TWENTY EIGHTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS

Transcription

1 TWENTY EIGHTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS CONFERENCE Nashville, Tennessee th st APRIL 20 & 21, 2017 TO PAY OR TO PLAY: OPTIONS AVAILABLE TO THE SURETY: FINANCE OR TAKEOVER? PRESENTED BY: G. MATTHEW KEENAN L. GRAVES STIFF, III Starnes Davis Florie, LLP 100 Brookwood Place, 7th Floor Birmingham, Alabama RON WILLS CapSpecialty 1600 Aspen Commons, Suite 300 Middleton, Wisconsin MICHAEL J. SUGAR, JR. Forcon International Corp Oakfield Drive Brandon, FL 33511

2 INTRODUCTION Choosing between financing a principal or taking over a project to remedy a default is a critical question. While it is always good to have the option to choose, the wrong decision could lead to significantly greater losses to the surety and even losses that exceed the penal sum of the bond. This paper will look briefly into how to approach that question and those factors that the surety practitioner should always consider when faced with this choice. I. Surety s Right to Finance or Takeover FINANCING v. TAKEOVER The first question when considering whether to finance a principal or takeover a project is whether the surety has the right to do either. Often, a surety will have the option to choose. The source of the surety s right for either option may be found in the indemnity agreement, bond or both. Accordingly, it is critical to have a good understanding of these agreements as well as evaluating the impact of any state laws or other regulations on the surety s right to advance funds to its principal or take over and complete the project. A. Indemnity Agreement The indemnity agreement between the surety and principal will often provide the surety with the right, but not the obligation, to either finance a principal or takeover the project. In fact, the indemnity agreement is sometimes the only contractual source of such rights. The following is an example of two such provisions: With respect to each bond executed by the Surety in connection with a contract, the Surety is hereby authorized, in its sole discretion, to make or guarantee advances or loans for the purpose of the contract... and the Indemnitors agree both that all such loans and advances... shall be conclusively presumed to be an indemnity obligation of the Indemnitors to the Surety, and that the Surety shall have the absolute right to cease making or guaranteeing advances or loans at any time and without notice to the Indemnitors.... the Surety, in its sole discretion, shall have the right, but not the obligation, to take possession of the work under the contract and any other contract, in connection with which the Surety has issued a bond or bond(s) and, at the expense of the Indemnitors, to complete, to arrange for completion, or... of the contract work. Note that both provisions expressly set forth the continued indemnity obligations with respect to either option taken by the surety. 1 In addition, the assignment rights typically found in the surety s indemnity agreement can be an important tool for a surety who elects to complete a project with a new contractor as all remaining contract funds, equipment, inventory and materials will often be assigned to the surety. 1 In addition to contractual rights, a surety who chooses to finance a principal may also still look to its rights under equitable subrogation or other common law rights to recover any funds advanced to its principal. See 1 Mike F. Pipkin, et al., Bond Default Manual (4th ed. 2015). 1

3 B. Performance Bond Similarly, the performance bond may be a source of such rights. While many different bond forms exist, the AIA Document A Performance Bond is a prime example of a form that clearly provides the surety with the option to choose whether to finance a principal or takeover a project from the principal (along with other options). Under the A312 Bond, provided there has been no owner default and all conditions precedent have been satisfied, the surety enjoys the right to either finance the principal to complete the project: 5.1 Arrange for the Contractor, with the consent of the Owner, to perform and complete the Construction Contract; or the surety may choose to takeover and complete the project with its own contractor: 5.2 Undertake to perform and complete the Construction Contract itself, through its agents or through independent contractors; or... The AIA Document A311 Performance Bond, on the other hand, does not contain an express option for financing a defaulted principal. Nonetheless, it is commonly understood that the surety has this right under the provision that the Surety may promptly remedy the default or the provision that the surety may [c]omplete the Contract in accordance with its terms and conditions. 2 C. Common Law Finally, some courts have found that a surety enjoys a common law right to take over and complete its principal s project even when the performance bond does not expressly provide for it. 3 Again, it is imperative that the practitioner familiarize himself/herself with all of the sources of the surety s rights before evaluating the surety s options when faced with a principal s default. II. Advantages/Disadvantages of Financing a Principal 4 In theory, there are many good reasons for the surety to choose to advance funds to its principal upon notice of a bond claim by the obligee. In practice, they are much more limited. In fact, the trend for many years has been away from financing a principal due to the many risks associated with it. As more than one treatise has noted, financing a principal is: the most controversial and most maligned of the completion options available to the performance bond surety. This is because financing is not a panacea but a danger-filled mine field which can 2 See, e.g., id. at See id. at 366 and cases cited therein. 4 For a discussion of issues unique to financing and takeover in the context of a federal project, see Gerard P. Sunderland; et al., Tenth Annual Northeast Surety & Fidelity Claims Conference, The Surety and the Federal Government: to Finance, to Takeover, or to do Nothing, That is the Question, (1999). 2

4 lead to disaster... In deciding whether to finance, the surety s natural prejudice should be not to take this step. This prejudice occurs because the arguments in favor of financing are much more persuasive and compelling in theory than they are in practice. 5 Nonetheless, there are advantages for a surety providing financial assistance to a principal, whether directly or through backdoor financing (i.e., payments to subcontractors and suppliers under a payment bond). The most common benefits for the financing surety are: Avoiding the typical problems that arise with the obligee, subcontractors, suppliers and creditors of the principal upon a principal default or when they discover that the principal is in financial trouble; The principal s subcontracts remain enforceable, which means those prices are locked in and are not renegotiated; The principal has a familiarity with the job that a new contractor lacks there is no learning curve on the project when you finance your principal; Avoiding other costs of hiring a new contractor, such as significant mark-ups for various allowances and contingencies; Reduced delays work stoppage and demobilization of the principal can result in liquidated damages; and Keeps your principal interested and motivated to pursue its affirmative claims. Other advantages are that financing can lead to securing collateral security from the principal or indemnitors that it would not otherwise have and insulating of the surety from claims by its principal and indemnitors when the financing agreement includes a release by the principal and indemnitors of any claims they may have against the surety. 6 On the other hand, the disadvantages to providing funds to a principal include: The surety s costs in monitoring the project; Funds advanced by the surety may not reduce the penal sum of the bond; Potential for miscalculating the principal s overhead; Risk of increased costs to complete; Tax issues; Difficulty in achieving substantial completion; Potential claims by the principal when the surety decides to cutoff funding; and Providing the principal with a potential defense to indemnity principals have argued alter ego or domination as a defense to indemnity based upon the surety s advancement of funds. 5 Pipkin, supra note 1, at 210 n.1. 6 Id. at

5 III. Advantages/Disadvantages of a Takeover When a surety elects to take over and complete a project, the surety explicitly assumes the performance obligations of its principal under the latter s contract with the obligee. 7 In other words, the surety steps into the shoes of its principal. The advantages to this option often include: Control over completion and costs; Control over information; Control over the scope of work; Ability to negotiate existing disputes over defects, change orders, extensions of time and liquidated damages; and Establishing of goodwill with the obligee. Conversely, some of the disadvantages for a surety that chooses to takeover its principal s project are: Potential waiver of the penal sum of the bond; Discovery of latent defects in the project; Potential loss of right to recover overpayments made by the obligee to the principal; 8 Undermining the principal s claims against the owner; Losing your goodwill with the principal who then becomes uncooperative and may be more motivated to contest indemnity obligations; and Unforeseen and increased costs due to the inherent risks of taking on any construction project. IV. Evaluating the Options A thorough investigation is key to evaluating whether to finance or takeover. One of the difficulties in conducting a thorough investigation of the principal, the project and other factors, however, is the time constraints placed on the surety given that any delays to the project may lead to additional losses to the surety. Often times, a construction consultant is a key and indispensable component to the surety s investigation as he/she is able to quickly step in and gather the necessary information and documents in a more efficient manner than anyone else. Regardless, the surety will often find that its investigation is hindered by a lack of time. Similarly, there may not always be enough time to fully evaluate the principal s defenses. Accordingly, the surety may decide to remedy the default under a reservation of rights. 7 See, e.g., Travelers Cas. & Sur. Co. v. Dormitory Authority-State of N.Y., 735 F. Supp. 2d 42, 80, n.66 (S.D.N.Y. 2010). 8 See Lumbermens Mut. Cas. Co. v. U.S., 654 F.3d 1305 (Fed. Cir. 2011). 4

6 A. Financing As it did during the underwriting process that took place when the surety first agreed to bond the principal, the surety will want to first obtain certain information and documents from the principal in order to be able to properly evaluate whether the principal is a candidate for financing. This information is commonly known as the four Cs cash, capacity, character and collateral. While the last C, collateral, is not a part of the original underwriting process, it is an obvious necessity when faced with a principal who needs financing. The first C, cash held by or available to the principal, will usually be insufficient and the surety will, thus, be looking for collateral security held by the principal or indemnitors that could be used to mitigate any loss. Capacity represents the principal s ability to perform and complete the project. While the contractor may represent that it is ready, willing and able to finish the job, the surety must investigate further and consider whether the people it has in place can do the job, whether they have the equipment and materials to complete and whether other circumstances exist that may ultimately put the contractor out of business. Character represents the trustworthiness of the principal and indemnitors. The surety must be able to trust the principal that it will diligently perform the work, cooperate, take its indemnity obligations seriously and minimize any loss to the surety. Additionally, other questions to ask are: How much unbonded work does the principal have? Other projects could represent additional financial trouble or they may be a stable source of income that helps to keep the principal solvent. Does the principal have a good relationship with its subcontractors? Financing a principal with deteriorating subcontractor and supplier relationships can lead to more headaches and costs for the surety. Is the project near substantial completion or in its early stages? Financing a principal makes the most sense when a project is near completion. What are the options for finding a completing contractor? If there are no good options for a new contractor that can finish the job at a reasonable cost due to the complexity of the project, the remoteness of the location or some other reason, then financing becomes a more attractive option. A surety may consider financing a design/build/manufacturing contractor that owns patents and copyrights to certain materials or machinery found in the completed structure. For example, the contractor may use a special, patented glass for the curtain wall system, and it is the only entity with a license to use it. To bring another contractor in to complete the job could require an entire redesign of the exterior skin of the building. Thus, financing may be the most reasonable and cost effective option. The reality, however, is that many principals in need of financing will not be in a position to satisfy their surety that advancing funds is the best option to remedy the default or minimize the surety s liability. Capacity and Character are considered by some to be the most important factors in any evaluation. As others have noted, a principal that cannot provide sufficient 5

7 assurance of its capacity to complete the work and of its character regarding its promise to indemnify and hold harmless the surety should not be financed. 9 B. Takeover Many of the same factors mentioned above should also be considered in evaluating whether to take over a project and complete. In both instances these factors will be heavily influenced by the myriad set of facts and circumstances presented by each particular principal and bonded project. For example, it may be determined that it is too expensive to bring in an entirely new contractor to finish a job when the project is near completion at the time of default. Yet, under another set of circumstances, a takeover at such a late stage in the project could be a reasonable option, such as when costs are spiraling out of control. In that situation, the surety may be able to better mitigate its losses by taking over the project and maintaining as much control as possible. At the other end of the spectrum, a default is entered against the principal when the project is still in its early stages. Sureties often find such projects to not be great candidates for a takeover because of the potential for more problems to occur and costs to rise due simply to the length of time remaining to finish the job. Furthermore: [e]arly payments made to the principal under the bonded contract are often for mobilization and other general conditions that do not correspond to actual completion of work on the project. As a result, it is not uncommon that the net exposure to the surety to complete a project in its early stages will approach, if not exceed, the penal sum of the bond. 10 Other key considerations for the surety contemplating a takeover are: Amount of the remaining contract balance compared to the cost to complete the project; Complexity of the project; Location of the project; Whether the completing contractor can finish the job on time; and Potential conflicts or difficulty with the obligee and its design professionals. Finally, it is critically important that all contract documents, plans and specifications are carefully reviewed so that the surety can address any issues related to insurance, warranties, payment of funds, deadlines and related matters during negotiations over the specific terms of the takeover agreement. 9 George J. Bachrach, Eleventh Annual Northeast Surety & Fidelity Claims Conference, Financing the Principal, p. 7 (2000). 10 See Pipkin, supra note 1, at

8 CONCLUSION The question of whether to finance the principal or to takeover and complete the project is extremely important. There will always be risks associated with any course of action taken by a surety to remedy a principal s default. The goal is simply to minimize those risks. Because every situation is different, the practitioner must always conduct a thorough investigation into the facts and in depth analysis of the risks and benefits to the surety in choosing between these two options. 7

9 BIOS Ron Wills is surety claims counsel for Capitol Indemnity Corporation. Before that he was surety claims counsel with Fireman s Fund. He has over 20 years of experience in the industry. Ron has a degree in Information Systems from the University of Georgia and was a Sr. Systems Analyst in software development for about 10 years before going to law school. He graduated with a J.D. from Georgia State University and is admitted to the practice of law in Georgia and Florida. After receiving his law degree, he worked in private practice for about three years with a firm that primarily practiced in the surety defense arena. Ron Wills CAPITOL INDEMNITY CORPORATION 1600 Aspen Commons, Suite 300 Middleton, WI (770) rwills@capspecialty.com Mike Sugar - is the president and founder of Forcon International Corp [1984]. Surety & Fidelity underwriter for The Hartford. Claims attorney/manager for Fidelity and Deposit Company of Maryland. Mr. Sugar graduated from the University of Buffalo in 1967 Bachelor of Arts. Juris Doctor from the University of Buffalo in He is a member of the Washington D.C., Pennsylvania (inactive) and Florida Bars (active). Mr. Sugar is the founder of the Southern Surety & Fidelity Claims Conference and the Northeast Surety & Fidelity Claims Conference. After law school, he moved to Paris, France and taught English at the School of Berlitz while growing a full red beard. Michael J. Sugar, Jr. FORCON INTERNATIONAL CORP Oakfield Dr. Brandon, FL (813) mjsugar@forcon.com Gray Stiff is a Senior Partner at Starnes Davis Florie LLP in Birmingham, Alabama. He has extensive experience in construction litigation, including representation of owners, contractors, and sureties, design professional defense and prosecution and defense of business and commercial claims. Gray was named Lawyer of the Year for Birmingham Litigation Construction in the 2016 edition of Best Lawyers in America, and he has been regularly selected by his peers for inclusion in Best Lawyers in America, In addition, Gray has been named to "Who's Who in Construction, Architecture & Engineering 2009" by the Birmingham Business Journal, which recognized him as one of the top construction litigation attorneys in Birmingham. He obtained a J.D. from Cumberland School of Law, Samford University (1978) and a B.A. from the University of Virginia (1973). Luther Graves Stiff, III STARNES DAVIS FLORIE LLP 100 Brookwood Place, 7th Floor Birmingham, Alabama

10 (205) Matt Keenan is a partner with Starnes Davis Florie LLP in Birmingham, Alabama. Matt's practice is focused on the representation of sureties and other entities in the defense and prosecution of business and commercial claims. He has been named a Rising Star for the State of Alabama by Alabama Super Lawyers in 2014 and Matt received his J.D. from the University of Alabama School of Law (2005) where he served on the Alabama Law Review. He is a graduate of Texas Christian University (1993). G. Matthew Keenan STARNES DAVIS FLORIE LLP 100 Brookwood Place, 7th Floor Birmingham, Alabama (205) gmk@starneslaw.com 9