Hello, this is attorney Bae Ki-hyung of Cheongchul Law Firm.

When entering into a construction contract, the owner (project client) requires the contractor (builder) to submit a bond issued by a construction guarantee cooperative or other financial institution to secure contract performance or the return of advance payments. However, it is not uncommon for a contractor in financial distress to make false statements in order to obtain the bond from the surety, such as inflating the actual contract amount or concealing advance payments it has already received.

Later, when a surety event occurs due to the contractor's bankruptcy or abandonment of the work and the owner claims the bond amount from the surety, the surety refuses payment (claims exemption), arguing that "it rescinds the surety contract because it issued the bond under a mistake induced by the contractor's fraud." From the owner's perspective, this is an absurd situation: it paid the construction price in reliance on a perfectly valid-looking bond, only to find overnight that it cannot recover a single won of the bond amount.

Today, drawing on Supreme Court precedent, I will explain clear standards on whether a surety can rescind the contract and be exempted from liability on the grounds of mistake or fraud when the contractor obtained the bond by deceiving the surety about material matters, and how the owner can be protected.

Fraud-Based Rescission of a Surety Contract and Protection of the Owner's Reliance – Standards of Judgment

[Question] When it is revealed that the builder obtained a bond by lying about the contract amount or advance payment details, can the surety rescind the surety contract on that ground and refuse to pay the bond amount to the owner?

[Answer] It is true that the surety may rescind the surety contract on the ground of the contractor's fraud. However, if the owner formed a new interest, such as newly paying the construction price in reliance on the bond, and was unaware of the contractor's fraud (good faith and no negligence), the surety cannot assert the rescission against the owner and must pay the bond amount.

On this issue, the Supreme Court clearly distinguishes between the grounds for rescinding a surety contract and the requirements under which the effect of that rescission is limited, as follows.

1. Rescission of the Surety Contract for the Contractor's Fraud (Principle)

When a surety issues a bond, matters such as the contract amount, construction period, and advance payments already made are highly material, as they are used to assess the probability of a surety event and to decide whether to enter into the surety contract. The Supreme Court holds that a contractor's false statement of, or failure to disclose, such material matters constitutes fraud against the surety, and if the surety was thereby led into a mistake, it may rescind the surety contract under the general principles of the Civil Act (민법) (Supreme Court Decision 2013Da5084, July 25, 2013; Supreme Court Decision 2001Da33000, November 13, 2003).

2. Limitation on the Effect of Rescission to Protect the Owner's Reliance (Exception)

However, the rescission of a surety contract does not always leave the owner bearing the loss. The Supreme Court has drawn a clear line, holding to the effect that where the surety creditor (owner) has acquired a new interest in reliance on the credit-security function of the surety contract, such as by entering into a contract with the debtor on the premise that the surety contract would be concluded, or by entering into a new contract or performing obligations on the basis of a bond already delivered by the surety, the surety cannot assert the rescission against the surety creditor unless there are circumstances such as the surety creditor having known or having been able to know of the fraudulent act (Supreme Court Decision 2012Da36760, July 11, 2013; Supreme Court Decision 98Da63162, July 13, 1999). In other words, if the owner was entirely unaware that the bond had been issued on false information (good faith), could not have known it (no negligence), and performed its obligations, such as paying the advance payment, in reliance on the bond, the surety must pay the full bond amount to the owner. Note, however, that this protection of reliance is limited to new interests arising after receipt of the bond (such as advance payments or construction price paid thereafter) and does not extend to claims that had already arisen before the bond was received. Indeed, the 2012Da36760 decision above divided the construction price into amounts before and after receipt of the bond and recognized protection only for the portion after receipt.

3. Where the Owner Breached Its Duty of Care, the Rescission Can Be Asserted

There are, however, exceptional cases in which the owner is not protected. Where there was an agreement between the owner and the surety, such as that 'the owner is responsible for examining whether the documents submitted by the debtor for concluding the surety contract are genuine,' and the owner's negligence in failing to exercise the care required in examining those documents left the surety unable to secure its right of reimbursement after performing its guarantee obligation, the surety may assert the rescission and be exempted from liability (Supreme Court Decision 2007Da1173, May 10, 2007).

Timing of Bond Receipt and Good Faith Without Negligence Must Both Be Proven

In practice, then, when a surety event has occurred and the surety refuses to pay the bond amount by citing the 'contractor's fraud' as an excuse, the owner (project client) must not simply accept this. In litigation, the key defensive strategy is for the owner to actively prove that it was in no position to know of the false statements in the documents the contractor submitted to the surety, and that it formed a new interest by legitimately paying advance payments or the construction price in reliance on a duly issued bond (good faith and no negligence), in order to recover the bond amount.

Conversely, the surety must meticulously establish not only the contractor's fraud but also that the owner, as a party to the construction contract, could sufficiently have known of the false statements or neglected its duty of care in examining the documents, in order to avoid an unwarranted payment of the bond amount.

Disputes over fraud-based rescission of surety contracts and protection of reliance lie at the intersection of interpreting the surety's terms and conditions and the demanding burden of proving the owner's good faith and lack of negligence. Because the outcome can vary greatly depending on the facts, a concrete legal review from the outset is essential.

Based on its deep understanding of the complex practice of surety disputes at construction sites and of Supreme Court precedent, Cheongchul Law Firm provides optimal solutions to protect clients' legitimate rights against unjustified refusals to pay bond amounts. If you are facing difficulties over a contractor's default and a claim on a bond, please consult the professionals at Cheongchul Law Firm.

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Attorney Bae Ki-hyung has served at the Defense Installations Agency and in the construction and real estate team of a major law firm, providing legal advice on the entire process of government contracts and construction projects, including public works, large-scale construction projects, national defense facility projects, and SOC infrastructure projects, and has extensive experience and expertise in resolving related litigation. If you need assistance with public works, private construction projects, public procurement contracts, state property, local government property, or public property, please feel free to contact us at any time.

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Cheongchul Law Firm consists exclusively of attorneys from Korea's top five major law firms, the prosecution service, and in-house legal teams of major corporations, and responds not with a single attorney but with a team of specialists in the fields relevant to each case. Going beyond resolving specific issues, Cheongchul provides comprehensive solutions across the entire business, offering legal consulting focused ultimately on achieving what the client wants. If you need help achieving your goals, please do not hesitate to contact Cheongchul.