TWENTY FORTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS CONFERENCE Charleston, South Carolina APRIL 18 TH & 19 TH, 2013

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1 TWENTY FORTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS CONFERENCE Charleston, South Carolina APRIL 18 TH & 19 TH, 2013 DRAFTING TAKEOVER AGREEMENTS TO MINIMIZE SURETY'S RISK PRESENTED BY: Rachel Walsh Krebs, Farley, and Pelleteri, PLLC 400 Poydras Street, Suite 2500 New Orleans, LA Christine Alexander Travelers Bond and Financial Products

2 DRAFTING TAKEOVER AGREEMENTS TO MINIMIZE SURETY S RISK Southern Surety Conference, April 17-19, 2013 Presented by: Rachel Walsh and Christine Alexander I. Introduction Once a principal has been declared in default, the surety must often decide whether to enter into a takeover agreement with the obligee, ensure completion of the project through other means, or dispute the default and litigate the merits of the obligee s declaration thereof. This paper will focus primarily on the issues facing the surety once it has decided to enter into a takeover agreement with the owner. II. Before Negotiating or Drafting a Takeover Agreement A. Read the performance bond. The performance bond often establishes the surety s rights and obligations in the event of a default, and establishes conditions precedent to the surety s liability. Bond forms vary widely in their triggering events, and some require not just a default, but a default and a declaration of default by the owner, while others require a default and actual termination of the bonded contract by the obligee. Others may permit partial defaults and partial terminations. Regardless, the surety should ensure that it has an obligation to act before taking affirmative steps to complete the project. 1 Further, and as permitted by the circumstances of the individual default, when the surety has decided to remedy the default, the surety has a number of remedies from which to choose. The surety may, for example, (1) finance the principal s completion of the contract; (2) takeover the performance of the contract by obtaining a new completion contractor; (3) tender a new contractor to the obligee while agreeing to pay the obligee s completion costs in excess of the remaining contract balance; (4) offer a cash settlement to the owner in exchange for a release; or (5) negotiate any other resolution to which the surety and obligee both agree. The language of the relevant bond may, however, severely restrict or eliminate the foregoing options. 2 1 The surety should also consider requirements of the underlying contract with regard to notice to cure, default, and termination. The obligee's failure to meet requirements of the underlying contract could preclude and/or provide defenses to a claim on the bond. 2 For example, generally, the AIA A-311 bond requires, as a condition precedent to the surety s performance, (1) a default by the principal, (2) a declaration of default by the obligee, and (3) no breach of contract by the obligee. All three of these requirements must be met before the surety is compelled to perform. If the conditions are met, the surety has three performance options. It can (1) promptly remedy the default, (2) take over and complete the contract according to its terms and conditions, or (3) obtain a bid or bids for completing the contract and arrange for another contractor to complete the contract, with the surety paying the difference between the cost of completion and the contract balance. The more detailed AIA A-312 bond, on the other hand, generally has four conditions that must be satisfied before the surety s obligations on the bond arise: (1) the obligee must have notified the surety and its principal of its intent to declare a default after arranging a conference with the surety and contractor to discuss 1

3 B. Read the Applicable Law. Statutory regulations often supersede the language of the bond and set forth the surety s rights and obligations. Rarely, the surety does not have an absolute right to takeover. 3 Further, statutes may mandate Takeover Agreement provisions. 4 C. Read the Underlying Contract. The underlying contract is almost always incorporated into the Takeover Agreement and largely establishes the surety s performance obligations. Thus, it is of utmost importance that the surety read and fully comprehend the contractor s obligations thereunder. III. Drafting the Takeover Agreement Once the surety has analyzed its rights and obligations, and opted to complete the defaulted contractor s work, a takeover agreement is critical to defining the parties expectations and minimizing the surety s risk. As unforeseen issues arise in connection with nearly every construction project, particularly completion work, the surety s best protection is to require a thorough and comprehensive takeover agreement that strives to address all contingencies. The takeover agreement should fully define and delineate the parties rights, duties and obligations. Though the original construction contract between the obligee and the principal is almost always incorporated by reference into the takeover agreement, the drafting and methods of performing the contract; (2) the obligee must have declared the principal s default and terminated the principal s rights to complete the contract, (3) the obligee must have agreed to pay the balance of the contract price to the surety or a contractor selected to perform the contract in accordance with the terms of the contract with the owner, and (4) the obligee must not itself be in default of its contractual obligations. Under the A-312 bond, the surety has five performance options on satisfaction of those conditions. The surety may (1) arrange for the contractor, with the obligee s consent, to perform and complete the contract; (2) undertake performance and completion of the contract itself, through its agents or independent contractors; (3) obtain bids or negotiated proposals from qualified contractors acceptable to the owner and arrange for another contractor to complete the contract; (4) determine the amount for which it may be liable to the owner and tender to the obligee an amount of money sufficient to satisfy its obligations; or (5) deny liability in whole or in part and notify the owner citing reasons therefore. Another example, the Federal Standard Form 25 Performance Bond, even more severely restricts the surety s options, and provides for payment as the only performance option. However, as it is written as a pure indemnity bond for payment of the penal sum, the surety s options upon default tend to be any option that the government is willing to accept. 3 See, e.g., FAR (b)-(c). But see, more generally, St. Paul Fire & Marine Ins. v. City of Green River, 93 F. Supp. 2d 1170 (D. Wy. 2000); Dragon Constr., Inc. v. Parkway Bank & Trust, 678 N.E.2d 55 (Ill. App. Ct. 1997); Tishman Westside Constr. LLC v. ASF Glass, Inc., 33 A.D.3d 539, 540 (N.Y. App. Div. 2006); Bd. of County Supervisors of County of Henrico v. Ins. Co. of N. Am., 494 F.2d 660, (4th Cir. 1974); Biomass One, L.P. v. S-P Constr., 799 P.2d 152, (Or. Ct. App. 1990). 4 See, e.g., FAR 9.404(e); 48 C.F.R (d) ( The contracting officer should consider a triparty agreement among the Government, the surety and the defaulting contractor to resolve the contractor s residual rights, involving assertion to unpaid prior earnings). 2

4 negotiation of the takeover agreement provides the surety with an opportunity to negotiate more favorable terms governing the scope of its obligations. A. Minimize the risk of unforeseen contingencies. i. Carefully define the scope of work. The takeover agreement should clearly identify the remaining scope of work to be completed by the surety so that any disputes in that regard are settled before work commences. Before defining the scope of work, the surety should: Have its consultant review the plans and specifications and identify all construction problems; Confer with its principal; Speak to the subcontractors and suppliers (often during the ratification process) to identify any problems of which they are aware; and Strive to resolve all pending change orders before execution of the takeover agreement. The takeover agreement should include a mutually agreed upon resolution to any issues regarding defective work, or should establish the party immediately responsible for performing the work, while reserving all rights, defenses and claims relating to said work. In negotiating a resolution to disputes regarding defective work, the surety must consider whether the identification of defects as latent or patent should affect the treatment thereof and whether the obligee s previous acceptance or rejection of the principal s work affects the surety s liability for said defects. 5 The surety should also consider the underlying contract, as any warranty obligations will likely become obligations of the surety unless the takeover agreement states otherwise and clearly defines the party responsible for those obligations. Also, by executing a takeover agreement, the surety should understand that it is likely undertaking the indemnification and/or insurance obligations of the underlying contract. If the surety wishes to avoid those obligations, the surety should expressly exclude them from its completion obligations and/or ensure that any such obligations are passed to the completion contractor via the completion contract. 6 ii. Define the contract balance. The takeover agreement should plainly state the contract balance (once it has been calculated and/or confirmed by the surety s consultant), and include a provision reiterating the obligee s absolute obligation to pay the entire contract balance to the surety and to no other party (including creditors and/or assignees of the principal). Ideally, the provision should commit the obligee to pay the entire contract balance with no right of setoff. In the event that no such clause exists, and the obligee assesses backcharges, the surety s only recourse will ultimately be to sue the obligee in order to recover 5 For an example of a controversy that may arise when defective work, and the treatment thereof, is not fully fleshed out in the takeover agreement, see Deluxe Building Systems v. Constructamax, Inc., et al., 2011 U.S. Dist. LEXIS (D.N.J. 2011). 6 See, e.g., Caravousanos v. King s County Hospital, 74 A.D.3d 716 (2d Dept. 2010). 3

5 said backcharges. Alternatively, if the obligee refuses to limit its right of setoff, the surety should require that the obligee list all claims and backcharges existing as of the date of the takeover to preclude the later assessment of unidentified and unaccounted for backcharges. iii. Protect the bond s penal sum. A surety is generally liable in excess of its bond penal sum if it takes over a project without first entering into an agreement limiting the surety s liability to the bond penalty. 7 Thus, it is of utmost importance that the surety perform no work without first limiting its liability. Provisions preserving the penal sum are relatively simple, as evidenced by the sample provision below: The liability of Surety under this Agreement is strictly limited to the penal sum of the Performance Bond. In no event will Surety be required to expend, in addition to the balance of the funds remaining under the Contract, more than the penal sum of its Performance Bond. Nothing in this Takeover Agreement constitutes a waiver of the penal sum or an increase in liability of Surety under the Performance Bond. 8 In addition to including such a provision in its takeover agreement, the surety should ensure that its completion contract includes a termination provision so that, if necessary, and on exhaustion of the contract balance and bond penal sum, the surety can withdraw from the project and leave the completion contractor with no claim for wrongful termination. C. Reserving Rights i. When rights should be reserved. Often, a surety believes that it is not obligated to complete a contract perhaps it believes the obligee s declaration of default to be improper or has identified surety defenses to the obligee s claim. Even when confronted with those circumstances, the surety often feels it 7 See, e.g., International Fid. Ins. Co., 98 F. Supp. at 428 ( [L]ong-established case law holds that a surety s takeover of its principal s contract pursuant to a performance bond always subjects the surety to liability beyond the penal sum of its bond. ); Caron v Andrew, Klien v J.D. & J.M. Collins, et al., 159 La 704, 106 So 120 (1925); McWalters & Barlett v United States, 272 F.2d 291 (10th Cir 1959); Beers v Wolf, 116 Mo 179, 22 SW 620 (1893); Howard v Fisher, 86 Colo 493, 283 P 1042 (1930); Mazzera v Ramsey, 72 Cal App 601, 238 P 101 (1925); Griffith v Rundle, 23 Wash 453, 63 P 199 (1900); Ausplund v Aetna Indemnity Co., 47 Ore 10, 81 P 571 (1905); Cf., Hunt v Bankers & Shippers Ins. Co., 73 AD2d 797, 423 NYS.2d 718 (1979), aff'd 50 NY2d 938; Copeland Sand & Gravel v Ins. Co. of North America, 288 Ore 325, 607 P2d 718 (1980); and State of Oregon v St. Paul, 288 F.2d 32 (9th Cir 1961); Daily and Kazlaw, Takeover and Completion, Bond Default Manual, Third Edition, 223, While provisions such as the foregoing are generally deemed sufficient to protect the bond s penal sum, case law addressing a takeover Surety s liability can be somewhat confusing for courts and practitioners as courts have taken mutually exclusive positions. For example, Egyptian American Bank, S.A.E. v. United States, 13 Cl. Ct. 337 (Cl. Ct. 1987), and People ex rel. Ryan v. Environmental Waste Resources, Inc., 782 N.E.2d 291 (Ill. 3d Dist. Ct. App. 2002), hold that the surety s liability is limited to the bond penal sum even upon takeover, while Village of Fox Lake v. Aetna Casualty and Surety Co., 534 N.E.2d 133 (Ill. 2d Dist. Ct. App. 1986), held that, notwithstanding a provision in the takeover agreement limiting the surety s liability to the penal sum, the surety s liability could exceed the penal sum. 4

6 necessary to complete to minimize any ultimate exposure. In such circumstances, the surety must reserve its rights and expressly state that the takeover agreement is subject to that reservation. Additionally, in defining the surety s scope of work, smaller disputes may arise regarding, for example, the treatment of defective work and/or previously assessed backcharges. If the parties are unable to reach a mutually agreeable resolution to outstanding disputes, but nonetheless wish to quickly begin completion work, a limited reservation of the surety s rights should be included in the takeover agreement. ii. Elements of an effective reservation. The concept of reserving rights stems largely from the doctrines of waiver and estoppel. Essentially, an effective reservation puts the recipient on notice that the surety is not intending its actions to constitute a waiver of rights or an estoppel. By providing the notice to the recipient, the recipient is advised that, notwithstanding the surety s actions, it may later assert its rights. While requirements for an effective reservation vary somewhat from jurisdiction to jurisdiction, generally, to be effective, the reservation of rights must first be adequately communicated to the intended recipient. 9 The reservation must also clearly and unambiguously inform the recipient of the position of the party reserving rights. The adequacy of the reservation is determined not by the recipient's subjective intent, but by whether the reservation fairly informs the recipient of the rights being preserved. 10 Finally, the reservation must be asserted in a timely fashion. 11 Further, as many standard AIA Forms provide that final payment waives all claims by the contractor unless the contractor notifies the owner of claims when the request is made, it is likely in the surety s best interests to require a clause in the takeover agreement expressly stating that a request for final payment constitutes no such waiver. iii. Reserve the principal s rights. In addition to the surety s rights, it may be necessary and/or advisable to include a clause reserving the rights of the principal. Should the principal dispute the alleged default, the 9 Bell Lavalin, Inc. v. Simcoe and Erie General Ins. Co., 61 F.3d 742 (9th Cir. 1995); Richards Mfg. Co. v. Great American Ins. Co., 773 S.W.2d 916 (Tenn. Ct. App. 1988); Caiazzo Plumbing and Heating Corp. v. United States Fidelity and Guaranty Company, 2004 U.S. Dist. LEXIS (S.D.N.Y. 2004) (citing Krugman and Fox Constr. Corp. v. Elite Assoc., Inc., 167 A.D.2d 514, 562 N.Y.S.2d 188 (2d Dep't 1990); Afsco Specialties Inc. v. Md. Casualty Co., 37 Misc. 2d 641, 235 N.Y.S.2d 147 (1962)); United States f/b/o East Coast Contracting, Inc. v. United States Fidelity and Guarantee Company, 2004 U.S. Dist. LEXIS (D. My. 2004). 10 St. Katherine Ins. Co. v. Shay, 1996 U.S. App. LEXIS (9th Cir. 1996); Transamerica Ins. Group v. Beem, 652 F.2d 663 (6th Cir. 1981); Val's Painting & Drywall, Inc. v. Allstate Ins. Co., 53 Cal. App. 3d 576, 588, 126 Cal. Rptr. 267 (1975); Miller v. Elite Ins. Co., 100 Cal. App. 3d 739, 754, 161 Cal. Rptr. 322 (1980); Henry vjohnson, 191 Kan 369, 381 P2d 538 (1963). 11 St. Leger v. American Fire and Cas. Ins. Co., 870 F. Supp. 641 (E.D. Pa. 1994), aff'd, 61 F.3d 896 (3d Cir. 1995); Shelby Steel Fabricators, Inc. v. U.S. Fidelity and Guar. Ins. Co., 569 So. 2d 309 (Ala. 1990); Western Cas. & Sur. Co. v. Newell Mfg. Co., 566 S.W.2d 74 (Tex.App. San Antonio 1978). 5

7 surety may wish to recognize the principal s stance and to expressly preserve the principal s rights in connection therewith. If nothing else, such a reservation may strengthen the surety s position should there be a later dispute regarding the principal s indemnification obligations. D. Negotiating liquidated damages. Almost all construction defaults involve a claim for delay damages, most often stemming from a liquidated damages provision in the original contract. As obligees generally recognize the benefit of a quick takeover and completion, they are often willing to negotiate the assessment of liquidated damages and make concessions to expedite the completion process. When negotiating, the surety s best tactic is often to conduct a thorough analysis (presumably through its consultant) and to argue that the delays were excusable and not the fault and/or responsibility of the defaulting contractor. If defenses (either contractor or surety) have been identified, said defenses can frequently be asserted to obtain a significant waiver of liquidated damages. Sureties should, however, undertake negotiations with some caution as entities, specifically governmental agencies, can spend a significant amount of time reviewing and approving takeover agreements. If negotiations result in a number of contract revisions, each of which requires various levels of bureaucratic oversight, an unreasonable amount of time could pass and liquidated damages, for which the surety is arguably responsible, will accrue. It is therefore essential to make demands that are realistic in light of the circumstances. Alternatively, if the parties are unable to reach agreement on responsibility for delay and/or liquidated damages, a reservation of rights is appropriate. E. Miscellaneous Considerations i. An issue that commonly arises is the extent to which the takeover agreement supersedes the underlying construction agreement. 12 A clause should thus be included in the takeover agreement pursuant to which the parties agree that, in the event of a conflict, the takeover agreement prevails. ii. Because of the nature of the performance bond as an extension of credit, not a policy of insurance covering fortuitous loss, the general rule is that a performance bond accords no third party rights to those with tort claims. The surety s role can, however, become muddied on the execution of a takeover agreement. For an added layer of protection, the surety may wish to include a provision in the takeover agreement reiterating that the surety s undertaking is solely to fulfill its obligations under the performance bond and that the takeover agreement contemplates neither third party beneficiaries nor tort liability See, e.g., Concra v. International Fidelity Ins. Co., 860 F.Supp. 13 (N.D.N.Y. 1994) (takeover agreement overrode construction agreement and compelled obligee to pay retention notwithstanding obligee s complaints over defective work). 13 In Scott v. Red River Waterway Commission, 41,009 (La.App. 2 Cir. 04/12/06), 936 So.2d 830, for example, a wrongful death action was filed against the Red River Waterway Commission and Bossier City arising from a vehicular accident purportedly caused by defects in a roadway sign and in the construction of the highway on which the accident occurred. Bossier City then filed a third party demand against Continental Casualty Insurance Company, the surety responsible for procuring the completion of the highway s construction. The trial court sustained the surety s exception of no cause of action, and its decision was upheld on appeal. H&S Corp. v. U.S. Fidelity & Guar. Co., 667 So.2d 393 (Fla. Dist. Ct. App. 1 st Dist. 1995). 6

8 III. Conclusion As every construction undertaking is unique and replete with its own set of challenges, there is no perfect takeover agreement form to be utilized in all circumstances. The concerns addressed in this paper should be considered before undertaking any completion work. The foregoing list of concerns is, however, far from all-inclusive. Thus, the surety should approach the negotiation and drafting process apprised of all risks and ready take advantage of any opportunity to mitigate its losses or minimize its exposure. After extensive citations to and analysis of the Public Works Act, the Second Circuit reasoned: [T]he language of Section 2241(C) and (D) of the [Public Works] Act indicates that [the surety s] liability is limited... and that any cause of action by a third party for personal injury arising from defects in [a public works] project would not extend to the surety. This conclusion is also supported by our general tort law. A bond surety is not the owner of the project and cannot be expected to perform in the project s actual construction which gives rise to a defective condition. Therefore, fault under Civil Code articles or 2315 would not arise as the result of an insuring, financial role of the surety. Id. at 837. While the city argued that Continental effectively undertook completion of the project and stepped into the shoes of the original contractor, the Second Circuit ultimately concluded that Continental did not perform beyond its role as surety and [that Continental did not] assume additional performance duties on the project which would give rise to legal responsibility for the alleged defective premises that caused the death of plaintiffs decedent. Id. at 838. The court distinguished the facts of Red River from those presented in Klein v. J.D. & J.M. Collins, 159 La. 704, 106 So. 120 (1925). In Klein, the court found that the surety who undertook completion of a contract was responsible for additional costs of completing the structure and delay damages above and beyond the penal sum of its bond. The Red River court noted that: The Klein case demonstrates that instead of a bond surety merely paying off an amount under its bond upon the contractor s default, it may contract with the owner to provide for a project s completion in some other manner. If the surety by that contract takes on the role of contractor and acts directly in completing the project, its liability can extend beyond the amount of its bond. 7