In Asset Builders Corporation v. Stronghold Insurance Company, Inc., the Supreme Court clarified that a surety’s obligation remains even if the principal contract is rescinded. This means that if a contractor fails to fulfill their obligations, the insurance company that issued the surety bond is still liable to compensate the project owner, ensuring that the latter is protected from losses due to the contractor’s default. This decision reinforces the reliability of surety bonds in construction projects, providing security to project owners.

When a Contractor Fails: Can the Surety Be Excused?

Asset Builders Corporation (ABC) contracted Lucky Star Drilling & Construction Corporation to drill a well, backed by surety and performance bonds from Stronghold Insurance Company. When Lucky Star failed to complete the work, ABC rescinded the contract and sought to recover losses from Stronghold. The trial court ruled against Stronghold’s liability, arguing that the rescission of the main contract automatically cancelled the surety bonds. This ruling was appealed, leading to the Supreme Court’s decision on the extent and nature of a surety’s obligations when the principal contract falters.

The Supreme Court emphasized the nature of a surety agreement under Article 2047 of the New Civil Code, highlighting that a surety binds themselves solidarily with the principal debtor. The court quoted:

Art. 2047. By guaranty a person, called the guarantor, binds himself to the creditor to fulfill the obligation of the principal debtor in case the latter should fail to do so.

If a person binds himself solidarily with the principal debtor, the provisions of Section 4, Chapter 3, Title I of this Book shall be observed. In such case the contract is called a suretyship.

This solidary liability means that the surety is directly and equally bound with the principal debtor. The Court, citing Stronghold Insurance Company, Inc. v. Republic-Asahi Glass Corporation, reiterated that:

X x x. The surety’s obligation is not an original and direct one for the performance of his own act, but merely accessory or collateral to the obligation contracted by the principal. Nevertheless, although the contract of a surety is in essence secondary only to a valid principal obligation, his liability to the creditor or promisee of the principal is said to be direct, primary and absolute; in other words, he is directly and equally bound with the principal.

The court clarified that the surety’s role becomes critical upon the obligor’s default, making them directly liable to the obligee. The acceptance of a surety does not grant the surety the right to intervene in the primary contract but ensures that the obligee has recourse should the principal obligor fail to perform. When Lucky Star failed to complete the drilling work on time, they were in default. This triggered Lucky Star’s liability and, consequently, Stronghold’s liability under the surety agreement.

The Court further explained that the clause “this bond is callable on demand,” found in the surety agreement, underscored Stronghold’s direct responsibility to ABC. ABC, therefore, had the right to proceed against either Lucky Star or Stronghold, or both, for the recovery of damages, according to Article 1216 of the New Civil Code:

The creditor may proceed against any one of the solidary debtors or some or all of them simultaneously. The demand made against one of them shall not be an obstacle to those which may subsequently be directed against the others, so long as the debt has not been fully collected.

The decision explicitly stated that Stronghold was not automatically released from liability when ABC rescinded the contract. Rescission was a necessary step to mitigate further losses from the delayed project. The Supreme Court noted that Lucky Star’s non-performance of its contractual obligations justified ABC’s claim against Stronghold, the surety.

Moreover, the Court invoked Article 1217 of the New Civil Code, which acknowledges the surety’s right to seek reimbursement from the principal debtor for payments made to the obligee. Thus, Stronghold, if compelled to pay ABC, could seek recourse from Lucky Star for the amounts paid under the surety and performance bonds. By clarifying these points, the Supreme Court reinforced the protective function of surety agreements in construction and other commercial contracts.

FAQs

What is a surety bond?	A surety bond is a contract where one party (the surety) guarantees the obligations of a second party (the principal) to a third party (the obligee). It ensures the obligee is compensated if the principal fails to fulfill its obligations.
Who are the parties in a surety agreement?	The parties are the principal (the one obligated to perform), the surety (the guarantor), and the obligee (the one to whom the obligation is owed).
What does it mean for a surety to be ‘solidarily liable’?	Solidary liability means that the surety is directly and equally responsible with the principal debtor for the debt. The obligee can demand payment from either the principal or the surety.
Does rescission of the main contract affect the surety’s obligation?	No, according to this ruling, the surety’s obligation is not automatically cancelled when the main contract is rescinded. The surety’s liability arises upon the principal’s default, regardless of the rescission.
What happens if the surety pays the obligee?	If the surety pays the obligee, the surety has the right to seek reimbursement from the principal debtor for the amount paid.
What was the main issue in the Asset Builders v. Stronghold case?	The main issue was whether Stronghold Insurance, as a surety, was liable under its bonds after Asset Builders Corporation rescinded its contract with Lucky Star Drilling due to non-performance.
What was the Supreme Court’s ruling?	The Supreme Court ruled that Stronghold Insurance was jointly and severally liable with Lucky Star for the payment of P575,000.00 and the payment of P345,000.00 based on its performance bond, despite the rescission of the principal contract.
What is the significance of the phrase “callable on demand” in the surety bond?	The phrase “callable on demand” emphasizes the surety’s direct and immediate responsibility to the obligee, allowing the obligee to claim against the bond as soon as the principal defaults.

The Supreme Court’s decision in Asset Builders Corporation v. Stronghold Insurance Company, Inc. clarifies the extent of a surety’s responsibility, reinforcing the importance of surety bonds in protecting parties from contractual breaches. It establishes that rescission of a contract does not automatically release the surety from its obligations, ensuring continued protection for obligees in case of default by the principal.

For inquiries regarding the application of this ruling to specific circumstances, please contact ASG Law through contact or via email at frontdesk@asglawpartners.com.

Disclaimer: This analysis is provided for informational purposes only and does not constitute legal advice. For specific legal guidance tailored to your situation, please consult with a qualified attorney.
Source: ASSET BUILDERS CORPORATION VS. STRONGHOLD INSURANCE COMPANY, INC., G.R. No. 187116, October 18, 2010