Obtaining the Benefits of a Performance Bond: Tread Carefully

Choity Khan | Construction Law Zone

When a party to a construction contract is faced with nonperformance of another party, often the desire to keep the project moving takes precedence in responding to the performance default. Problems arise, however, when the party who is owed the performance acts without first considering the terms and conditions of the written instruments governing the parties’ relationship on the project. For example, a construction contract may require the posting of payment and performance bonds guaranteeing, among other things, the performance of the bonded contract work by obligating the guarantor – a surety – to arrange for the completion of the work.  Where a party fails to perform as promised, the party promised the performance should first review the language of both the construction agreement and any associated surety bonds before taking action, so as not to lose the benefits of the contract and/or bonds, as was the case in Arch Ins. Co. v. Graphic Builders, LLC, No. CV 19-12445-NMG, 2021 WL 534807 (D. Mass. Feb. 12, 2021).

Performance bonds almost universally contain one or more conditions precedent to trigger the surety’s obligations. Generally, courts interpreting such condition precedent language often require strict adherence to the condition’s language to trigger the bond’s obligations, which often leaves the beneficiary of the bond – the bond obligee – without a remedy.

The general contractor in Arch Ins. Co. was one such obligee. During the construction of an apartment building in the Charlestown section of Boston, the general contractor deemed the subcontractor in default when the general contractor discovered that rain leaked through 260 of the modular window units that the subcontractor fabricated, delivered, and began installing. Rather than terminate the subcontractor, the general contractor instead hired several third-party subcontractors at a cost of more than $2.8 million to remediate the defective work. According to the general contractor, terminating the defaulted subcontractor would have been “the equivalent of shooting [itself] in the face.” Though that may have been the case, the general contractor’s decision adversely affected its right to invoke the performance bond, as the document’s language obligated the surety’s performance only on the condition (common among performance bonds) that the general contractor terminate its subcontract with the subcontractor. The District Court agreed with the surety that its obligation had not been triggered, holding that the general contractor “indisputably failed to comply with a condition precedent and, therefore, cannot enforce the obligation of [the surety] to indemnify which arises pursuant to the Performance Bond and/or the incorporated subcontract.” The Court added that, for the same reason, the general contractor materially breached the bond’s terms, and discharged the surety from any and all liability, including investigating and indemnifying the general contractor’s claims of losses sustained.

In reaching its decision, the Court disregarded the general contractor’s argument that notwithstanding any conditions precedent, the surety had an independent duty to indemnify the cost of remediating the subcontractor’s faulty work. The general contractor has appealed the District Court’s order, and it remains to be seen whether the First Circuit will arrive at the same conclusion and perhaps address the general contractor’s independent duty argument.

Regardless, when faced with nonperformance, a party should carefully review the terms of a performance bond to determine what conditions precedent are necessary to obligate the surety’s performance. Failure to do so may have devastating consequences.

Performance Bond Surety Takeover – Using Terminated Contractor to Complete Work

David Adelstein | Florida Construction Legal Updates

When a contractor is defaulted under a performance bond, can its surety hire the same defaulted contractor to complete the work?  Stated differently, can the performance bond surety engage its defaulted bond-principal in taking over and completing the same work the contractor was defaulted under?   The answer is “yes” if you are dealing with a standard form AIA A312 performance bond (and other bond forms that contain analogous language), as demonstrated by the recent decision in Seawatch at Marathon Condominium Association, Inc. v. The Guarantee Company of North America, 2019 WL 4850194 (Fla. 3d DCA 2019).

In this case, a condominium association hired a contractor in a multi-million dollar contract to renovate condominium buildings.  The contractor provided the association, as the obligee, a performance bond written on an AIA A312 performance bond form.  During construction, the association declared the contractor in default and terminated the contractor. In doing so, the association demanded that the performance bond surety make an election under paragraph 4 of the AIA A312 bond form that gave the surety the following options:

4.1 Arrange for the CONTRACTOR, with consent of the OWNER, to perform and complete the Contract; or

4.2 Undertake to perform and complete the Contract itself, through its agents or through independent contractors; or

4.3 Obtain bids or negotiated proposals from qualified contractors acceptable to the OWNER for a contract for performance and completion of the Contract, arrange for a contract to be prepared for execution by the OWNER and the contractor selected with the OWNER’S concurrence, to be secured with performance and payment bonds executed by a qualified surety equivalent to the Bonds Issued on the Contract, and pay to the OWNER the amount of damages as described in paragraph 6 in excess of the Balance of the Contract Price incurred by the OWNER resulting from the CONTRACTOR Default; or

4.4 Waive its right to perform and complete, arrange for completion, or obtain a new contractor and with reasonable promptness under the circumstances;

4.4.1 After investigation, determine the amount for which it may be liable to the OWNER and, as soon as practicable after the amount is determined, tender payment therefore to the OWNER; or

4.4.2 Deny liability in whole or in part and notify the OWNER citing reasons therefore.

Seawatch at Marathon Condo. Ass’n, 2019 WL at *1-2.

The surety elected the option under section 4.2, underlined and bolded above.  The surety wanted to complete the construction contract and provided the association with a surety takeover agreementi.e., an agreement where the surety takes over the completion of the defaulted / terminated contractor’s contract.   The takeover agreement was predicated on the terminated contractor continuing to serve as the contractor to finish the contract.

The association rejected the takeover agreement largely because it was adamant that the terminated contractor cannot serve as the completion contractor under the takeover agreement.  The association also argued that the surety could not properly elect section 4.2 because it was not a licensed contractor and needed to be a licensed contractor in order to undertake the completion of the defaulted contract.  Because an agreement could not be reached, the association filed a lawsuit for declaratory relief on these issues seeking judicial intervention as to its rights under the performance bond.

A. The Performance Bond Surety Can Use the Defaulted Contractor to Complete the Work

The trial court, as affirmed on appeal, held that the surety was well within its rights under section 4.2 of the bond to complete the contract with the defaulted contractor (bond-principal).  Section 4.2 places NO restrictions on the surety in using the defaulted contractor or any other contractor, for that matter.   As noted by the appellate court:

Finally, “[i]t is common practice for a surety undertaking to complete the project itself to hire the original contractor, as [Guarantee] elected to do here.”  “By completing the project itself, the surety obtains greater control than it would have had if it elected to require the obligee to complete, because the surety can select the completing contractor or consultants to finish the project as well as control the costs of completion.”

Seawatch at Marathon Condo. Ass’n, 2019 WL at *4 (internal quotations omitted).

B. The Performance Bond Surety Does Not Need to be a Licensed Contractor to Enter into Takeover Agreement

The appellate court summarily rejected the argument by the association that the surety needed to be a licensed contractor to enter into a takeover agreement and undertake the completion of the defaulted contract.  Since the surety is not actually performing the completion, the court rejected this outright which would prohibit the surety from ever exercising rights under section 4.2 unless it was a licensed contractor.

One thing to consider after reading the outcome of the case is that there is nothing to prevent the obligee of a bond from modifying a standard form bond form, or my preference, creating its own manuscript performance bond form.  Creating your own performance bond form gives you more flexibility regarding rights to trigger a surety’s obligations under the bond and the recourse under the bond.

Properly Trigger the Performance Bond

David Adelstein | Florida Construction Legal Updates | December 25, 2017

performance bond is a valuable tool designed to guarantee the performance of the principal of the contract made part of the bond.   But, it is only a valuable tool if the obligee(entity the bond is designed to benefit) understands that it needs to properly trigger the performance bond if it is looking to the bond (surety) to remedy and pay for a contractual default.  If the performance bond is not properly triggered and a suit is brought upon the bond then the obligee could be the one materially breaching the terms of the bond.  This means the obligee has no recourse under the performance bond.  This is a huge downside when the obligee wanted the security of the performance bond, and reimbursed the bond principal for the premium of the bond, in order to address and remediate a default under the underlying contract.

 

A recent example of this downside can be found in the Southern District of Florida’s decision in Arch Ins. Co. v. John Moriarty & Associates of Florida, Inc., 2016 WL 7324144 (S.D.Fla. 2016).  Here, a general contractor sued a subcontractor’s performance bond surety for an approximate $1M cost overrun associated with the performance of the subcontractor’s subcontract (the contract made part of the subcontractor’s performance bond).  The surety moved for summary judgment arguing that the general contractor failed to property trigger the performance bond and, therefore, materially breached the bond.  The trial court granted the summary judgment in favor of the performance bond surety.  Why?

 

The performance bond in this case appeared to be an AIA performance bond (the AIA Document A312 Performance Bond or modified version thereof).   This appears clear from the following finding by the court:

 

Under the bond in this case, Arch’s [performance bond surety] obligations are not triggered unless Moriarty [general contractor-obligee]: (1) first provides notice to R.C. [subcontractor-principal of bond] and Arch that it is “considering declaring a Contractor Default”; (2) “declares a Contractor Default, terminates the Construction Contract and notifies [Arch]”; and (3) “agree[s] to pay the Balance of the Contract Price … to [Arch] or to a contractor selected to perform the Construction Contract.” …Once Moriarty complies with those three conditions precedent, the bond then requires Moriarty to allow Arch to mitigate its damages by arranging for the completion of the subcontract itself. Lastly, before Moriarty may properly make a demand under the bond, it must provide seven days’ notice to Arch.”

 

The general contractor, as commonly done, notified the subcontractor and subcontractor’s surety that it was considering declaring the subcontractor in default, but never (i) formally declared the subcontractor in default, (ii) terminated the subcontractor, or (iii) agreed to pay the subcontract balance to the performance bond surety.  Thus, the general contractor (obligee) never allowed the surety to mitigate damages by arranging completion of the subcontract upon the subcontractor’s (bond principal) default.

 

Remember, in order to preserve a performance bond claim it is important to properly trigger the performance bond and the surety’s role under the bond.  This means dotting your i’s and crossing your t’s when it comes to declaring the bond principal in default under the specific terms of the bond.   Moreover, if you are the obligee, consider preparing the performance bond form so that you can remove some of the underlying notice provisions in the bond to make the bond more favorable to you.

Risk is More Than Just a Board Game: A Guide to Performance Bonds

Brian L. Lynch | Faegre Baker Daniels | June 21, 2017

Although other forms of security are possible to secure performance of a construction contract, corporate surety performance bonds remain the construction contract guarantee of choice for owners in both public and private projects.

The performance bond is generally meant to protect the named obligee (i.e., the owner) against the contractor’s default. As such, the surety’s performance obligation is usually offered in various expressions that specifically protect owners, such as the performance of the contract; payment for labor and materials furnished in furtherance of the contract; indemnification of the owner against loss caused by the contractor’s failure to perform; or completion of the contract unconditionally. There are, however, a few different types of bonds that are commonly referred to under the heading of “performance bonds,” which may limit sureties to only one or a few of these different remedies upon the bond being triggered. This has important risk-allocation implications, and it is important that all of the contracting parties know and understand all different types of performance bonds..

The four types of bonds commonly lumped together under the heading of “performance bond” include:

  1. Traditional performance bonds, such as the AIA A312 performance bond
  2. Indemnity bonds, such as the Federal Standard Form 25 performance bond
  3. Completion bonds
  4. Manuscript bonds

Traditional Performance Bonds/AIA A312 Performance Bond

The A312 Performance Bond is one of the clearest, most definitive and most widely used type of traditional common law “performance bonds” in private construction. This type of bond gives sureties a wide array of options following the triggering of its liability, including 1) arranging for the contractor to continue to perform the contract, 2) taking over and completing the contract itself, 3) tendering to the owner a substitute contractor, 4) buying back the bond for the amount the surety may be liable to the owner or 5) denying liability. The A312 Performance Bond also contains an important risk-mitigation provision for contractors and sureties in that it limits, to the extent allowed by law, the duration of the bond to two years after the contractor completes its work at the applicable project.

Indemnity Bond/Federal Standard Form 25 Performance Bond

Under an indemnity bond, the surety’s performance obligation is limited to reimbursing the owner (up to the penal sum of the bond) for any cost of completing the bonded contract in excess of contract funds that remain unpaid at the time the contract is terminated. An indemnity bond exposes the surety to increased risk, since the surety has no control over the owner’s completion of the contract and incurrence of completion costs. Contrary to the A312 Performance Bond, the Federal Standard Form 25 Performance Bond is a type of statutory indemnity bond that simply provides for “payment” as the only performance option. Although written as a pure indemnity bond for “payment of the penal sum,” the surety’s options upon default on a Form 25 Bond are whatever the government agrees to accept.

Completion Bond

Under a completion bond, the surety’s performance obligation is limited to a single option: to take over the work and complete the contract at the sole expense of the surety. While this type of bond is preferred by lenders who finance private construction, such an unconditional completion bond is rarely accepted by sureties without significant qualification to require the owner and its lenders to continue funding completion with funds remaining unpaid under the bonded contract. The completion bond typically names the owner as obligee and its construction lender as a “co-obligee,” thus giving both the owner and construction lender equal rights to enforce the bond.

Manuscript Bond

Last, but not least, is the tailored manuscript combined obligations bond that frequently is prepared by large owners intent on shifting as much risk as possible to the surety and contractor. This type of bond is written by lawyers employing a “belt and suspenders” approach that combines performance, indemnity, completion and lien-free property obligations in a single instrument tailored to apply to specific risks. Because these types of bonds shift risk in drastic ways, they are rarely used in either the public or private sector.

Conclusion

Overall, these different performance bonds — especially manuscript bonds — can have a drastic effect on risk allocation and remedies available to the surety upon triggering of their obligations. As a result, it is important that all contracting parties understand what kind of performance bond is required under the contract and how it may be used to ensure contractor performance.

Subcontractors Must be Careful Providing Bonds when General Contractor Does Not

Christopher G. Hill | Construction Law Musings | April 5, 2017

After I wrote the title to this post, I thought, “Well, that says it all, doesn’t it?” I also considered the fact that for those that read this construction law blog on a regular basis, I am likely stating the obvious. I then thought about the fact that there can be confusion regarding the purpose of bonds versus insurance. Couple this with the fact that Murphy was an optimist, and I thought this would be a good reminder.

Bonds and insurance have one fundamental difference between them. When your construction company buys insurance, that insurance is meant to protect your company. When your company provides a payment and/or performance bond, that bond is there not to protect your company but to protect everyone else on the job and the project itself. Where insurance will pay for your company’s qualifying errors so that that money does not come out of the bottom line, a bond contract will have an indemnification agreement whereby anything paid by the surety will then be reimbursed by you and your company dollar for dollar (as opposed to just the premium).

Given the above, the basic answer to why a subcontractor should be careful of providing a payment and performance bond on a construction project where the general contractor is not providing a bond is that it adds more imbalance to an already unbalanced relationship. The subcontractor is looking uphill for payment and may face contractual issues from a “pay if paid” clause to flow down notice and other provisions from the prime contract. To add payment and performance bonds to the mix, particularly where the general contractor does not provide the same, puts the subcontractor in the position of adding a layer of protection to the general contractor over and above that found in the contract. This is a layer of protection that the general contractor is correspondingly not willing or able to provide to the subcontractor.

Some other questions that should come to mind where this scenario plays out are the following: 1. Is the general contractor in a financial position to be bondable? Its lack of a bond may be due to some financial instability that pushes sureties away because any indemnity would be worthless. 2. Is this a general contractor the subcontractor want to work for? Clearly in this situation, the general contractor is not willing to trust that the subcontractor will be able to complete the work. 3. Is the subcontractor truly willing to take on this additional risk?

Of course, many of these issues are mitigated in the instance where the general contractor provides its own payment and performance bond and exercises its rights either contractually or by statute (such as the Little Miller Act) to require subcontractors to provide bonds.