What To Do With Performance Bonds When Projects Default

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1 What To Do With Performance Bonds When Projects Default By Gary Strong January 18, 2018, 3:12 PM EST In today s economic climate, performance bonds are important for construction contracts. While performance bonds provide some security to subcontractors who are hired by the contractor as well as the owner who pays the contractor, this security is not guaranteed as sureties have surety defenses that provide a surety with an opportunity to disclaim coverage under the performance bond. This article will focus up what are a performance bond surety s options when there is a project default and what types of unique defenses the performance bond surety can use to its benefit. Gary Strong Before one delves into performance bonds, a brief summary of suretyship is necessary. Suretyship is distinguishable from insurance. The suretyship relationship is a three-party relationship (principal, oblige and surety). The principal is the primary obligor who performs contractual obligations (e.g. the contractor on a construction project). The obligee is the entity that enters into a contract with the principal and is the recipient of the obligations (e.g. project owner or governmental unit on a construction project). The surety is the secondary obligor which guarantees the principal s obligations will be performed.[1] Surety s Options During Default Once the project owner, whether it be public or private, has formally issued its declaration holding the principal in default, the surety has several options: 1) fund the principal to completion, 2) perform the work itself, 3) tender a completion contractor, or 4) tender payment to the owner.[2] Option number one (i.e. financing) involves paying the principal s bills to completion. This is

2 typically done when the project is nearing completion. This option saves time and expense of hiring a new construction manager and hopefully will keep the costs within the remaining contract balance. Generally speaking, if there is a project default and a replacement contractor is hired, the costs will increase for the basic reason the completion contractor(s) know full well that the project owner needs the project completed as soon as possible. In the second option, the surety performs the work itself by executing a takeover agreement with the owner and retaining its own completion contractor to complete the work. This option also is typically chosen where the project is close to being completed. This option is sometimes considered more advantageous to the surety because the surety retains more control on the project and gains the additional security of another surety bonding the completion contractor. The third option is for the surety to tender a completion construction manager / contractor to the owner. Here, the surety will obtain independent bids, usually bonded by another surety. The main difference between option two and three is that in the latter the project owner has more involvement. Once the bidder is awarded the contract, the surety allows the owner and any of its representative to direct the replacement contractor. The fourth option is where the surety buys back the bond. Here the surety will tender payment of the cost to complete less remaining contract balance but only up to the penal sum, in return for a fill release by the owner. This is typically done where the net cost to complete exceeds the penal sum of the performance bond. This option is rarer than the others because buying back the bond could affect the surety s indemnification rights against its principal and indemnitor(s). Performance Bond Defenses The liability of a surety under a performance bond is not triggered unless there is a default by the principal.[3] Therefore, the bond duration has been deemed to extend only to the point of substantial completion... at which point the owner is determined to have received performance substantially as bargained for and thus is not legally justified in terminating the bonded contract for default. [4] Upon the owner s termination of the contractor for default and subsequent demand under the surety s performance bond, the surety is entitled to utilize the remaining contract

3 balances to complete the contract work. Alternatively, the surety may use the contract balances to offset an owner s claim for its own completion costs. Essentially, the surety relies upon the bonded contract funds as collateral security against its corresponding loss and expense. Thus, where an owner has prematurely or improperly depleted contract funds prior to involving the surety, the surety can assert a claim for overpayment and/or the related defense of impairment of collateral. Generally, a surety may assert an overpayment claim or defense when the bond obligee has improperly or prematurely depleted the contract balance prior to the surety s involvement. Often, this occurs when a project owner releases payments to the bonded contractor in contravention of an express contractual provision, such as provision requiring the owner to retain a certain percentage of the contract funds pending the contractor s satisfaction of certain conditions.[5] Overpayment may also occur where the obligee pays for patently defective, noncomplaint and incomplete work, including work that has not actually progressed to the extent that progress payments have been made e.g., where 80 percent of the contract funds has been paid to the contractor though only 40 percent of the contract work has been completed.[6] Under the doctrine of impairment, where there has been an overpayment, the surety is generally entitled to a discharge from liability.[7] One way in which a surety may prevail on such defense occurs where it can prove that the obligee has materially modified the bonded contract, increasing the surety s risk. Based upon the nature and extent by which its risk have been increased by such a modification e.g., whether the increased risks are measureable the surety may be entitled to either a complete or pro tanto discharge of its bond obligations.[8] The surety may likewise obtain a pro tanto discharge where it has been prejudiced by the obligee s depletion of contract funds through premature payments or overpayments in contravention of the terms of the bonded contract. When seeking only a discharge from bond liability, the surety asserts overpayment as a defense. Another defense that a performance bond surety can assert is that based upon a material alteration to the contract between obligee and contractor. A material alteration is a nonconsensual increase of the surety s risk by some act of the obligee that changes the bonded contract.[9] Yet not every nonconsensual act qualifies a material alteration. The change must represent a material, substantial departure from the original risk, so that a

4 reasonable person would either have not undertaken the risk at all, or would have charged a greater premium.[10] Examples of material alterations include changing the project from building a warehouse to building a residential building or hospital, adding or deleting an entire floor, imposing an inordinate amount of additive and deductive change orders, or failure to obtain lien waivers.[11] Examples of nonmaterial alterations including changing the location of the building by a few inches or feet, adding a basement and failure of the owner to obtain builder s risk insurance.[12] Therefore, given the subjective standard of determining if a material alteration exists, this is a fact dependent inquiry often to be decided by a jury. Conclusion While in many instances, certain defenses can allow the surety to disclaim coverage, this usually would require the surety to go through a long and lengthy litigation to prove its case. When asserting its defenses, the surety needs to sustain its burden of proof both as to the defense itself and also that the event giving rise to that defense caused actual prejudice to the surety. The actual prejudice to the surety is something that differs on a case by case basis. Gary Strong is a partner with Seiger Gfeller Laurie LLP. His practice is focused on the areas of construction defect defense and professional liability defense. The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice. [1] Restatement (Third) of Suretyship and Guarantee 11, (1996). [2] United States Fid. & Guar. Co. v. Braspetro Oil Servs. Co., 369 F.3d 34, 67 (2nd Cir. 2004); International Fidelity Ins. Co. v. United States, 25 Cl. Ct. 469, 479 (1992); Granite Computer Leasing Corp. v. Travelers Indem. Co., 894 F.2d 547, 552 (2nd Cir. 1990); [3] Marilyn Klinger, et. al., Ch. 6, Contract Performance Bonds, The Law of Suretyship 81,

5 109 (Edward G. Gallagher ed., 2d ed., Am. Bar. Ass n 2000). [4] 4 Philip L. Bruner & Patrick J. O Connor, Jr., Bruner & O Connor on Construction Law 12:9 (West 2002 & Supp. 2008). [5] Nat l Sur. Corp. v. United States, 118 F.3d 1542 (Fed. Cir. 1997). [6] Blackfeet Tribe of the Blackfeet Indian Reservation v. Blaze Constr. Inc., 108 F. Supp.2d 1122 (D. Mont. 2000); United Pacific Insurance Co. v. United States, 16 Cl. Ct. 555 (1989) [7] Restatement (Third) of Suretyship and Guaranty. 37, [8] Walsh Const. Co. v. Egan, 542 N.Y.S.2d 471 (Albany Cty 1989); Transamerica Insurance Co. v. City of Kennewick, 785 F.2d 660 (9th Cir. 1986); American Fidelity Fire Insurance Co. v. Pavia-Byrne Engineering Corp., 393 So. 2d 830 (La. Ct. App. 2d Cir. 1981), writ denied, 397 So. 2d 1362 (La. 1981); William Aupperle & Sons Inc. v. American Indemnity Co., 75 Ill.App.3d 722 (3d Dist. 1979). [9] Midland Steel Warehouse Corp. v. Godinger Silver Art Ltd., 275 A.D.2d 341 (1st Dep t 2000); Hartford Fire Ins. Co. v. Facilities Development Corp., 249 A.D.2d 765 (3d Dep t 1998). [10] Id. [11] The Law of Suretyship, 2d edition at (American Bar Ass n 2000). [12] Id.