

Some misrepresentations, however, so obviously increase the risk to the fidelity insurer that they are, for all intents and purposes, material as a matter of law. In the fidelity context, failure to disclose knowledge of prior employee dishonesty in an application for fidelity bonding is accepted as one such misrepresentation.[15] The Court of Appeals for the Second Circuit examined a misrepresentation of this type in In re Payroll Express Corp.[16] In that case, the insurers issued employee theft policies to Payroll Express Corp (“PEC”). The president and CEO of PEC, in applying for the policies, was required to answer the following questions: (a) “[H]as the proposer suffered a loss during the past five years?  If ‘Yes' give brief details and amount involved,” and (b) “[i]s there any other information which is or may become material to the proposed insurance and which is not already disclosed to the underwriters?” In response to the questions, the CEO admitted to a single burglary loss of $1,500,000 and stated that there was no additional material information.[17] In fact, there had been 18 losses during the previous five years, and the CEO and other employees had long been diverting funds for their own use.[18] In analyzing the effect of the misrepresentations, the court determined that the misrepresentations were “reasonably related to the estimation of the risk or the assessment of the premium,” so there could be “no doubt that [the CEO’s] failure to inform [the insurer] in response to question 36 that certain employees were embezzling funds from PEC was material as a matter of law.”[19]

2. Reliance

Under the common law, reasonable reliance by the defrauded party is an essential element of fraud in the inducement.[20] In the insurance context, the statutes or decisional law in some states define materiality such that reliance is subsumed thereunder with the result that reliance is eliminated as a separate element of a cause of action for fraud in the inducement. Some jurisdictions, however, follow the common law and retain the requirement that reliance on the misrepresentation must be established as part of the prima facie case for rescission.[21]

The decision in Shapiro v. American Home Assur. Co.,[22] is an example of the approach which does not require separate proof of reliance. There, the court examined the issue of reliance upon misrepresentations in an application for directors and officers liability insurance under Massachusetts law. In opposing the insurer’s motion for summary judgment, the insured argued that reliance must be shown separately in order to rescind the policy.[23] The Shapiro court flatly rejected that contention holding that “[it] is likely that reliance is not treated as an independent requirement because the standard of materiality under Massachusetts common and statutory law is such that any statement that is shown to be material is one so central to the risk being insured that the insurer would be expected to take it into consideration in making the underwriting decision.”[24] The court noted that the longstanding Massachusetts definition of materiality in insurance contracts is facts “the knowledge or ignorance of which would naturally influence the judgment of the underwriter in making the contract at all, or in fixing the rate of the premium.”[25] Under this standard, reliance is presumed once materiality is shown.

The decision in Zimmerman v. Continental Cas. Co.,[26] exemplifies the approach which does require a separate showing of reliance. In that casethe insurer sought to rescind an accident policy based upon the decedent insured’s misrepresentations in the application for insurance.[27] The Nebraska Supreme Court, looking to the language of the applicable statute,[28] held that “in order for misrepresentations in an application for insurance to constitute a defense to an action on the contract it is incumbent upon the insurance company to plead and prove, among other things, that the statements or misrepresentations were made knowingly by the insured with the intent to deceive and that the insurance company relied and acted upon such statements or representations and was deceived by them to its injury.”[29] The Court noted that this result would have been attained under either the special accident insurance statute, Nebraska Revised Statutes §44-710.14, or the general insurance statute, Nebraska Revised Statutes §44-358.[30] The jury instructions, however, did not require the insurer to prove that it had relied to its detriment upon the misrepresentations, and in light of that omission, the Zimmerman court remanded the case for a new trial.[31]

B.        Intent to Deceive

1.         Statutory Requirements

a.         Intent to Deceive Not Required

Most states which have statutes governing rescission for fraud follow common law principles and permit rescission for an innocent misrepresentation which is material as well as for a misrepresentation made with the intent to deceive.[32] The Arkansas statute is typical and provides as follows:

  • All statements and descriptions in any application for an insurance policy or annuity contract, or in negotiations therefor, by, or in behalf of, the insured or annuitant shall be deemed to be representations and not warranties. Misrepresentations, omissions, concealment of facts and incorrect statements shall not prevent a recovery under the policy or contract unless either:
    • Fraudulent;
    • Material either to the acceptance of the risk or to the hazard assumed by the insurer; or
    • The insurer in good faith would either not have issued the policy or contract, or would not have issued a policy or contract at the premium rate as applied for, or would not have issued a policy or contract in as large an amount or would not have provided coverage with respect to the hazard resulting in the loss if the true facts had been made known to the insurer as required either by the application for the policy or contract or otherwise.[33]

In such jurisdictions, an innocent misrepresentation which meets the applicable materiality test will suffice.[34] In New York, an innocent material misrepresentation renders an insurance contract void from the outset.[35] California provides by statute that “[c]oncealment, whether intentional or unintentional, entitles the injured party to rescind insurance”[36] and that “[if] a representation is false in a material point, whether affirmative or promissory, the injured party is entitled to rescind the contract from the time the representation becomes false.”[37] Though using different language, the Illinois statute is to the same effect; it provides that no “misrepresentation or false warranty shall defeat or avoid the policy unless it shall have been made with actual intent to deceive or materially affects either the acceptance of the risk or the hazard assumed by the company.”[38] The effect, however, is the same: intent to deceive is not required.

b.         Intent to Deceive Required

The strictest states, which appear to be in the minority, require that in all cases there be some proof of intent to deceive in order for an insurer to rescind a fidelity bond or other insurance contract. The Louisiana statue, for instance, provides that “no oral or written misrepresentation or warranty made in the negotiation of an insurance contract, by the insured or in his behalf, shall be deemed material or defeat or void the contract or prevent it attaching, unless the misrepresentation or warranty is made with the intent to deceive.”[39] The courts in Missouri, which does not have a statute governing rescission of insurance policies, apply a doctrine of “false swearing” which requires proof that the insured made the representation with an intent to deceive the insurer.[40]

2.         Equitable Fraud

Some states that do not have statutory provisions governing the rescission of insurance contracts, such as New Jersey,[41] apply a doctrine of equitable fraud under which the evaluation of misrepresentations on insurance applications entails an analysis as to whether the questions were “objective” or “subjective.” In FDIC v. Moskowitz,[42] the court noted that under New Jersey law, the “‘insurer need not show that the insured actually intended to deceive.’ … Rather ‘[e]ven an innocent misrepresentation can constitute equitable fraud justifying rescission.’”[43] Only the answers to “objective questions” will constitute equitable fraud which supports rescission for an innocent misrepresentation. The court explained:

Equitable fraud, however, distinguishes between subjective and objective questions on the application. Objective questions seek information within the applicant’s knowledge, such as whether the applicant has been examined or treated by a physician. Subjective questions seek to probe the applicant’s state of mind and are concerned with more ambiguous issues, such as what is the state of the applicant’s health or whether the applicant has or has had a specified disease or illness. Answers to subjective questions do not constitute equitable fraud if the question is directed toward probing the knowledge of the applicant and determining the state of his mind and . . . the answer is a correct statement of the applicant’s knowledge and belief.[44]

In the Moskowitz case, a bank applied for a financial institution bond. The application contained a question asking whether there was “‘any criticism of your operations in the last State or Federal examination.’”[45] The bank answered in the negative even though a joint report of state and federal regulators contained many negative observations some of which the bank had acknowledged.[46] Although finding that the question was subjective in that one person’s definition could differ from that of another, the report detailed extensive comments and was “rife with criticism” such that “only one reasonable conclusion may be drawn from a fair reading of the 1988 Report — the regulators criticized [the bank].”[47] Thus, the court concluded that under such circumstances, the response was “objectively false,”[48] and therefore even though the question may have been “subjective,” rescission was nevertheless required.

The court in Liebling v. Garden State Indem.,[49] also addressed the distinction between subjective and objective questions on an application for a claims-made attorney malpractice insurance policy. In that case, the insurer sought to rescind the policy because the attorney-applicant answered “No” to a question as to whether the firm was “‘aware of any circumstances, or any allegations or contentions as to any incident which may result in a claim being made against the firm.’”[50] At the time that the question was answered, the applicant represented the plaintiff in a personal injury action and had been advised by the judge’s chambers that a motion to dismiss the case for failure to prosecute had been granted. He justified his negative response to the question on the ground that the court’s written order dismissing the matter had not yet been entered and might have been based on the negligence of the attorney who preceded him as attorney for the plaintiff.. The Liebling court found that the question was subjective and that therefore “equitable fraud is present only if the answer was knowingly false.”[51] The court affirmed summary judgment granting rescission because the attorney “did not honestly believe that he was secure [from a possible malpractice claim] . . . and [t]herefore, his answer in the application was knowingly false.”[52]

3. The Restatement of Suretyship & Guaranty

The Restatement (Third) of Suretyship & Guaranty provides:

§ 74. Fidelity Coverage

Unless the contract creating the secondary obligation or the circumstances indicate to the contrary, when (i) the principal obligor is an employee of the obligee and (ii) the underlying obligation is the faithful performance of the principal obligor's duties to the obligee, the obligee is treated for purposes of § 12 (When Secondary Obligation Is Voidable Due to Misrepresentation) as having induced the secondary obligor's assent to the secondary obligation by representing to the secondary obligor that the obligee was unaware of any previous acts by the principal obligor that would have breached the underlying obligation.[1]

The Restatement of Suretyship included a provision addressing contracts that provide fidelity coverage because “they can fall, at least in part, within the § 1 concept of secondary obligations”[2] and the Restatement of Suretyship rules governing rescission of surety bonds for fraud in the inducement apply “with particular focus in the context of fidelity coverage.”[3] The commentary notes that in providing coverage, the fidelity insurer “is relying largely on the fact that it is the obligee [insured] that has selected the principal obligor as an employee in which trust and confidence are placed.”[4] When the insured retains an employee whom it knows to be dishonest, the insurer’s reliance is misplaced with the result that the insurer underwrites a risk which is different than that which it intended. For that reason, the Restatement of Suretyship regards the insured’s silence as a representation that it is unaware of previous dishonesty by the employees to be covered, and if that statement is untrue, the misrepresentation is to be treated as material and therefore justifying rescission. The illustration to the commentary reflects a classic case for rescission of a fidelity bond:

On April 6, 1996, O obtained a fidelity bond from S, pursuant to which S agrees to satisfy any losses to O resulting from P's failure faithfully to execute the duties inherent in P's position as O's treasurer. At that time, O knew that P had previously embezzled funds from O on at least three occasions. S was unaware of these previous acts of P. Because O is treated as having represented that it was unaware of any previous acts of P that would trigger S's liability under the bond, O has made a material misrepresentation to S. Under § 12(1), the fidelity bond is voidable by S.[5]

The commentary also observes:

Of course, if the previous acts of the principal obligor are disclosed to the secondary obligor there is no longer the same reliance by the secondary obligor on the obligee's placement of trust and confidence. Thus, the principle of § 12(3) would not apply.[6]

C.        Attribution of Knowledge to the Insured Corporation

Fidelity insurance is issued to protect the insured against the perfidy of its employees. An issue arises, however, when the person who signs the application on behalf of the insured has either committed some covered defalcation or has actual knowledge of other employees who did. A corporation only has such knowledge as is in the possession of its officers, employees and directors, and as a general principle of agency, an officer’s knowledge is imputed to the corporation.[7] An exception may arise, however, when the officer acts adversely to the interest of the corporation.

            1.         Adverse Domination

The Restatement (Second) of Agency provides:

§ 280. Agent’s Knowledge of His Own Unauthorized Acts

If an agent has done an unauthorized act or intends to do one, the principal is not affected by the agent's knowledge that he has done or intends to do the act.[8]

Comment c to section 280 makes it clear that

If, in order to protect himself against the embezzlement or other wrongdoing of an agent, the principal obtains a contract of indemnity which states that the signer has no knowledge of any prior wrongdoing by the agent, the knowledge of his own embezzlement by the agent who signs the contract is not imputed to the principal. The risk of embezzlement by dishonest agents is the risk insured against and it would defeat the purpose of the contract to bind the principal by the knowledge of such agents.[9]

Section 282 of the Restatement, however, seems to present a conflicting approach, at least in part. That section provides as follows:

§ 282. Agent Acting Adversely to Principal

  • A principal is not affected by the knowledge of an agent in a transaction in which the agent secretly is acting adversely to the principal and entirely for his own or another's purposes, except as stated in Subsection (2).
  • The principal is affected by the knowledge of an agent who acts adversely to the principal:
    • if the failure of the agent to act upon or to reveal the information results in a violation of a contractual or relational duty of the principal to a person harmed thereby;
    • if the agent enters into negotiations within the scope of his powers and the person with whom he deals reasonably believes him to be authorized to conduct the transaction; or
    • if, before he has changed his position, the principal knowingly retains a benefit through the act of the agent which otherwise he would not have received.[10]

Section 282(1) is completely consistent with section 280. Section 282(2), however, expressly contemplates even when the agent is acting adversely to the interests of the principal, the knowledge of the former will be attributed to the latter in certain circumstances. One of those situations arises when “the agent enters into negotiations within the scope of his powers and the person with whom he deals reasonably believes him to be authorized to conduct the transaction.”[11] On its face, section 282(2)(b) appears to include an employee or officer knowingly misrepresenting the honesty of persons to be covered by fidelity insurance as part of the process of negotiating the policy with the insurer. Thus, section 282(2)(b) would permit attribution of the employee’s knowledge to the insured, while section 280 clearly prohibits any such attribution. Because commentary to section 280 specifically addresses that situation and the commentary to section 282(2) does not, it may be that the drafters of the Restatement simply did not regard the rule of section 282(2) as applying to misrepresentations by a dishonest employee on an insurance application while affording some protection to parties which negotiate contracts in other contexts.

In any event, the majority of courts endorse the position taken by section 280.[12] In Puget Sound Nat’l Bank v. St. Paul Fire & Marine Ins. Co.,[13] for example, the Washington Court of Appeals held that a director’s knowledge was not, in fact imputed to the principal, a bank. In Puget Sound Nat’l Bank, one of the bank’s directors owned an insurance brokerage and arranged for his clients to finance their premiums through the bank. He was the sole contact between the customers and the bank. Later review of these loans showed that many were fraudulent, with the customers either having financed far less than their promissory notes indicated or being completely unaware that the loans existed all.[14] The director who defrauded the bank was also the individual who, as the procuring agent for the bank, filled out the application for fidelity insurance. Following the discovery of the director’s defalcations, the bank sued the insurer for recovery under the policies. The insurer claimed that the director’s knowledge of his own fraudulent scheme was imputed to the bank, rendering the fidelity policies void ab initio. The insurer argued, among other things, that the director was acting in the bank’s interests in obtaining the policies, and thus his knowledge would be imputed to the bank.[15] Rejecting the insurer’s position, the court found that both the director’s defalcations and his concealment thereof on the policy applications were not in the bank’s interest, and also found that the bonds were obtained at the request of the bank’s board of directors and were signed by another officer of the bank who had no involvement in the director’s fraud.[16] On these findings, the court refused to impute the director’s knowledge to the bank.

The minority position, in cases of dishonest officers procuring fidelity bonds, is that while an officer’s prior misconduct or fraudulent application for insurance may be adverse to the corporation’s interest, the act of procuring fidelity coverage is in the corporation’s interest, and thus the dishonest officer’s knowledge is entirely imputed to the corporation, including the knowledge of his prior defalcations. An early example of this view is Gordon v. Continental Casualty Co.[17] decided in 1935. In Gordon, the Pennsylvania Supreme Court addressed the case of the president of a bank who fraudulently represented on an application for fidelity coverage that the bank was unaware of any reason to believe that any corporate officers or directors were dishonest or otherwise unworthy of the trust invested in them, and that the bank was unaware of any covered losses in the five years prior to the application. At the time, the president had embezzled $26,000.00 from the bank.[18] The court held that while the president was acting adversely to the bank’s interest in his fraudulent misrepresentation, obtaining the fidelity coverage was in the bank’s interest as evidenced by the fact that the board of directors instructed him to obtain the insurance. Therefore, the court held, the president’s knowledge of his own misdeeds was imputed to the bank.[19]

More recently, in the Payroll Express case,[20] the United States Trustee overseeing the corporate bankruptcy contended that the CEO’s knowledge of employee fraud at the time that he executed the application for insurance should not be attributed to PEC because of the protections afforded the corporate form.[21] The Trustee argued that the CEO was acting adversely to PEC’s interest and on his own behalf, presumably because of the embezzlement in which he took part. The court disagreed, finding that the CEO was acting in PEC’s interest in obtaining the fidelity policy.[22] The court held that the insured, PEC, could not take advantage of the benefits of the fidelity policy, e.g. coverage for the embezzlement committed by the CEO and other employees, and simultaneously disavow the CEO’s actions in applying for the policy.

The court also imputed the officer’s knowledge to the corporation in Tri-State Armored Services, Inc. v. Subranni (In re Tri-State Armored Services, Inc.).[1] There, the insurer sought to rescind fidelity insurance on the grounds that answers to several questions in applications for coverage were untrue. The insured’s former president and majority shareholder had long engaged in dishonest and fraudulent activities, including regular diversion of corporate funds for his own use. Employees and other officers of the insured were well aware of, and in some cases participated in, these defalcations; and even after the dishonest officer resigned, continued to consult him in most matters.   Eventually the insured filed for bankruptcy.

The insurer asserted that the insured made material misrepresentations regarding its losses each time that it submitted an application for renewal of the policy.[2] The insured claimed that it could not be charged with the knowledge of its officers. The Court rejected this contention, holding “that the corporation is affected with constructive knowledge, regardless of its actual knowledge, of all material facts of which its officer or agent receives notice or acquires knowledge while acting in the course of his employment and within the scope of his authority, and the corporation is charged with such knowledge even though the officer or agent does not in fact communicate his knowledge to the corporation.”[3] This knowledge includes knowledge of fraud by officers of the corporation. In addition, the court held that “an agent's misrepresentations bind the principal if the agent was authorized to represent the principal in obtaining the contract”[4] and that “[if] the court is satisfied that the officer or employee making the innocent, or negligent or willful misrepresentations on behalf of the insured had the actual, implied, or apparent authority to do so, the misrepresentations will be imputed to the insured.”[5]

2.         The Sole Representative Doctrine

In cases where an agent or employee is acting adversely to the interests of the corporation, the wrongdoer’s knowledge is not ordinarily imputed to the corporation.[6] Where the agent is the sole representative of the corporation, however, this rule may not apply. Under that exception when the dishonest agent is the sole representative of the principal with respect to the transaction, then the principal is chargeable with the dishonest agent’s knowledge of all things relevant to that transaction, including his misrepresentations. In In re Fuzion Technologies Group, Inc.[7] the court explained the sole actor doctrine and its rationale thus:

[I]f an agent is the sole representative of a principal, then that agent's fraudulent conduct is imputable to the principal regardless of whether the agent's conduct was adverse to the principal's interests. The rationale for this rule is that the sole agent has no one to whom he can impart his knowledge, or from whom he can conceal it, and that the corporation must bear the responsibility for allowing an agent to act without accountability.[8]

In Post v. Maryland Casualty Co.[9] the Washington Court of Appeals applied the sole representative exception to the case of an owner and president of two corporations who obtained on behalf of the corporations fidelity bonding as protection against fraud, embezzlement and other dishonesty of the corporations’ employees which included the president. The president held almost all of the corporations’ stock except for qualifying shares held by the other directors.[10] The bond contained a stipulation that the corporations had no knowledge of any acts of fraud or dishonesty committed by any employees. When the bonds were issued, the president had already committed various acts of fraud and mismanagement and, by the time he was replaced by a receiver, had embezzled over $25,000 from the corporations.[11] The Post court recognized the “general rule” that knowledge of an agent is attributable to the principal and an “exception” to the rule when the principal acts adversely to the interests of the principal.[12] The court, however, also recognized, “a qualification to the exception,” that when “‘the agent, though engaged in perpetrating an independent fraudulent act on his own account, is the only representative of the principal, his knowledge is imputed to the principal . . . .’”[13] The court held, as would the later decision in In Re Payroll Express Corp., that a corporation cannot simultaneously seek the benefit of the contract and ignore the fraud perpetrated in obtaining the policy.[14] As the officer was the sole representative of the corporations, his knowledge of his own fraud and deceit was imputed to the corporations and the court held the bonds void ab initio.[15]

III.       SURETY BONDS

Unlike fidelity insurance, the surety bond creates a three-party relationship.[16] The party which typically applies for the bond, the principal, is not the party which benefits from its issuance, the obligee. Because the principal deals directly with the surety, the obligee would usually have no reason to know when the principal induces the surety to issue the bond by fraud. Allowing the surety to rescind a bond on the basis of the principal’s fraud, of which the obligee has no knowledge, would violate the obligee’s separate interest in the protection afforded by the bond.

Common law rules governing rescission do not neatly apply in such a context. When the surety is induced to issue the bond as a result of the obligee’s affirmative misrepresentation of facts material to the surety’s risk, there is no difficulty in refusing to allow the obligee to benefit by its wrongdoing. The thorny issue arises when the obligee has knowledge of facts which would affect the surety’s decision whether to issue the bond and the obligee remains silent. Under common law principles, non-disclosure of a fact affecting the surety’s risk might well support rescission.[17] Whether the obligee has an obligation to disclose facts material to the surety’s risk must be evaluated in light of the surety’s responsibility for investigating its undertaking through queries of its principal and other means. The issue is to identify those situations in which the obligee has a duty to disclose and may have breached that duty.

A.        The Parameters of the Defense in the Suretyship Context

1.         Fraudulent Inducement or Misrepresentation by the Obligee as a Basis for Rescission

An obligee does not stand in a fiduciary relationship to the surety.[18] Nevertheless, “[i]n all suretyship relations, the creditor/obligee owes the surety a duty of continuous good faith and fair dealing,”[19] and, as with contracts generally, a suretyship contract induced by the obligee’s fraud is subject to rescission.[20]

The word “fraud” encompasses at least several, if not a multitude of, sins. Under general contract law, an affirmative statement of fact, which is known to be false and is communicated with an intent to deceive, will clearly support rescission.[21] Even an innocent misrepresentation, if made as to a material fact and justifiably relied upon, will render a contract voidable.[22]

Applying those principles to the suretyship context, section 12(1) of Restatement (Third) of Suretyship and Guaranty[23] provides:

§ 12 When Secondary Obligation Is Voidable Due to Misrepresentation

            (1) If the secondary obligor’s[24] assent to the secondary obligation is induced by a fraudulent or material misrepresentation by the obligee upon which the secondary obligor is justified in relying, the secondary obligation is voidable by the secondary obligor.[25]

More simply: if the surety’s issuance of its bond is based upon an affirmative misrepresentation which is either fraudulent or material by the obligee and on which the surety is justified in relying, the bond is voidable by the surety.[26]

2.         Fraudulent Inducement or Misrepresentation by the Principal or a Third Party as a Basis for Rescission

While discovery of an affirmative misrepresentation by the obligee may allow a surety to rescind and void its bond, fraud by the principal or a third party alone generally will not be a defense to a claim by the obligee. Absent the obligee’s knowledge of, or participation in, the principal’s or third party’s fraud or misrepresentation, the surety’s obligation cannot be rescinded. Rather, the surety will have a cause of action against only the principal or third party for damages resulting from such fraud or misrepresentation.[27]

Thus, section 12(2) of the Restatement of Suretyship provides as follows:

(2) If the secondary obligor’s assent to the secondary obligation is induced by a fraudulent or material misrepresentation by either the principal obligor or a third person upon which the secondary obligor is justified in relying, the secondary obligation is voidable by the secondary obligor unless the obligee, in good faith and without reason to know of the misrepresentation, gives value or relies materially on the secondary obligation.[28]

Section 119 of the Restatement of Security, upon which section 12(2) Restatement of Suretyship is based, provides as follows:

§ 119 Fraud or Duress on Surety by Principal

Where the surety by fraud or duress of the principal has been induced to become bound to the creditor [obligee], the fraud or duress is not a defense against the creditor [obligee], if, without knowledge of the fraud, he has extended credit to the principal on the security of the surety’s promise or relying on the promise, has changed his position in respect of the principal.[29]

Hence, if the surety has been fraudulently induced by the principal or a third party to issue a bond, and the obligee had no knowledge of the fraud and proceeded to enter into a contract with the principal in reliance upon the surety’s bond, the surety has no defense to the obligee’s claim. If, on the other hand, the obligee knew of the principal’s fraud and failed to disclose it, the surety may, under certain circumstances, be discharged in full.

These principles were applied recently in In re Commercial Money Center, Inc., Equipment Lease Litigation,[30] a case which shows that differentiating between the obligee and the principal is not necessarily a simple task. In that case, sureties issued bonds in connection with transactions between a number of investor banks and Commercial Money Center (“CMC”) which purportedly leased equipment and vehicles to numerous lessees in exchange for lease payments. CMC then pooled the leases and sold them (or their anticipated income streams) to the banks. The surety issued “bonds”[31] guaranteeing that the lease payments would be paid by the lessees and/or by CMC which, as servicer or sub-servicer of the lease pools, was responsible for receiving the payments and delivering them to the banks. The banks and the sureties agreed that most of CMC’s leasing business was a sham in that many of the leases never existed, were never consummated, were forged, or were sham transactions with CMC-affiliated entities. Those parties also agreed that CMC operated a “Ponzi scheme” in which early investors were paid using money generated by new investors. The sureties alleged that they were induced to issue the bonds by CMC’s misrepresentations as to its financial condition, the leasing program, lease default rates, lease recoveries and related matters. Eventually, the banks ceased receiving lease payments and CMC filed for bankruptcy.[32]

The surety[33] denied the banks’ claims and, when sued, sought a declaration that its bond obligations were invalid and unenforceable by reason of CMC’s fraud. The banks moved for partial judgment on the pleadings under Fed. R. Civ. P. 12(c). They invoked the “basic principle of surety law that ‘fraud or misrepresentation practiced by the principal alone on the surety, without any knowledge or participation on the part of the creditor or obligee, in inducing the surety to enter into the suretyship contract will not affect the liability of the surety.’”[34] In response, the surety argued that because the bonds named CMC as the “First Named Insured,” CMC was the obligee and that its fraud did void the bonds and the general rule did not apply.[35] The court rejected the surety’s argument because it was clear from the face of the documents that the ultimate flow of proceeds of the bonded transactions was to the banks, not CMC, and that therefore the banks were intended to be the party to whom the surety owed its obligations.[36] As a result, the general rule applied, and CMC’s fraud did not relieve the surety of its obligation to the banks.[37]

3.         The Obligee’s Failure to Disclose as a Basis for Rescission

In the construction surety context, the case of an obligee making an affirmative misrepresentation to a surety which induces the surety to issue a bid, performance or payment bond rarely arises. This is, in large part, because, in the construction context, both the obligee and the surety usually deal directly with the principal and not with each other. Thus, the more common situation is that in which the obligee possesses, but fails to inform the surety of, facts which bear upon the risk to be undertaken by the surety.

Does the obligee have an obligation to disclose such facts to the surety, even if the surety has not made inquiry to the obligee? The answer is, it depends on both the facts and the jurisdiction. Unlike a fidelity bond relationship, where there is “an absolute duty upon the obligee to volunteer disclosure of all facts materially affecting the risk to the surety,”[38] or a relationship of trust and confidence between the parties which, in and of itself, makes concealment fraudulent, [39] a prospective obligee of a contract bond has no absolute duty to inform the surety of facts affecting the risk which are known to the obligee.[40] The obligee has a duty to speak only under certain circumstances.

B.        The “Old” Restatement of Security Section 124(1) and the “New” Restatement of Suretyship Section 12(3)

The most widely accepted formulation of the circumstances which impose a duty upon the prospective obligee to disclose material facts to the surety has been that set forth in section 124(1) of the “old” Restatement of Security, now incorporated into section 12(3) of the “new” Restatement of Suretyship.[41]

Section 124(1) of the Restatement of Security provided as follows:

§ 124. Non-Disclosure by Creditor

(1) Where before the surety has undertaken his obligation the creditor knows of facts unknown to the surety that materially increases the risk beyond that which the creditor has reason to believe the surety intends to assume, and the creditor also has reason to believe that these facts are unknown to the surety, failure of the creditor to notify the surety of such facts is a defense to the surety.[42]

            Section 12(3) of the Restatement of Suretyship is based on and derived from section 124(1) of the Restatement of Security and provides as follows:

§ 12. When Secondary Obligation Is Voidable Due to Misrepresentation

            . . .

(3)  [I]f, before the secondary obligation becomes binding, the obligee:

            (a)  knows facts unknown to the secondary obligor that materially increase the risk beyond that which the obligee has reason to believe the secondary obligor intends to assume; and

            (b)  has reason to believe that these facts are unknown to the secondary obligor; and

            (c)  has a reasonable opportunity to communicate them to the secondary obligor;

the obligee's nondisclosure of these facts to a secondary obligor constitutes a material misrepresentation.[43]

The new Restatement of Suretyship goes a bit further than the Restatement of Security did by identifying the factors to be considered in determining whether the obligee has reason to believe that (i) facts unknown to the secondary obligor materially increase the risk beyond that which the secondary obligor intends to assume and (ii) such facts are unknown to the secondary obligor. Those factors, set out in section 12(4), are the obligee’s reasonable beliefs as to:

(a) the nature of the secondary obligor’s relationship to the principal obligor;

(b) the nature of the secondary obligor’s business; and

(c) the secondary obligor’s ability to obtain knowledge of such facts independently in the exercise of ordinary care.[44]

The new Restatement of Suretyship § 12(3) also provides the following illustration in the appended commentary:

Developer A will enter into a construction contract with contractor C only if C procures payment and performance bonds satisfactory to A. B, who has issued bonds for C in the past, agrees to issue the bonds to A. Unknown to B, C has just suffered a series of business reverses leaving C equitably insolvent. A does not disclose this to B. A is aware of this state of facts, knows that it is unknown to B, and that it increases the risk beyond that which B intends to assume; nonetheless, A fails to disclose it to B despite opportunity to do so. A's nondisclosure is a material misrepresentation.[45]

In general terms, an obligee has a duty to speak “[w]here he realizes that the surety is acting or is about to act in reliance upon a mistaken belief about the principal in respect of a matter material to the surety’s risk.[46]   Section 124(1) “is merely a special application in suretyship of the rule of Contracts that fraud creates a defense,”[47] for non-disclosure by the obligee under the circumstances of the rule “constitutes fraud on the surety.”[48] When applicable, section 124(1) provides a complete defense to the surety, because it has been held to require the rescission of the bond and the discharge of the surety’s obligations thereunder.[49] It is also important to remember that under section 124(1), “it is not necessary that the concealment or the failure to disclose facts material to the surety be willfully done by the creditor, or that the creditor have the intent to deceive.”[50]

Although section 12(3) of the Restatement of Suretyship and its predecessor, section 124(1) of the Restatement of Security, appear somewhat sweeping on their face, the commentary to those sections imposes important limitations: “It [duty to disclose] does not place any burden on the creditor to investigate for the surety’s benefit. It does not require the creditor to take any unusual steps to assure himself that the surety is acquainted with facts which he may assume are known to both of them.”[1] Perhaps the most important limitation on the usefulness of these sections arises as a result of the very reason for the existence of the rule. Essentially, a prospective obligee has a duty to make disclosure to the surety when the obligee has reason to foresee that the surety is about to act under a mistaken belief as to the risk. By its very nature, however, suretyship involves an assumption of risk, and that fact circumscribes the existence and extent of the obligee’s duty. Thus, the commentary to Restatement of Security § 124(1) expresses the limitation as follows:

            Every surety by the nature of his obligation undertakes risks which are the inevitable concomitants of the transactions involved. Circumstances of the transactions vary the risks which will be regarded as normal and contemplated by the surety. While no surety takes the risk of material concealment, what will be deemed material concealment in respect of one surety may not be regarded so in respect of another.[2]

            As with its predecessor, the comments to the new Restatement of Suretyship § 12(3) also stress the limitations of the obligee’s duty:

It should be noted that this subsection places no burden on the obligee to investigate for the benefit of the secondary obligor. Nor does it require the obligee to take any particular steps to ascertain whether the secondary obligor is acquainted with facts that the obligee may reasonably believe are known to both of them.[3]

            If a fact known to the obligee relates to a risk which is regarded as normal and contemplated by the surety, then it is unlikely that the obligee will be held to an obligation to disclose that fact in the absence of a direct inquiry by the surety.[4] The case law is replete with statements that an obligee may reasonably assume that the surety will acquire from the principal or otherwise all information which it considers relevant to its risk and, indeed, that the surety has an obligation to conduct is own investigation of facts bearing upon the risk which it contemplates.[5]

The Restatement Rule has been adopted or otherwise referred to in connection with a contract surety’s non-disclosure defense by courts in at least the following states: Alaska,[6] Arizona,[7] California,[8] Colorado,[9] Georgia,[10] Idaho,[11] Illinois,[12] Indiana,[13] Maine,[14] Michigan,[15] Montana,[16] New Jersey,[17] Oregon,[18] Wisconsin,[19]and Washington.[20] The Restatement Rule has also been adopted by the Fifth Circuit to discharge sureties from their bond obligations under federal law.[21] North Carolina has applied the rule in Williston on Contracts[22] which is substantially similar to the Restatement Rule as to a surety’s non-disclosure defense.[23]

C.        New York: The Restatement Rule Plus

Until the Second Circuit decision in Rachman Bag Co. v. Liberty Mutual Insurance Co.,[24] there was some ambivalence among courts in New York as to the legal principles governing a surety’s non-disclosure defense. In State v. Peerless Ins. Co.,[25] an Appellate Division decision upheld by the Court of Appeals, the court refused to adopt the Restatement of Security section 124(2), which imposed a duty upon the obligee, arising after the issuance of the bond, to disclose facts justifying termination of the bond under circumstances comparable to those set out in section 124(1). There, the surety issued a bond to the State of New York to secure a wholesale cigarette dealer’s financial obligations including payment of cigarette taxes. Although the dealer’s repeated failures to make timely payment demonstrated its deteriorating financial condition, the state continued to permit the dealer to incur additional liability for taxes without informing the surety of the dealer’s defaults. Holding that section 124(2), under which the surety was arguably entitled to a discharge, did not set forth the law of New York and that the State had no duty to keep the surety informed about the principal’s financial condition or its prior defaults unless the surety made direct inquiry to it,[26] the court affirmed summary judgment against the surety.

In an earlier case, Chemical Bank v. Layne,[27] a federal court applied New York law to discharge a surety from his loan guarantee because the creditor bank failed to inform him that stock which it held as collateral for the loan was restricted.   Analyzing the same New York cases relied upon in State v. Peerless Ins. Co., the court held that if an obligee has reason to know that the surety is about to undertake an obligation under the mistaken impression of facts material to the risk and the obligee has knowledge of those facts, he has a duty to inform the surety. Although the court made no reference to section 124(1), its holding applied the same underlying principle. In that case, the guarantor made a general inquiry to the bank as to the stock, but the bank did not disclose the restrictions which substantially reduced the value of the stock. Because the restrictions were not readily ascertainable, the guarantor’s failure to discover them did not constitute a failure of his duty to investigate. Although the fact that the guarantor made inquiry to the bank was crucial[28] because it put the bank on notice that the guarantor was ignorant of the true facts, the court suggested in dicta that inquiry by the surety was not a necessary prerequisite to the defense if it otherwise appeared that the obligee knew that the surety was mistaken and if the undisclosed fact would not have been discoverable upon reasonable investigation by the surety.[29]

In Layne, the guarantor argued that it should be relieved of its obligation on the additional grounds that the bank failed to disclose that the borrower’s debt included the borrower’s guarantee of the debts of third parties and that the bank had released other guarantors of the borrower’s debt. The court rejected those grounds because the defendant’s guarantee was so broad and vested the bank with such great latitude in dealing with the borrower’s debt that the undisclosed transactions must be regarded as included within the risk contemplated by the guarantee. Therefore the guarantor should have inquired as to them, and his failure to do so negated the defense.[30] That holding illustrates an important limitation on the surety’s defense which also applies under the Restatement Rule. When the undisclosed fact relates to a contemplated risk, a prospective obligee is entitled to assume that a surety, in the discharge of its duty to investigate its risk, will learn of the fact unless the obligee knows of circumstances which make it unlikely that the surety will discover the fact upon a reasonable investigation. In such a case, therefore, unless the surety makes inquiry of the obligee, the obligee, in the words of the Restatement sections 124(1) and 12(3), does not have “reason to believe that these facts are unknown” to the surety.[31]

Rachman Bag involved an obligee which brought an action against a surety seeking payment of a loss allegedly covered under a bond issued by the surety. The bond purported to secure a normal business transaction between the principal and the obligee, but, unbeknownst to the surety, the bond actually secured an arrangement whereby the principal would repay through services over $400,000 stolen from the obligee by the principal’s president. Upon learning of the true nature of the transaction, the surety refused to honor the bond and sought to be discharged thereunder. The district court granted the surety’s motion for summary judgment.

On appeal, the Second Circuit, applying New York law, adopted the same tri-part formulation as the Restatement of Security § 124(1) and the Restatement of Suretyship §12(3) (then in draft form), which was applied by the district court, but found that “this test lacks an essential fourth element: a duty on the part of the obligee to disclose the relevant information.[32] Thus, the court listed the elements of fraudulent concealment as follows:

(1)        the obligee must know facts that materially increase the surety’s risk, and have reason to believe that surety would be unwilling to assume such a higher risk;

(2)        the obligee must have reason to believe that such facts are unknown to the surety;

(3)        the obligee must have the opportunity to communicate the relevant information to the surety; and

(4)        the obligee must have the duty to disclose the information based upon its relationship to the surety, its responsibility for the surety’s misimpression, or other circumstances.[33]

As to this fourth element, the court noted that the relevant New York case law provides “no definitive test for determining when an obligee’s duty to disclose material information arises.”[34] However, the court pointed out that “New York courts have generally held such a duty to arise when the obligee had either a relationship of trust and confidence with the surety or some degree of responsibility for the surety’s misimpression.”[35] Among the relevant circumstances which New York courts have pointed to in finding this duty of disclosure are:

(1)        Where the obligee deals directly with the surety in obtaining the bond;

(2)        Where the obligee affirmatively creates a misimpression such that failure to correct it would amount to an affirmative misrepresentation;

(3)        Where the obligee colludes with the principal in creating the deception to the surety;

(4)        Where the principal is the obligee’s employee or agent; and

(5)        Where the obligee has unique access to material information.[36]

The Second Circuit ultimately reversed the district court’s summary judgment ruling in favor of the surety, finding a factual issue as to whether the fourth element (i.e. a duty to disclose) was present.[37]

In light of this added fourth element of Rachman Bag, the law in New York appears to be that a surety may only be discharged where the obligee either makes an affirmative misrepresentation or fails to disclose a misrepresentation that it either participated in or could be held partly responsible for. Hence, in the situation where an obligee knows of a misimpression of the surety which affects its risk, but does not partake in that misimpression or otherwise deal directly with the surety in obtaining the bond, the obligee would appear to have no duty to speak under New York law.

D.        Application of the Defense

The opinion of the California Supreme Court in the Sumitomo Bank case is the leading decision adopting the Restatement Rule for the surety’s non-disclosure defense. The court there found that section 124(1) contained three elements which were “conditions prerequisite to the imposition of a duty on a creditor to disclose facts it knows about the debtor to the surety.”[38] Those elements, each of which must be established by the surety (and which now form the basis of the new Restatement of Suretyship section 12(3)), are:

(1)        The obligee has reason to believe that facts known to him materially increased the risk beyond that which the surety intends to assume;

(2)        The obligee has reason to believe that those facts are unknown to the surety; and

(3)        The obligee has a reasonable opportunity to communicate those facts to the surety.[39]

The application of each of these elements shall be discussed in turn.

1.         Material Increase of Intended Risk

The old section 124(1) commentary specifically identified three facts which are among those that will be regarded as material to the surety’s risk: (1) the financial condition of the principal, (2) secret agreements between the parties, and (3) the relations of third parties to the principal.[40] In the reported cases, the non-disclosed matter asserted as a defense by the surety typically relates to one of those three facts.

In the Sumitomo Bank case, the surety, who executed a continuing guarantee of borrowers’ present and future indebtedness to a bank,[41] argued that the bank failed to inform him that the borrowers needed a loan to pay federal income taxes. That fact, the guarantor asserted, materially increased his risk on the guarantee because it evidenced the borrowers’ financial difficulties. The court disagreed and rejected the defense for failure to meet the first prong of the tri-partite test. The guarantor had introduced no evidence as to the borrowers’ financial condition when the guarantee was executed, and therefore there was no basis for a finding as to the scope of the risk which the guarantor intended to assume. Accordingly, there was no basis upon which the court could conclude that the bank had any reason to believe that the borrowers’ inability to pay his taxes increased the risk beyond that which the guarantor intended to assume.[42] Moreover, the court held that borrowing to pay taxes was so commonplace that that fact, in and of itself, did not provide a basis for imposing a duty of disclosure.[43]

In a case involving the application of federal law to a surety’s bond obligations, St. Paul Fire & Marine Ins. v. Commodity Credit Corp.,[44] two sureties were discharged pursuant to section 124(1) because of the failure of the obligee, a governmental agency, to disclose facts which demonstrated that the bond principal’s financial condition was so poor that it was unlikely that the principal could perform its contract obligations. The principal was an agricultural cooperative which entered into a contract with the Commodity Credit Corporation in connection with the government’s agricultural price-support program. Under the program, the agency made loans to the cooperative or its members which were secured by agricultural products which were held by the agency. The cooperative was allowed to sell its equity interest in the products provided that it “redeemed” the collateral within 15 days of a sale. Redemption consisted of repayment of the loan made in respect of the collateral. A month prior to the issuance of the sureties’ bonds, the cooperative experienced a financial crisis as a result of which it was unable to make its redemption payments within the required 15 days, and the agency waived that requirement. The agency conducted an investigation. It learned that the cooperative had probably been using loan proceeds improperly as operating funds instead of holding such proceeds in trust for its members as required by the contract and that its financial situation was so precarious that a catastrophe could be expected within months. Finding that the earlier financial crisis and the likelihood of future defaults substantially increased the sureties’ risk, the court held that the agency had a duty to disclose those facts to the sureties. Because it did not, the sureties were completely released of their bond obligations.[45]

In another case decided by a federal court of appeals, Rocky Mountain Tool & Mach. v. Tecon Corp.,[46] an obligee’s failure to disclose facts demonstrating the principal’s inability to perform did not result in the discharge of the surety. In that case, which involved the construction of a dam, a second-tier subcontractor entered into a direct contract with the general contractor after the bankruptcy of the subcontractor with whom the second-tier subcontractor had originally contracted. The general contractor required the second-tier subcontractor to post a bond to secure the new contract which was issued by the second-tier subcontractor’s surety on the original contract. Shortly before the issuance of the bond, however, the general contractor informed the second-tier subcontractor that its progress was grossly inadequate and that unless substantial improvement was demonstrated, the general contractor would terminate the contract and take over the work. There was no improvement, and two weeks after the issuance of the bond, the general contractor terminated the second-tier subcontractor, completed its work, and sued its surety for the resulting loss. Upon a jury verdict, the trial court entered judgment against the surety.

Although the Tenth Circuit made no reference to section 124(1), it stated that, on general contract principles, non-disclosure could support rescission “where it is reasonably foreseeable that the other party will be deceived unless you do speak up.”[47] Nevertheless, the court held that the surety was not entitled to a directed verdict, that it had the burden of proving non-disclosure of material fact, and that the question of the information possessed, and the risk contemplated, by the surety were fact questions properly submitted to the jury, whose verdict was adverse to the surety.[48] The opinion does not set forth the facts that were known to the surety. It does mention, however, that the surety had also issued the bond which secured the second-tier subcontractor’s original contract with the subcontractor who later went bankrupt. One may infer that the fact that the principal went to the surety for a second bond on the same project was regarded as a circumstance so unusual that the surety should have conducted an investigation sufficient to learn that the principal was far behind schedule. However, the court made no reference to a surety’s duty to investigate and did not indicate whether the surety conducted an investigation. The result in this case strongly suggests that if a surety is faced with an unusual situation, its failure to conduct an investigation commensurate to that situation may result in a determination that the surety did not regard the undisclosed facts as material.

As noted in the Restatement commentary, undisclosed agreements between the obligee and the principal are regarded as material to the surety’s risk.[49] In two construction cases, however, a surety was unable to avoid liability based upon allegations that the obligee made a secret side deal with the principal. In Harris & Harris Constr. Co. v. Crain & Denbo, Inc.,[50] a general contractor on a municipal water and sewer improvement project entered into an agreement with a subcontractor pursuant to which the subcontractor agreed to perform all of the general contractor’s obligations. That arrangement was made because the subcontractor did not have a state contractor’s license and was therefore unqualified for the municipal project. The parties agreed upon the amount of profit to be realized by the general contractor. At the surety’s insistence, however, that amount was substantially reduced in the subcontract agreement. After the execution of the subcontract but before the issuance of the bond, a letter was written and found in the general contractor’s files which increased the amount of the profit to be paid to the general contractor. The letter was signed by the subcontractor who claimed at the trial that it had been dictated by the general contractor. The general contractor denied that assertion and suggested that the subcontractor, which had use of its facilities, prepared the letter and left it in the general contractor’s file. Although the letter suggested to the general contractor that there was reason to question the principal’s ability to perform the subcontract, it conducted no investigation. Instead, it merely informed the subcontractor orally that it did not accept the terms of the letter. Although the subcontractor’s surety knew that the subcontractor was not licensed for the municipal project and had written bonds for the subcontractor on prior occasions, its investigation did not include any request for information from the general contractor, and the general contractor did not inform that surety of the letter. Shortly after the commencement of the work, the subcontractor was terminated for failure to make a cash deposit required by the subcontract, and the general contractor completed the project and sued the surety for the loss.

The North Carolina Supreme Court upheld the trial court’s denial of the surety’s motion for non-suit on the ground that the alleged secret agreement never became effective and thus did not increase the surety’s risk.[1] Although the court acknowledged that the letter caused the general contractor to suspect that something was wrong, it found that the general contractor had not learned of any facts regarding the subcontractor’s ability to perform which were not already known to the surety or which could not have been discovered by it upon a reasonable investigation.[2] In doing so, the court observed that in “ordinary cases,”[3] it may be assumed that the surety obtains all information which it requires from its principal.[4] However, the facts of this case are decidedly not ordinary. They suggest that a higher level of profit was an essential element of the arrangement between the general contractor and the subcontractor, for why otherwise would the subcontractor agree to less remuneration, and that the parties intentionally concealed the letter because they knew that the surety would not issue the bond if it knew of the letter. When the subcontractor defaulted and the general contractor looked to the bond, it claimed to have repudiated the letter. Under such circumstances, of course, any inquiry by the surety of the obligee or the principal would have been futile.

In the second case, Chrysler Corp. v. Hanover Ins. Co.,[5] the obligee entered into a contract with a building owner to supply and install air conditioning equipment. The obligee then entered into a subcontract with the principal pursuant to which the principal was to furnish all labor and materials for the installation of the equipment. The air conditioning equipment was apparently to be furnished by the obligee to the principal through the principal’s sister corporation, which was indebted to the obligee on previous transactions. The obligee and principal orally agreed that 20% of the principal’s progress payments and the entire retainage would be applied by the obligee to the sister corporation’s indebtedness and not paid to the principal. The oral agreement was not disclosed to the surety. Due to financial difficulties, the principal was unable to pay its subcontractors or to complete the work. The obligee did so and sued the surety for its loss. The trial court rejected the surety’s discharge defense, although it deducted from the obligee’s award the amounts credited to the sister corporation under the oral agreement. On appeal, the Seventh Circuit affirmed the judgment, and held that it was the principal’s failure to disclose the oral agreement which deceived the surety and that a surety is not relieved of its obligations to the obligee on account of the principal’s fraud.[6] The court held that the obligee was an “innocent” party because it “made no representations to defendant whatsoever, and it had no obligation to do anything to make certain that the defendant was not misinformed.”[7] That holding, which is expressed in absolute terms, directly contradicts cases relying upon section 124(1) or general common law principles to impose a duty on an obligee to disclose material facts under certain circumstances.

There was a strong dissent in Chrysler Corp. which asserted that the oral agreement was material on its face[8] and that the obligee should have expected that a surety would have assumed from the written subcontract that the full amount of progress payments were to be made in cash to the principal.[9] Those observations satisfy the first two prongs of the section 124(1) test, although the dissent did not cite the Restatement but relied upon material modification cases to argue that the oral agreement discharged the surety. In answer to the majority’s finding that the obligee made no representations to the surety, the dissent argued that the obligee, by placing the written subcontract in the principal’s hands, “represented that the method of payment was one materially different from that actually agreed upon” and that the obligee thereby gave the principal “an opportunity to secure a bond which he could not have otherwise secured.”[10] This very interesting theory might provide a basis for satisfying the third part of the section 124(1) test, which requires that the obligee have had an opportunity to communicate with the surety, particularly in construction situations where the contract is typically appended to the required bond form for submission to the surety and there is often no communication between the surety and the obligee prior to the issuance of the bond.

2.         Reason to Believe that Undisclosed Facts Are Not Known by the Surety

Even when section 124(1) or like principles are applied to suretyship contracts, rescission of the bond is often denied. Such denials are usually based, at least in part, upon a holding that a surety should not be relieved of liability for the obligee’s non-disclosure of a fact which the surety should have discovered. The surety, itself, has a duty to investigate facts pertinent to the risk which it contemplates assuming under its bond. The obligee is entitled to assume that the surety will conduct such an investigation; and if facts known to the obligee are such that a reasonable investigation should reveal them, the obligee may assume that they are known to the surety. In such circumstances, the obligee will be said to have had no reasonable basis for believing that the surety is unaware of those facts. Consequently, the obligee will have no duty to disclose the facts even if he realizes that the facts are material to the surety’s risk.

For example, in Ransom v. United States,[11] a bidder on a federal construction project to rehabilitate housing units at an air force base submitted a bid so far below the next low bid and the government’s estimate that the contracting officer requested that the bidder review the bid and advise of any error. When the bidder replied that, due to a mistake, his bid was $400,000 too low, the government offered him the opportunity to withdraw the bid without penalty. Eschewing that option, the bidder confirmed its original bid, and the contract was awarded to him on that basis. The bid mistake was not disclosed to the surety which issued performance and payment bonds. When the contractor defaulted, the surety arranged for the completion of the contract at a loss of $2,700,000. The surety then sued the government under the Tucker Act,[12] arguing that the suretyship relationship constituted a contract between the surety and the government which imposed upon the government an obligation to deal with the surety fairly and in good faith. Invoking section 124(1), the surety asserted that the government’s failure to disclose the principal’s bid mistake constituted a violation of its obligation of good faith and fair dealing. Applying federal common law,[13] the court held that in accepting the bonds, the government did not assent to contractual obligations for which it could be held liable to the surety for non-disclosure.[14] The court held further that section 124(1) did not require a different conclusion because that section merely recognizes a defense but does not impose liability upon an obligee for failure to comply with its requirements.[15] This distinction accords with familiar principles under which legal fraud, consisting of a knowing misrepresentation with intent to deceive, must be proven to establish affirmative liability, while avoidance of contract obligations may be based merely upon equitable fraud which does not require an intent to deceive. The court held that the record contained no facts supporting a contention that the government had committed legal fraud.[16]

The court in Ransom nevertheless went on to consider the application of section 124(1) to the facts before it. It found that section 124(1) requires that “sureties themselves must exercise reasonable diligence to become knowledgeable about the circumstances of a transaction and the principal’s financial condition; if there are suspicious circumstances, the sureties have a duty to inquire.[17] The surety did not exercise reasonable diligence; for if it had, it would have discovered the relatively low amount of its principal’s bid because the bid results were “public information.”[18] That was the very information which caused the government to question the principal’s bid; and if the surety had availed itself of that information, it would have had the same reasons to investigate. Therefore, the court concluded, the government had no reason to suspect that the surety did not know of the bid error or did not have a reason to investigate its principal’s bid.[19]

Although inquiry by the surety of the obligee is not a prerequisite of the defense under section 124(1),[20] such inquiry is often found to have occurred in cases upholding the defense.[21] An inquiry by the surety may indicate to the obligee that the surety is not in possession of pertinent information and thereby provide the basis for a holding that the obligee had a reason to believe that undisclosed material facts were unknown to the surety. For example, In First Nat’l. Bank & Trust v. Notte,[22] a prospective guarantor of a loan agreement asked the lending bank about the borrower’s credit record. The bank replied that the borrower’s record was good and that she had paid prior loans. The face of the loan agreement, which was co-signed by the guarantor, recited that the bank held a lien on real estate as collateral, when the bank had withdrawn its request for the lien, and that the proceeds of the loan were to be used in the borrower’s business, when part of the proceeds had been used to pay off a prior loan. Neither the fact of the bank’s withdrawal of the request for the real estate lien nor its use of the loan proceeds were disclosed to the guarantor. Remanding for a new trial because the case had been submitted to the jury on tort theories of misrepresentation rather than contract principles, the Supreme Court of Wisconsin held that section 124(1) governed the guarantor’s defense that he was discharged because of the bank’s failure to disclose material facts. In this connection, the court said that when the surety has made inquiry, “the creditor knows that the surety lacks knowledge of a material fact affecting the risk.”[23] One of the factual issues to be determined by the jury on remand was whether the scope of the surety’s inquiry was sufficiently narrow that the bank’s responses to his questions were adequate, for “[t]he nature and extent of the inquiry will determine the extent of the duty to disclose.”[24]

3.         Opportunity to Communicate

An obligee’s failure to disclose material facts will support rescission of the bond only if the obligee had “a reasonable opportunity to communicate them to the surety.”[25] That requirement is particularly troublesome to construction contract sureties because bonds are frequently issued without direct communication with the obligee. The precise meaning of the condition is unclear, and the Restatement commentary does not address it. Moreover, courts appear to have taken conflicting approaches. In the Ransom case,[26] one of the reasons advanced by the court for rejecting the surety’s reliance on section 124(1) was that the government could not have known for certain that the principal’s bid bond surety would issue the performance and payment bonds and that “[t]here is no precedent for imposing on the Government a duty to guess who a contractor will use as a performance and payment surety.”[27]

In Georgia-Pacific Corp. v. Levitz,[28] however, the guarantor of a loan was discharged under section 124(1) even though there is no indication in the opinion that the guarantor had any communication with the creditor. In that case, the guarantor had been the president of a corporation and had executed a personal guarantee of the corporation’s future indebtedness to its supplier. Sometime thereafter, when the corporation owed nothing to the supplier, the guarantor sold his interest in the corporation, severed all ties with it, but did not revoke his guarantee. Approximately six months later, the supplier undertook a credit review of the corporation as a result of which its credit manager concluded that the corporation was at the brink of insolvency and recommended against further extensions of credit. Rejecting that advice, the supplier shipped additional goods to the corporation on credit without informing the guarantor of the results of its credit review.[29] Despite the fact that there was no apparent communication between the supplier and the guarantor after the credit review, the court held that section 124(1) required that the guarantor be discharged of his obligation because the supplier knew that the guarantor had not been associated with the debtor for six months and therefore had reason to believe that the guarantor would not know of the debtor’s declining fortunes.[30] The court in that case apparently believed that the creditor’s obligation included a duty to seek out and inform the guarantor that the debtor was on the brink of insolvency before extending further credit to it.

IV.       WAIVER

Even when the insured or obligee is found to have procured the fidelity coverage or bond by fraud or material misrepresentation, acts by the fidelity insurer or surety can waive its right to rescission. First, the insurer or surety may under certain circumstances disclaim a fraud defense by a provision in the policy or bond to that effect. Second, the insurer or surety can lose its remedy of the right to rescission by failing to act promptly upon discovery of the fraud.

A.        Waiver by Contract — Disclaimer and Its Limitations

Provisions in guarantees and surety bonds which recite that the obligation is absolute regardless of otherwise available defenses have been enforced to bar fraud in the inducement as a defense. In Citibank, N.A. v. Paplinger,[31] defendants personally guaranteed a loan to their corporation by plaintiff banks. When the corporation filed for bankruptcy and the banks sued on the guaranties, the defendants claimed fraud in the inducement, alleging that in the negotiations for the loan, the banks had promised to extend additional credit to the corporation and that they never did so. The New York Court of Appeals affirmed summary judgment in favor of the banks on the basis of a provision in the guaranty which declared that the obligation therein was “‘absolute and unconditional’” and was “‘irrespective of (i) any lack of validity . . . of the [guaranteed loan] . . . or any other agreement or instrument relating thereto’ or ‘(vii) any other circumstance which might otherwise constitute a defense’ to the guarantee.”[32] Although the disclaimer did not specifically refer to the promised additional credit, “the substance of defendant’s guarantee forecloses their reliance on the claim that they were fraudulently induced to sign the guarantee by the banks’ oral promise of an additional line of credit.”[33] The court also noted that “[t]o permit that [the claim of fraud in the inducement] would in effect condone defendants’ own fraud in ‘deliberately misrepresenting [their] true intention’ when putting their signatures to their ‘absolute and unconditional’ guarantee.”[34]

The sureties in JPMorgan Chase Bank v. Liberty Mutual Insurance Company,[35] were confronted with the Paplinger holding when they asserted fraud in the inducement as a defense to the claims of plaintiff obligee. The bonds in JPMorgan Chase were issued in connection with contracts pursuant to which plaintiffs made advance payment of a set sum to Enron entities in return for subsequent deliveries of specified quantities of natural gas and crude oil over a period months. The bonds secured the obligation of the Enron entities under the contracts and to make monetary payments in the event of a default on the delivery requirements. Plaintiffs sought payment under the bonds of over $1 billion. The sureties defended on the basis of fraud in the inducement. The sureties asserted that the contracts were part of a fraudulent arrangement by which loans from the plaintiff bank to the Enron entities were disguised as sales of oil and gas in the ordinary course of the Enron entities’ business. The disguised loans were accomplished, the sureties claimed, by secret agreements between the Enron entities and entities controlled by the purchaser/obligee.

The plaintiffs moved for summary judgment, and the sureties opposed on the ground that they had been induced to issue the bonds by the plaintiffs’ failure to disclose the true nature of the transactions. In response, the plaintiffs invoked a provision of the bonds which stated that the obligations of the sureties “‘are absolute and unconditional, irrespective of the value, validity or enforceability of [the underlying transactions] . . . [and] irrespective of any other circumstance whatsoever that might otherwise constitute a legal or equitable discharge or defense of a surety in its capacity as such.’”[36] The plaintiffs argued that as those provisions were substantially the same as the disclaimer contained in the guarantee in the Paplinger case, the same result should obtain and the sureties should be barred from asserting fraud in the inducement. The court, however, disagreed and denied summary judgment. Relying on the Second Circuit decision in Manufacturers Hanover Trust Co. v. Yanakas,[37] the court rejected “the extraordinary proposition — the logical extension of plaintiffs’ interpretation” that mere recitation that an obligation is “absolute and unconditional” can disclaim any and all extrinsic fraud between “sophisticated parties.”[38] Quoting Yanakas, the court declared that “‘the touchstone is specificity,’ that is, a clear indication that the disclaiming party has knowingly disclaimed reliance on the specific representations that form the basis of the fraud claim.”[39] Thus, although the disclaimer language in Paplinger was broad and general, it was negotiated as part of the same negotiations in which the guarantors later said the oral promise to extend additional credit was made. Further specificity was unnecessary in such circumstances because the guarantors in agreeing to the disclaimers had to know at a minimum that the disclaimers precluded reliance on oral promises made during those negotiations. Specificity was required in the JPMorgan Chase case, however, because there was no basis for suggesting that the sureties knew or were on notice of the secret agreements by which the purported asset sales were effectively converted into loans.[40]

The court also found that nothing in the Paplinger case precluded a fraud in the inducement defense based on misrepresentations in the bonds themselves. The court noted that the bonds recited that the principal and the obligee had entered an “‘Inventory Forward Sales Contract’” and expressly provided that the sureties’ obligations would cease once all of the gas or oil “‘is fully delivered.’”[41] The court said that “[p]lainly implicit in these representations is the assertion that the Sureties are being asked to insure the sale and future delivery of a commodity, rather than being asked to insure, unlawfully, a disguised loan transaction.”[42] Such representations did not concern an extrinsic fact which was collateral to the bonded obligation; they went to the nature of the obligation itself. Absent specificity, a general disclaimer could not reasonably be read to apply in that circumstance.

Some cases have distinguished and limited the JPMorgan Chase decision. In WestRM-West Risk Markets, LTD., v. Lumbermens Mutual Casualty Co.,[43] for example, sureties which secured payments owing under premium financing agreements asserted fraud in the inducement based upon the obligees’ alleged failure to disclose facts material to the risk which they assumed. The bonds contained disclaimer language which the sureties sought to avoid by reliance on the JPMorgan Chase opinion. The court rejected the sureties’ argument because the conclusion reached in JPMorgan Chase “was based largely on the fact that when the defendants had negotiated the disclaimers, they were completely unaware that other parties were negotiating separate agreements that transformed the asset sales into loans.”[44] It should be noted, however, that the court also concluded that even if the disclaimer provisions did not bar the fraud defense, it would nonetheless fail because the facts did not meet the requirements for fraudulent concealment under New York law.[45]

In MBIA Insurance Corp. v. Royal Indemnity Co.,[1] an insurer which issued credit risk insurance policies insuring payment of principal and interest on underlying student loans alleged that the policies were procured by fraudulent concealment by the entity which had originated the loans or acquired them from the original lenders. The beneficiaries of the policies were banks which provided financing to the lender and took pools of the student loans as security. When the lender defaulted, the beneficiaries sued the insurer. Asserting fraud in the inducement, the insurer sought rescission. The banks did not dispute that the insurance was procured by fraud; instead, they sought summary judgment on the basis of disclaimer provisions in the policies. Affirming summary judgment for the banks in part, the Third Circuit held that the disclaimer provisions unambiguously precluded the asserted fraud defense.[2] The insurer, however, citing JPMorgan Chase, argued that the disclaimers were unenforceable because they lacked sufficient specificity. The Third Circuit agreed with the district court that “JPMorgan Chase is ‘an unusual and extreme case [that] . . . provides little guidance.’”[3] It said further:

Though characterized as a fraudulent inducement, the transaction in JPMorgan Chase bordered on a fraud in the factum — ‘the sort of fraud that procures a party’s signature to an instrument without knowledge of its true nature or contents.’ . . . In such a case, where the party does not even know the ‘true nature’ of what it is signing, it is unsurprising that the standards for effective waiver would be stricter, if waiver is possible at all. Cf. Restatement [(Second) of Contracts] §§ 163-164 (explaining that a contract fraudulently induced is voidable, whereas a ‘contract’ procured through fraud in the factum is no contract at all).[4]

In In re Commercial Money Center, Inc.. Equipment Lease Litigation,[5] the suretyship contracts were issued to secure payments under pooled leases to investor banks. The surety asserted that it was induced to issue the contracts by the misrepresentations of the originator of leases as to its financial condition, the true nature of the transactions, and the performance of the leases. In moving for judgment on the pleadings under Fed. R. Civ. R. 12(c), the banks argued, among other things, that the surety had waived any fraud defense by provisions in the suretyship contracts which contained waiver language which was both broad and specific at the same time. A typical provision stated:

The Company is responsible to the Named Insured for the individual underwriting of each lessee and Lease, including but not limited to, all relating credit matters, issues of fraud, bankruptcy, that the lease is a true lease and not a secured financing, usury, that the lease is valid, binding and enforceable, and the accurate and timely performance by any servicer or subservicer designated by the Company, and the Company shall assert no defenses to any claim under this Policy as a result of any of the foregoing.[6]

In holding that those provisions barred the surety’s fraud defense, the court distinguished the JPMorgan Chase because the waiver language specifically included fraud and because the nature of the “sham” was fundamentally different.

Illinois Union [the surety] cannot complain that the transaction was a sham in the same sense that the court so found in JPMorgan — the sureties in that case were duped into entering an illegal financial guaranty rather than an insurance contract. In this case, despite the fraud allegations, . . . the agreements were exactly what they purported to be . . . . Illinois Union knew the type of contract into which it was entering, and could have investigated the parties involved in the underlying leases. It did not do so.[7]

Even more important, in the court’s view was the fact that JPMorgan Chase involved collusion between the obligee and the principal which justified application of “the proposition that the ‘wrongdoer, whether willful or negligent, should not be benefit from his own wrongdoing.’”[8] For the Commercial Money Center court, the fact that the obligee in JPMorgan Chase participated in the misrepresentations created equities which were fundamentally distinguishable from the case before it in which the fraud was perpetrated by the originator of the leases alone.[9]

B.        Waiver by Lack of Action — Ratification

The fidelity insurer or surety may lose its fraud defense by means other than contracting it away. If the insurer or surety fails timely to assert the defense or take other prompt action to properly rescind the fidelity or surety bond, it may be deemed to have ratified the fraud. Once the insurer or surety discovers a material misrepresentation that would entitle it to rescission, it must act on that right within a reasonable period of time or potentially be barred from asserting the defense.[10] In Continental Insurance Co. v. Kingston,[11] for example, the Utah Court of Appeals held that “[t]he rule is that where a party has been induced to enter into a contract by false and fraudulent representations, he may upon discovering the fraud rescind the contract; but the great weight of authority holds that if the party defrauded continues to receive benefits under the contract after he had become aware of the fraud, or if he otherwise conducts himself with respect to it as though it were a subsisting and binding engagement, he will be deemed to have affirmed the contract and waived his right to rescind."[12] The Kingston Court held that evidence of such acceptance would include retaining the premium paid for coverage or accepting further premiums.[13]   In the Kingston case, the insurer had continued to insure the risk after it had discovered material misrepresentations in the applications for coverage and had accepted further premiums. The Court held that the insurer’s conduct was a bar to rescission.[14] Some courts disagree and hold that an insurer’s acceptance of a premium will not automatically waive the right to seek rescission.[15] In order to ensure preservation of the rescission defense, however, the insurer or surety should refund the premium upon discovery of any material misrepresentations or failure to disclose material information.

CONCLUSION

When applicable, rescission results in a contract being voided in its entirety. The remedy, therefore, affords the fidelity insurer or surety a complete defense to a claim of an insured or obligee and is not limited to the extent of demonstrable prejudice. Effective use of this powerful tool depends upon careful attention to the application of fraud in the inducement principles in the context of fidelity insurance or surety bonds. Each provides particular challenges. The most problematic for the fidelity insurer is the fact that often the individuals against whose dishonesty the coverage is intended to protect are persons who are responsible for applying for the policy. As the knowledge of those persons is, in most jurisdictions, not attributed to the corporate insured, the insurer may find itself without recourse when dealing with those who apparently had authority to act for and bind the applicant. The surety may face a similar risk from a principal which seeks to misrepresent material facts in order to obtain bonds. The prudent surety will be aware of the necessity of carefully verifying the representations of its principal. Even though the obligee has its separate interest, it will be subject to a duty to disclose material facts to the surety when it has reason to believe that those facts will affect the surety’s risk and that the surety is unaware of them. Making inquiry of the intended obligee during the underwriting process will enhance the surety’s ability to protect itself in the event of fraud in the inducement because doing so both affords the obligee the opportunity to communicate with the surety and may put the obligee on notice of facts which the surety regards as material and of which it may not be aware. Lastly, both the fidelity insurer and the surety should be aware of the possibility that an otherwise valid fraud defense may be waived and that they must act promptly to rescind coverage when material misrepresentations are discovered.

[1] Bogda M.B. Clarke is Senior Vice President/General Counsel at International Fidelity Insurance Company in Newark, NJ, and Armen. Shahinian and James D. Ferrucci are partners in Wolff & Samson PC located in West Orange, NJ, New York, NY and Philadelphia, PA. The authors acknowledge the assistance of Scott J. Goldstein, an associate at Wolff & Samson, in the preparation of this article.

[2] Restatement (Second) of Contracts § 164 (1981).

[3] Id. § 159. “An action intended or known to be likely to prevent another from learning a fact [concealment] is equivalent to an assertion that the fact does not exist [i.e. constitutes a misrepresentation].” Id. § 160. Non-disclosure of a fact may be equivalent to an assertion that the fact does not exist when the person failing to disclose knows that disclosure “is necessary to prevent some previous assertion from being a misrepresentation,” when the person knows that “disclosure would correct a mistake of the other party as to a basic assumption on which that party is making the contract” and non-disclosure amounts to a failure to act in good faith, when the person knows that disclosure “would correct a mistake of the other party as to the contents of a writing, evidencing or embodying an agreement in whole or in part,” or when the other person is entitled to know the fact “because of a relation of trust and confidence between them.” Id.§ 161.

[4] Id. § 162(1).

[5] Id. § 162(2).

[6] A fraudulent misrepresentation need not be material because it is intended to induce assent to the contract, and “the maker cannot insist on his bargain if it is attained, however unexpectedly.” Id. § 164 cmt. b.

[7] Id. § 162 cmt. a.

[8] Michael Keely, Introduction to Annotated Financial Institution Bond 1, 1 (Michael Keely ed. American Bar Ass’n., 2d ed. 2004).

[9] Financial Institution Bonds had previously been named “Bankers Blanket Bonds.” In 1986, the Surety Association of America, which promulgates standard forms of fidelity insurance for the industry, changed the name to its current title. Edward G. Gallagher, Ch. 1, A Concise History of Standard Form No. 24, 1986 Edition in Annotated Financial Institution Bond 5, 5, supra note 8.

[10] See, e.g., Ark. Code. Ann. § 23-109-107 (West 2005); Me. Rev. Stat. Ann. tit. 24, §2411 (2005); Wyo. Stat. Ann. §26-15-109 (2005)

[11] See, TIGIns. Co. of Michigan v. Homestore, Inc.,40 Cal. Rptr. 3d 528, 538 (Cal. Ct. App. 2006) (examining the attempted rescission of a Directors and Officers Liability policy); Am. States Ins. Co. v. Ehrlich, 701 P.2d 676, 678-79 (Kan. 1985) (examining rescission of an automobile liability insurance policy).

[12] Cal. Ins. Code. § 334 (West 2005).

[13] Geer v. Union Mut. Life Ins. Co. 7 N.E.2d 125, 128 (N.Y. 1937) (internal quotes omitted) (noting that the statute provided that statements in an application for a life insurance policy shall be deemed, in the absence of fraud, to be a representation and not a warranty with the result that a misstatement in the form of a warranty is treated as an ordinary representation therefore and will not constitute a defense unless it was made fraudulently or was material and induced issuance of the policy).

[14] Berger v. Minnesota Mut. Life Ins. Co. of St. Paul, Minnesota,723 P.2d 388, 391-92 (Utah 1986) (examining a credit life insurance policy).

[15] See, Prudential Ins. Co. of Am. v. Gutowski, 113 A.2d 579, 581-82 (Del. 1955) (examining a life insurance policy).

[16] See, In re Payroll Express Corp, 186 F.3d 196, 207 n.3 (2d Cir. 1999), discussed infra text accompanying notes 17-20; FDIC v. Underwriters of Lloyds of London, 3 F. Supp. 2d 120, 140 (D. Mass. 1999) (bank answered “none” to the question on the bond application regarding knowledge of irregularities in operations where the bank was well aware of fraudulent activities of two loan officers that it had discharged). When the insured does not become aware of an employee’s dishonesty until after the policy has been issued, the issue is one of coverage as fidelity policies typically provide that coverage is terminated as to such an employee as soon as the insured learns, or reasonably should have learned, of that employee’s dishonesty. See, e.g., Cmty. Sav. Bank v. Fed. Ins. Co., 960 F. Supp. 16, 20 (D. Conn. 1997); Troy State Bank v. Bancinsure, Inc., No. 92,115, 109 P.3d 203, 2005 WL 824031, at *3-*4 (Kan. Ct. App. April 8, 2005). Questions of misrepresentation and rescission do not arise because, in such situations, the insured did not know of the dishonesty when it submitted the application for the policy.

[17] 186 F.3d 196 (2d Cir. 1999) (applying New Jersey law).

[18] Id. at 201.

[19] Id. at 203.

[20] Id. at 207 n.3.

[21] Restatement (Second) of Contracts § 164 (1981), discussed supra Part I.

[22] See, e.g. Or. Rev. Stat. §742.013 (2005); Utah Code Ann. §31A-21-105 (West, Westlaw through end of 2005 Spec. Sess.); Utah Power & Light Co. v. Fed. Ins. Co., 983 F.2d 1549, 1554 (10th Cir. 1993) (interpreting Utah law); John Hancock Mut. Life Ins. Co. v. Weisman, 27 F.3d 500, 504 (10th Cir. 1994)(interpreting New Mexico law in the context of a disability insurance policy), Zimmerman v. Cont’l Cas. Co., 150 N.W.2d 268, 272 (Neb. 1967) (interpreting Nebraska law in the context of an accident insurance policy).

[23] 584 F. Supp. 1245 (D. Mass. 1984) (applying Massachusetts law).

[24] Id. at 1250.

[25] Id.

[26] Id. (quoting Daniels v. Hudson River Fire Ins. Co.,66 Mass. 416, 425 (Mass. 1853)).

[27] 150 N.W.2d 268 (Neb. 1967).

[28] Id. at 270.

[29] That statute, Neb. Rev. Stat. §44-710.14 (West, Westlaw through 1st Reg. Sess. 99th Leg. (2005)), applies to only sickness and accident insurance. The general insurance statute, in effect both at the time of the Zimmerman decision and at the present time, Neb. Rev. Stat. §44-358 (West, Westlaw through 1st Reg. Sess. 99th Leg. (2005)), provides that “[no] oral or written misrepresentation or warranty made in the negotiation for a contract or policy of insurance by the insured, or in his behalf, shall be deemed material or defeat or avoid the policy, or prevent its attaching, unless such misrepresentation or warranty deceived the company to its injury. The breach of a warranty or condition in any contract or policy of insurance shall not avoid the policy nor avail the insurer to avoid liability, unless such breach shall exist at the time of the loss and contribute to the loss, anything in the policy or contract of insurance to the contrary notwithstanding.”

[30] Zimmerman, 150 N.W.2d at 272.

[31] Id.

[32] Id.

[33] See, e.g., Alfa Life Ins. Corp. v. Lewis, 910 So.2d 757, 762 (Ala. 2005) (citing Ala. Code § 27-14-7 (2005)); Vermont Mut. Ins. Co. v. Chiu, 21 S.W.3d 232, 235 (Tenn. Ct. App. 2000) (citing Tenn. Code Ann. § 56-7-103 (West 2005)).

[34] Ala. Code § 27-14-7 (2005)

[35] See, e.g., Supermercados Econo v. Integrand Assur. Co.,359 F. Supp. 2d 62, 69-70 (D. Puerto Rico 2005) (applying Puerto Rican law); Wassom v. State Farm Mut. Auto. Ins. Co.,173 S.W.3d 775, 781 (Tenn. Ct. App. 2005).

[36] Kulikowski v. Roslyn Sav. Bank, 503 N.Y.S.2d 863, 864 (N.Y. App. Div. 1986).

[37] Cal. Ins. Code. § 331 (West 2005).

[38] Cal. Ins. Code. § 359 (West 2005).

[39] 215 Ill. Comp. Stat. Ann. 5/154 (West 2005); see, also Tenn. Code Ann. § 56-7-103 (West 2005).

[40] La. Rev. Stat. Ann. §22:619(a) (West 2005).

[41] Gould v. M.F.A. Mut. Ins. Co., 331 S.W.2d 663, 669 (Mo. Ct. App. 1960); see also United Fire and Cas. Co. v. Historic Pres. Trust, 265 F.3d 722, 730-31 (8th Cir. 2001) (applying Missouri law and noting that the requirement of intent is usually inserted in Missouri jury instructions).

[42] New Jersey has a statute governing rescission of certain insurance policies, N.J. Stat. Ann. 17B:24-3; however, that statute applies to only life insurance, health insurance, and annuity policies. N.J. Stat. Ann. 17B:24-3 (2005).

[43] 946 F. Supp. 322 (D.N.J. 1996) (applying New Jersey law).

[44] Id. at 329 (quoting Ledley v. William Penn. Life Ins. Co., 651 A.2d 92, 95 (N.J. 1991)).

[45] Id. (internal quotations and citations omitted).

[46] Id. at 325.

[47] Id. at 325-27.

[48] Id. at 330.

[49] Id.

[50] 767 A.2d 515 (N.J. Super. Ct. App. Div. 2001).

[51] Id. 517.

[52] Id. at 519.

[53] Id. at 525.

[54] Restatement (Third) of Suretyship & Guaranty §74 (1995).

[55] Id. cmt. a. Section 1 defines the nature and attributes of the suretyship relationship.

[56] Id. Rescission of surety bonds is addressed infra Part III.

[57] Id.

[58] Id. cmt. b, illus. 1.

[59] Id. cmt. b.

[60] See, e.g., Gordon v. Cont’l Cas. Co. 181 A. 574, 576 (Pa. 1935), discussed  infra text accompanying notes 70-72.

[61] Restatement (Second) of Agency § 280 (1958).

[62] Id. cmt c.

[63] Id. § 282.

[64] Id. § 282(b).

[65] Puget Sound Nat’l Bank v. St. Paul Fire & Marine Ins. Co.,645 P.2d 1122, 1128 (Wash Ct. App. 1982).

[66] Id.

[67] Id. at 1124-1125.

[68] Id. at 1127.

[69] Id.

[70] 181 A. 574 (Pa. 1935).

[71] Id. at 574.

[72] Id. at 578.

[73] In re Payroll Express Corp, 186 F.3d 196 (2d Cir. 1999), discussed supra text accompanying notes 17-20.

[74] Id. at 207.

[75] Id.

[76] 332 B.R. 690 (Bankr. D.N.J. 2005) (applying New Jersey law).

[77] Id. at 707.

[78] Id. at 713 (internal quotations omitted).

[79] Id. at 714.

[80] Id.

[81] FDIC v. Lott, 460 F.2d 82, 88 (5th Cir. 1972).

[82] 332 B.R. 225 (Bankr. S.D. Fla. 1972).

[83] Id. at 231 (analyzing the sole representative defense in the context of a claim by the United States Trustee against defendant law firm for negligence); see also In re Plaza Mortgage and Fin. Corp., 187 B.R. 37, 45 n.6 (Bankr. N.D.Ga. 1995).

[84] 97 P.2d 173 (Wash. Ct. App. 1939).

[85] Id. at 174-75.

[86] Id. at 174.

[87] Id. at 175-76.

[88] Id. at 176 (quoting Aetna Cas. & Insurer Co. v. Local Bldg. & Loan Ass’n. 19 P.2d 612 (Okla. 1933)).

[89] Id. at 178.

[90] Id.

[91] In re Commercial Money Center, Inc., Equipment Lease Litigation, No. 1:12CV16000, MDL Docket No. 1490, 2005 WL 2233233 (N.D. Ohio Aug. 19, 2005) at *4.

[92] See Restatement (Second) of Contracts § 161 (1981), discussed supra note 3. Non-disclosure is grounds for rescission when disclosure “would correct a mistake of the other party as to a basic assumption on which that party is making the contract.” Id. § 161(b).

[93] See Sumitomo Bank of Cal. v. Iwasaki, 447 P.2d 956, 959 n.3 (Cal. 1968); First Nat’l Bank & Trust v. Notte, 293 N.W.2d 530, 534 (Wis. 1980). The existence of a fiduciary relationship denotes a relationship of trust and confidence which, in itself, creates a duty of full disclosure of all relevant facts. See Restatement (Second) of Contracts § 161(d).

[94] Sumitomo Bank, 447 P.2d at 959; Notte, 293 N.W.2d at 534. As in those decisions, issues relating to an obligee’s fraud upon the surety arise most often in cases in which the surety is a party who has entered into a guarantee of his principal’s debt, and hence the obligee is frequently referred to as the “creditor.”

[95] See Sumitomo Bank, 447 P.2d at 959; Notte, 293 N.W.2d. at 539; St. Paul Fire & Marine Ins. v. Commodity Credit Corp., 646 F.2d 1064, 1075 (5th Cir. 1981) (“in some respects, however, the suretyship bond is fragile, easily broken by the creditor’s actions during its creation”) (applying federal law); Rocky Mountain Tool & Mach. v. Tecon Corp., 371 F.2d 589, 597 (10th Cir. 1966) (applying Colorado law); Chemical Bank v. Layne, 423 F. Supp. 869, 880 (S.D.N.Y. 1976); Sec. Bank v. Mudd, 696 P.2d 458, 461 (Mont. 1985); Georgia Pacific Corp. v. Leevitz, 716 P.2d 1057, 1059 (Ariz. Ct. App. 1986). See also Restatement (Third) of Suretyship and Guaranty § 12(1) (1995).

[96] Restatement (Second) of Contracts §§ 162 and 164.

[97] Id. § 164(1); Notte, 293 N.W.2d at 537 (“The most innocent misrepresentation may result in unforeseen liability to a likewise innocent surety . . . . [B]etween two innocent parties, the party making the representation will bear the loss.”).

[98] The Restatement (Third) of Suretyship & Guaranty (1995) is derived from and supercedes sections 82-211 of the Restatement of Security (1941).

[99] In the Restatement of Suretyship, the surety is referred to as the “secondary obligor,” the suretyship contract or bond is referred to as the “secondary obligation,” and the principal is referred to as the “principal obligor.” Restatement (third) of Suretyship & Guaranty § 1 cmt. d.

[100] Restatement (third) of Suretyship & Guaranty § 12(1).

[101] See Sumitomo Bank of Cal. v. Iwasaki, 447 P.2d 956, 959 (Cal. 1968); Notte, 293 N.W.2d at 532 (“if a party to a contract is induced to manifest his assent to the contract by means of a fraudulent or material misrepresentation by another party to the contract, the contract is voidable if the recipient justifiably relies on the misrepresentation”) and at 534, 538-39 (adopting Restatement (Second) of Contracts § 306 (Tent. Draft. No. 11, 1976) which now appears as section 164 of the Restatement (Second) of Contracts); Rocky Mountain Tool & Mach. Corp. v. Tecon, 371 F.2d at 589, 597-98 (10th Cir. 1966).

[102] E.g., Int’l. Fid. Ins. Co. v. Wilson, 443 N.E.2d 1308, 1310-14 (Mass. 1983) (sustaining surety’s fraud judgment against principal, indemnitors and third party for fraudulently inducing surety to issue performance and payment bonds).

[103] Restatement (Third) of Suretyship & Guaranty §12(2).

[104] Restatement of Security § 119 (1941).

[105] No. 102CV16000, MDL Docket No. 1490, 2005 WL 2233233 (N.D. Ohio Aug. 19, 2005). This opinion is referred to as the “Illinois Union Order” and is one of three opinions dealing with the fraud in the inducement defense which have been entered in this multidistrict litigation. The citation for the others are No. 1:02CV16000, MDL Docket No. 1490 (N.D. Ohio Aug. 19, 2005), which is referred to as the “Lead Opinion,” and No. 1:02CV16000, MDL Docket No. 1490, 2006 WL 1272559 (N.D. Ohio May 9, 2006).

[106] In the opinion discussed in the text, the Illinois Union Order, the sureties issued contracts which were in the form of insurance policies, not bonds. The court, however, held that the obligations under the so-called policies “are fundamentally identical to those set forth in classic surety contracts.” Id. at *10. Because the policies satisfied “the substantive criteria for suretyship,” the court held, as a matter of law, that the documents established a suretyship relationship between the surety and the bank. Id. at *8. Hence, for clarity, the so-called policies will be referred to as bonds.

[107] No. 1:02CV16000, MDL Docket No. 1490, 2005 WL 2233233 at *1-*2.

[108] In the Illinois Union Order, the court considered the banks’ claims against only Illinois Union Insurance Company of America; the claims against the other sureties were considered in the companion Lead Opinion referred to supra note 105.

[109] Id. at *13 (quoting Am. Mfg. Mut. Ins. Co. v. Tison Hog. Mkt., Inc., 182 F.3d 1284, 1288 (11th Cir. 1999)).

[110] Id. at *11.

[111] Id. The court also analyzed “policies” containing language which did not quite so clearly identify the banks as the party who was to receive the ultimate payments. Nevertheless, the court concluded that other documents comprising the transactions required the same conclusion, id. at *12. In the companion Lead Opinion, supra note 105, the court denied the banks’ motion for judgment on the pleadings against sureties other than Illinois Union because it found that there were factual questions as to whether or not the banks were obligees on the bond

[112] In the third opinion, No. 1:02CV16000, MDL Docket No. 1490, 2006 WL 1272559 (N.D. Ohio May 9, 2006), the court let stand the surety’s fraud defense as to the claim of one of the banks because the surety alleged, with sufficient specificity, that the bank had knowledge of the true facts regarding the transactions which it actively concealed from the surety. Id. at *8.

[113] Sumitomo Bank of Cal. v. Iwasaki, 447 P.2d 956, 960 (Cal. 1968); Restatement (third) of Suretyship & Guaranty § 74 (1995).

[114] See First Nat’l Bank & Trust v. Notte, 293 N.W.2d 530, 535 (Wis. 1980); Restatement (Second) of Contracts § 161(d).

[115] See, e.g., Rachman Bag Co. v. Liberty Mut. Ins. Co., 46 F.3d 230, 236 (2d Cir. 1995), on remand, 905 F. Supp. 95, aff’d, 101 F.3d 1393; Sumitomo Bank, 447 P.2d at 959; Notte, 293 N.W.2d at 534; Harris & Harris Constr. Co. v. Crain & Denbo, Inc., 123 S.E.2d 590, 598 (N.C. 1962); St. Paul Fire & Marine Ins. Co. v. Commodity Credit Corp., 646 F.2d 1064, 1072 (5th Cir. 1981); Chemical Bank v. Layne, 423 F. Supp. 869, 880 (S.D.N.Y. 1976).

[116] Sections 82-211 of the Restatement of Security have been incorporated into and superceded by the Restatement(Third) of Suretyship. Many, if not most, of the suretyship concepts in the two Restatements are the same. Indeed, one of the reasons for the promulgation of the Restatement of Suretyship was because the drafters thought that, under the Restatement of Security, suretyship did not receive the attention that it deserved as a body of law in itself because it was “clumped” together with other subjects. Restatement (Third) of suretyship & Guaranty, fwd., at IX.

[117] Restatement of Security § 124(1).

[118] Restatement (Third) of Suretyship & Guaranty §12(3). Because section 12(3) is derived from section 124(1) and contains the same formulation, it is virtually certain that jurisdictions which adopted section 124(1) would now apply section 12(3). Likewise, courts will no doubt look to the cases decided under section 124(1) in analyzing section 12(3). For these reasons, section 124(1) and 12(3) are both useful sources and both will be examined in this article, sometimes being hereinafter referred to as the “Restatement Rule.”

[119] Id. § 12(4).

[120] Id. § 12(3) cmt. f, illus. 5.

[121] Restatement of Security § 124(1) cmt. b; accord Sumitomo Bank of Cal. v. Iwasaki, 447 P.2d 956, 959 (Cal. 1968); First Nat’l Bank & Trust v. Notte, 293 N.W.2d 530, 534 (Wis. 1980); and St. Paul Fire & Marine Ins. v. Commodity Credit Corp., 646 F.2d 1064,1073 (5th Cir. 1981).

[122] Restatement of Security § 124(1) cmt. a.

[123] Id.

[124] See Sumitomo Bank, 447 P.2d at 965 (failure to disclose “will discharge the surety from liability.”); Notte, 293 N.W.2d at 539 (a party who has been induced to enter into a contract by fraud “has the election of either rescission or affirming the contract and seeking damages.”); Sec. Bank v. Mudd, 696 P.2d 458, 461 (Mont. 1985) (as the obligee bank failed in its duty to disclose under section 124(1), the surety “was released as guarantor” of the principal’s note”); and St. Paul Fire & Marine Ins. v. Commodity Credit Corp., 646 F.2d at 1074 (obligee’s failure to disclose under section 124(1) “is a complete defense to liability.”).

[125] Notte, 293 N.W.2d at 534 (“The motive behind the concealment or misrepresentation is immaterial.”); accord Restatement of Security § 124(1) cmt. b (“The rule stated in this Section applies an objective test of the materiality of the facts not disclosed rather than the intent of the creditor in failing to make the disclosure.”).

[126] Restatement of Security § 124(1) cmt. b; accord Sumitomo Bank, 447 P.2d at 963; Notte, 293 N.W.2d at 536.

[127] Restatement of Security § 124(1) cmt. b.

[128] Restatement (Third) of Suretyship & Guaranty § 12(3) cmt. f (1995).

[129] See Sumitomo Bank, 447 P.2d at 960. “If the surety requests information, the creditor must disclose it,” Restatement of Security § 124(1) cmt. b. (1941).

[130] See Rachman Bag Co. v. Liberty Mut. Ins. Co., 46 F.3d 230, 235 (2d Cir. 1995) (“it is the duty of sureties to look out for themselves and ascertain the nature of their obligations.”); Sumitomo Bank, 447 P.2d at 961; St. Paul Fire & Marine Ins. v. Commodity Credit Corp., 646 F.2d 1064, 1072 (5th Cir. 1981) (“The law does not favor the indifferent, unseeing surety who fails to help himself.”); Ransom v. United States, 17 Cl. Ct. 263, 270 (1989), aff’d, 900 F.2d 242 (Fed. Cir. 1990) (sureties “must exercise reasonable diligence to become knowledgeable about the circumstances of a transaction and the principal’s financial condition”); Chemical Bank v. Layne, 423 F. Supp. 869, 871 (S.D.N.Y. 1976) (“while an obligee has an obligation to disclose under appropriate circumstances, “[i]t is equally clear that duties of inquiry and awareness fall on the guarantor.”); In re Decker, 225 F. Supp. 716, 719 (W.D. Va. 1964), rev’d on other grounds, 329 F.2d 836 (4th Cir. 1964) (obligee had no duty “to inform the surety of a fact which he could have readily ascertained by inquiry either from his son [the principal] or, presumably, from any of the other persons concerned.”) In re Polevski Estate, 452 A.2d 469, 471 (N.J. Super. Ct. App. Div. 1982) (surety’s reliance on section 124(1) rejected because, inter alia, surety failed to investigate); and Harris & Harris Constr. Co. v. Crain & Denbo, Inc., 123 S.E.2d 590, 598 (N.C. 1962) (“[I]n ordinary cases, it may be assumed that the surety obtains from the principal all of the information which he requires” (quoting 4 Williston on Contracts, Rev. Ed. § 1249 at 3577).

[131] Still v. Cunningham, 94 P.3d 1104, 1110 n.10 (Alaska 2004).

[132] Georgia-Pacific Corp., Williams Furniture Div. v. Levitz, 716 P.2d 1057, 1059 (Ariz. App. 1986).

[133] Sumitomo Bank, 447 P.2d at 961.

[134] Ground Imp. Techniques, Inc. v. Merchs. Bonding Co., 63 F.Supp.2d 1272, 1276-77 (D.Colo. 1999).

[135] Am. Mfg. Mut. Ins. Co. v. Tison Hog Market, Inc., 182 F.3d 1284, 1289 n.4 (11th Cir. 1999).

[136] Andrus v. Zion’s First Nat’l Bank., 588 P.2d 452, 454-55 (Idaho 1978).

[137] McLean County Bank v, Brokaw, 519 N.E.2d 453, 458 (Ill. 1988).

[138] Fortmeyer v. Summit Bank, 565 N.E.2d 1118, 1121-22 (Ind. Ct. App. 1991).

[139] Me. Nat’l Bank v. Fontaine, 456 A.2d 1273, 1275 (Me. 1983).

[140] P.R. Post Corp. v. Md. Cas. Co., 242 N.W.2d 62, 65 (Mich. App. 1976).

[141] Sec. Bank v. Mudd, 696 P.2d 458, 461 (Mont. 1985).

[142] In re Polevski Estate, 452 A.2d 469, 471 (N.J. Super. Ct. App. Div. 1982).

 [143] Valley State Bank v. Gibson, 668 P.2d 459, 460 (Or. Ct. App. 1983).

[144] First Nat’l Bank & Trust v. Notte, 293 N.W.2d 530, 534 (Wis. 1980).

[145] Peoples Nat’l Bank of Wash. v. Taylor, 711 P.2d 1021, 1026 (Wash. Ct. App. 1985).

[146] St. Paul Fire & Marine Ins. Co. v. Commodity Credit Corp., 646 F.2d 1064, 1072 (5th Cir. 1981). The United States Claims Court, in a decision affirmed by the Federal Circuit, rejected the surety’s reliance on section 124(1) of the Restatement of Security to support an affirmative claim against the government.  Ransom v. United States, 17 Cl.Ct. 263, 270 (1989), aff’d, 900 F.2d 242 (Fed. Cir. 1990).

[147] See 10 Samuel Williston & Walter H.E. Jaeger, Williston on Contracts § 1249 (3d ed. 1967).

[148] Harris & Harris Constr. Co. v. Crain & Denbo, Inc., 123 S.E.2d 590, 598 (N.C. 1962) (holding that the obligee had no duty to disclose alleged collateral agreement with the principal because it had not been agreed to).

[149] 46 F.3d 230 (2d Cir. 1995).

[150] 489 N.Y.S.2d 213 (N.Y. App. Div. 1985), aff’d, 492 N.E. 2d 779 (N.Y. 1986).

[151] State v. Peerless Ins. Co., 489 N.Y.S. 2d at 218. Under section 124(1), inquiry by the surety to the obligee is not required if circumstances giving rise to the duty otherwise appear. See Sumitomo Bank of Cal. v. Iwasaki, 447 P.2d 956, 961 (Cal. 1968).

[152] 423 F. Supp. 869 (S.D.N.Y. 1976).

[153] Id. at 879.

[154] Id. at 871, 880-81.

[155] Id. at 877-78.

[156] See discussion infra Part III.D.1.

[157] Rachman Bag Co. v. Liberty Mut. Ins. Co., 46 F.3d 230, 235 (2d Cir. 1995).

[158] Id. at 236-37.

[159] Id. at 236.

[160] Id.

[161] Id. at 236-37.

[162] Id. at 238. On remand, a jury trial was held on the fraudulent concealment issue, and a jury found that the surety had proven fraudulent concealment. The district court denied the obligee’s motion for judgment notwithstanding the verdict, finding that the jury could reasonably have found the existence and breach of a duty on the part of the obligee. Rachman Bag Co. v. Liberty Mut. Ins. Co., 905 F.Supp. 95, 98-99 (E.D.N.Y. 1995). This ruling was affirmed by the Second Circuit. Rachman Bag Co. v. Liberty Mut. Ins. Co., 101 F.3d 1393 (2d Cir. 1996).

[163] Sumitomo Bank of Cal. v. Iwasaki, 447 P.2d 956, 965 (Cal. 1968).

[164] Id. Tri-partite formulation has been adopted by other courts. See Peoples Nat’l Bank of Wash. v. Taylor, 711 P.2d 1021, 1026 (Wash. Ct. App. 1985); Sec. Bank v. Mudd, 696 P.2d 458, 460 (Mont. 1985); accord Restatement (Third) of Suretyship & Guaranty §12(3) (1995).

[165] Restatement of Security §124(1) cmt. b (1941). Unlike section 124(1), the new Restatement of Suretyship §12(3) does not enumerate facts which will be considered material. It does, however, provide illustrations where these facts are found to be material. For example, one illustration states that the obligee’s failure to disclose to the surety that the principal “suffered a series of business reverses leaving it equitably insolvent” is a material misrepresentation. Restatement (Third) of Suretyship & Guaranty §12(3) cmt. f. illus. 5 (1995).

[166] Under section 124(1), each extension of credit on a continuing guarantee creates a new suretyship contract.  Sumitomo Bank, 447 P.2d at 964; see also Restatement of Security §124(1) cmt. c.

[167] Sumitomo Bank, 447 P.2d at 966; see also Peoples Nat’l Bank of Wash. v. Taylor, 711 P.2d 1021, 1027 (Wash. Ct. App. 1985) (holding that a bank had no reason to believe that providing a bridge loan to the borrower materially increased the risk which the guarantor intended to assume).

[168] Sumitomo Bank, 447 P.2d at 966.

[169] 646 F.2d 1064 (5th Cir. 1981).

[170] Id. at 1074-75.

[171] 371 F.2d 589 (10th Cir. 1966) (applying Colorado law).

[172] Id. at 597 (quoting approved jury instruction).

[173] Id. at 597-98.

[174] Restatement of Security § 124(1) cmt. b. (1941).

[175] 123 S.E.2d 590 (N.C. 1962).

[176] Id. at 598. Although the court did not refer to section 124(1), it relied on the substantially similar rule enunciated in Williston, supra note 147.

[177] Id.

[178] Id. (quoting 4 Williston on Contracts, Rev. Ed. § 1249 at 3577).

[179] Id.

[180] 350 F.2d 652 (7th Cir. 1965) (applying Indiana law).

[181] Id. at 656. Under Restatement of Security § 119 (1941), the principal’s fraud is not chargeable to the obligee unless the obligee has knowledge of it. See also Restatement (Third) of Suretyship & Guaranty § 12(1) (1995).

[182] Chrysler Corp., 350 F.2d at 656.

[183] Id. at 657.

[184] Id. at 658.

[185] Id.

[186] 17 Cl.Ct. 263 (1989), aff’d, 900 F.2d 242 (Fed. Cir. 1990).

[187] 28 U.S.C. § 1491(a)(1).

[188] 17 Cl.Ct. at 270.

[189] Id. at 268. Balboa Ins. Co. v. United States, 775 F.2d 1158 (Fed. Cir. 1985), was held not to apply because there was no notice to the government of any impending default of the principal. 17 Cl.Ct. at 272.

[190] 17 Cl.Ct. at 279.

[191] Id. at 279 n. 3.

[192] Id. 270.

[193] Id. at 271.

[194] Id.

[195] Sumitomo Bank of Cal. v. Iwasaki, 447 P.2d 956, 961 (Cal. 1968).

[196] See, e.g., Marine Nat’l Bank v. Fontaine, 456 A.2d 1273, 1276 (Me. 1983); and St. Paul Fire & Marine Ins. Co. v. Commodity Credit Corp., 646 F.2d 1064, 1072-73 (5th Cir. 1981); see also Chemical Bank v. Layne, 423 F. Supp. 869, 878-82 (S.D.N.Y. 1976), discussed supra text accompanying note 154, as to significance of inquiry to the obligee in a case which was not decided on the basis of section 124(1).

[197] 293 N.W.2d 530 (Wis. 1980).

[198] Id. at 536.

[199] Id.

[200] Restatement of Security § 124(1) (1941); Restatement (Third) of Suretyship & Guaranty § 12(3) (1995).

[201] Ransom v. United States, 17 Cl.Ct. 263 (1989) aff’d, 900 F.2d 242 (Fed. Cir. 1990).

[202] Id. at 271; see also In re Polevski Estate, 452 A.2d 469, 471 (N.J. Super. Ct. App. Div. 1982).

[203] 716 P.2d 1057 (Ariz. Ct. App. 1986).

[204] Under section 124(1), each new extension of credit creates a new suretyship contract, Restatement of Security § 124(1) cmt. c.

[205] 716 P.2d at 1059.

[206] 485 N.E.2d 974 (N.Y. 1985).

[207] Id. at 977 (quoting the guarantee).

[208] Id.

 [209] Id. (quoting Danann Realty Corp. v. Harris, 157 N.E.2d 597, 600 (N.Y. 1959)).

[210] 189 F. Supp. 2d 24 (S.D.N.Y. 2002).

[211] Id. at 27.

[212] 7 F.3d 310 (2d Cir. 1993).

[213] JPMorgan Chase, 189 F. Supp. 2d at 27.

[214] Id.

[215] Id.

[216] Id. at 27-28.

[217] Id. at 28.

[218] 314 F. Supp. 2d 229 (S.D.N.Y. 2004).

[219] Id. at 235.

[220] Id. at 237-40 (citing, among other cases, Rachman Bag Co. v. Liberty Mut. Ins. Co., 46 F.3d 230 (2d Cir. 1995)).

[221] 426 F.3d 204 (3d Cir. 2005).

[222] Id. at 210-11.

[223] Id. at 217 (quoting district court).

[224] Id. (citations omitted).

[225] No. 1:02CV16000, MDL Docket No. 1490, 2005 WL 2233233 (N.D. Ohio Aug. 19, 2005) discussed in detail supra Part III.A.2.

[226] Id. at *4.

[227] Id. at *23.

[228] Id. (quoting JPMorgan Chase Bank v. Liberty Mut. Ins. Co., 189 F. Supp. 2d 24, 28 (S.D.N.Y. 2002)).

[229] Id.

[230] See, e.g., Cont’l Ins. Co. v. Kingston, 114 P.3d 1158, 1161 (Utah App. 2005); Jobe v. Int’l Ins. Co., 933 F.Supp. 844, 860-61 (D. Ariz. 1995); Walters Auto Body Shop, Inc. v. Farmers Ins. Co., Inc., 829 S.W.2d 637, 641-42 (Mo.App. 1992).

[231] 114 P.3d 1158 (Utah App. 2005).

[232] Id. at 1161.

[233] Id.

[234] Id. at 1164.

[235] See, e.g., Chicago Ins. Co. v. Kreitzer & Vogelman, 265 F.Supp.2d 335, 344 (S.D.N.Y. 2003).