A contractor hiring a subcontractor may prefer arbitration to litigation in cases of dispute. But when the contractor has issued a payment bond, the sub has a choice of payment sources-either from the contractor or from the surety who issued the contractor's payment bond.
It may be difficult to compel the sub to proceed in arbitration if he chooses to file suit under the bond. There are, however, a few things that the contractor can do to ensure that such a dispute proceeds in arbitration.
It is, of course, always possible that the parties may agree to arbitrate a dispute after it has arisen. But a more likely scenario is that one party will see a benefit in drawing the dispute out or raising the cost of the litigation in the hopes of achieving a better result.
A contractor who wants to preserve its right to arbitrate with a sub needs to include an arbitration provision in its subcontract. An arbitration provision in the subcontract, however, does not always mean that arbitration would be required when the sub makes a claim on the contractor's payment bond. Formally, the sub's claim would be against the surety, not the contractor, and would be based on a different contract, the bond, which may or may not contain an arbitration clause.
If the sub files suit under the bond and the surety tenders the defense to the contractor, the contractor may wind up litigating essentially the same dispute in court that the contractor had sought to place into arbitration. An individual contractor has little ability to change the payment bond's form language, as opposed to the contractor's control over the contents of its own subcontract.
Two approaches have been used to compel subcontractors to arbitrate claims under a bond, where those claims are based on an underlying subcontract that contains an arbitration clause. The first is "incorporation." This requires an express term in the payment bond stating that it "incorporates" the terms of the subcontract. In such a case, the arbitration clause in the subcontract is part of the bond as if it were set forth in the bond itself. If the bond expressly incorporates the subcontract, the contractor or surety can argue that the arbitration clause is also a term in the bond and that arbitration should be compelled under the bond.
There are some caveats to this approach. First, while most courts that have addressed this question have found that arbitration is required where a bond "incorporates" a contract with an arbitration clause, not all jurisdictions agree. Second, the incorporation term in the payment bond obviously must incorporate the subcontract, not just the contractor's own contractual obligations. A payment bond that guarantees all of a contractor's payment obligations on a project will commonly incorporate the contract between the contractor and the party who hired the contractor (whether general contractor or owner). This does not mean that any subcontracts issued by the contractor are also incorporated into the bond. Third, if the arbitration clause is not broad enough-if it is limited only to disputes between specified entities-the courts may not read the clause as requiring arbitration under the bond, even if it is incorporated into the bond.
The second approach is based upon a legal doctrine called "estoppel," and requires the subcontract to contain a very broad arbitration clause. Such a broad clause may require the sub to arbitrate "any" or "all" disputes that "relate to" or "arise from" the subcontract, without any limitations either on the type of claim or the parties involved. The clause should not, for example, be limited to disputes between the contractor and sub. If the subcontract contains such a broad clause, the contractor or surety can argue that the sub's promise in the subcontract should extend to the bond, since any claims for payment under the bond would necessarily be based upon the sub's work under the subcontract and the subcontract would govern whether any payments to the sub are due.
This line of argument is relatively new, although a line of federal cases has recognized "estoppel" in similar situations and the courts have found it essentially fair to hold the subcontractor to its broad promise. To maximize the chance of "estoppel" being applied, the contractor can take a few steps in drafting its arbitration clause. First, the contractor should make sure the clause applies to "any and all disputes arising from or relating to this subcontract," or similar language. Second, the clause should not expressly refer only to disputes between the contractor and subcontractor. Third, it may be advisable to insert language such as "including but not limited to any claims under any bond" to make the parties' intentions clear. Without control over the language in the payment bond itself, drawing a very broad arbitration clause in this fashion provides the best chance of compelling subs who seek to recover under a payment bond into arbitration.
Construction Business Owner, February 2007