TWENTY FIFTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS CONFERENCE New Orleans, Louisiana APRIL 10 TH & 11 TH, 2014 WHAT IS A DEFAULT AND WHY DOES IT MATTER PRESENTED BY: Jarrod W. Stone, Esquire Manier & Herod 150 Fourth Avenue North, Suite 2200 Nashville, TN 37219 (615) 244-0030 Kimberly B. Czap Philadelphia Insurance Companies
A. What is a Default? 1. Introduction Many modern performance bonds condition the surety s potential liability upon the principal being in default under the bonded contract. Nonetheless, some courts have held that a surety s performance bond liability is coextensive with its principal s liability for breach of the bonded contract, which essentially renders the surety liable for any breach of the bonded contract (such a latent defects that are discovered post-completion). However, those courts have generally skipped any substantive analysis of whether the underlying breach (or the principal s failure to cure the breach) would constitute a material breach (or default) sufficient to trigger the surety s potential liability under a performance bond that conditions the surety s liability upon the principal s default. Thankfully for surety practitioners, a number of courts have recognized the important distinction between a mere breach and a material breach, as well as the corollary concepts of material breach and substantial performance. Moreover, more sophisticated parties have attempted to contractually define the events/conditions that would qualify as a default sufficient to trigger the surety s potential liability under a performance bond that conditions the surety s liability upon the principal s default. Nonetheless, an understanding of the concept of breach versus default and an understanding of the concept of material breach versus substantial performance are critical to the proper analysis of a surety's potential exposure under a performance bond that conditions the surety's duty to perform/potential liability under the principal's default. 2. Breach v. Default When faced with a potential claim against a performance bond that conditions the surety's duty to perform/potential liability upon the principal's default, a surety practitioner must understand widely accepted common-law distinction between the principal s mere breach of a bonded contract and the principal s default under a bonded contract. In the leading case on the issue of breach versus default, the Fifth Circuit has explained: Although the terms breach and default are sometimes used interchangeably, their meanings are distinct in construction suretyship law. Not every breach of a construction contract constitutes a default sufficient to require the surety to step in and remedy it. To constitute a legal default, there must be a (1) material breach or series of material breaches (2) of such magnitude that the obligee is justified in terminating the contract. Under this rationale, a default sufficient to trigger the surety's duty to perform/potential liability cannot occur as a matter of law unless the principal s breach of the bonded contract constitutes a material breach. Though a non-material breach of the bonded contract may give rise to a breach of contract claim against the principal, a non-material breach is not sufficient to trigger a default and, therefore, is not sufficient to trigger a claim against a performance bond conditioned upon the principal s default. 2
In jurisdictions recognizing the distinction between a mere breach and a material breach, the issue of whether a breach rises to the level of a material breach sufficient to support a declaration of default is most often litigated after the obligee terminates the principal s right to complete the bonded contract. To say the least, the determination of whether a breach should be considered a material breach giving rise to a default is fact intensive, and the legal standard for materiality is not uniform. A leading treatise has labeled the legal standard for materiality as amorphous and has commented that [a]lthough the materiality of breach is the paramount issue in every contract termination dispute, there surprisingly is no adequate common law legal standard by which material breach may be judged. Thus, if the jurisdiction at issue recognizes the well-established distinction between a mere breach and a material breach sufficient to constitute a default, the surety practitioner should endeavor to identify the specific factors a court would consider while attempting to answer the difficult question of whether a particular breach should be deemed material or nonmaterial. A discussion of the numerous factors that may be considered is beyond the scope of this publication. Nonetheless, the issue of whether a breach should be deemed material or non-material is often extremely fact intensive, which normally preclude summary judgment for being a potential remedy the surety can obtain. 3. Default v. Substantial Performance As noted above, the propriety of the determination of default will often center upon whether the breach constitutes a material breach because only a material breach should qualify as a default sufficient to trigger the surety's duty to perform/potential liability under a performance bond that conditions such potential liability upon the principal's default. Surety practitioners should be aware that some courts focus on the issue of whether the principal materially breached the bonded contract or whether the principal substantially perform its obligations under the bonded contract. A leading contract law treatise has explained: The doctrine of material breach is simply the converse of the doctrine of substantial performance. Substantial performance is performance without a material breach, and a material breach results in performance that is not substantial. Accordingly, a finding of substantial performance necessarily precludes a finding of a material breach. Similar to the question of material breach, the question of substantial performance is frequently litigated after the obligee terminates the principal s right to complete the bonded contract before final completion and acceptance, and the legal standard for substantial performance is not uniform. Courts can be broadly distributed into separate camps regarding their approaches to analyzing substantial performance. On the one hand, some courts view the question of substantial performance objectively and focus on whether the bonded project can be used for its intended purpose despite the existence of defects and/or whether the purpose of the bonded contract has been fulfilled. On the other hand, some courts force the trier of fact to analyze the underlying degree of defectiveness using amorphous standards like pervasive, unimportant, minor, trivial, or slight, which are subjective and/or relative terms, or focus on the intent of the principal using standards like inadvertence, an honest mistake, or willfulness. Unfortunately, the two latter types of analyses seem to result in an I know it when 3
I see it determination for substantial performance that provides little predictability and breeds future litigation regarding the same issues. Nonetheless, once a bonded project has reached and/or passed the point of substantial completion, the principal is generally deemed to have substantially performed its obligations under the bonded contract, and many courts conflate the terms substantial completion and substantial performance. Unless the bonded contract specifically provides otherwise, the term substantial completion generally refers to the point at which the underlying project is capable of being used for its intended purposes and/or the obligee has obtained, for all intents and purposes, all of the benefits it reasonably anticipated receiving under the contract. If substantial performance of a construction contract precludes a determination of a material breach sufficient to warrant a declaration of default and/or termination, final completion and acceptance of the bonded contract should theoretically preclude a later declaration of default and foreclose the surety s future liability for latent defects under a performance bond conditioned upon the principal s default. Because substantial completion precedes final completion and acceptance, by syllogism, substantial performance also precedes final completion. Consequently, final completion, like substantial performance, should preclude a finding of material breach. Because a contract that has been finally completed and accepted by the obligee should be deemed a contract that the principal has, at a minimum, substantially performed, no subsequent failure by the principal to cure a latent defect should be deemed a material breach, at least in jurisdictions equating substantial completion with substantial performance. When faced with this logical assertion, an obligee may argue that a latent defect is so serious that it should be deemed a material breach of the bonded contract regardless of the fact that the latent defect was discovered after final completion and acceptance of the bonded project. As a counter, surety professionals should argue that there are no varying degrees of materiality; to the contrary, a breach is either a material breach or it is not a material breach, and a finding of substantial performance precludes a finding of a material breach as a matter of law. In order for a post-completion latent defect to qualify as a material breach sufficient to constitute a default, the latent defect would have to somehow undo or negate the presumption of substantial performance that should be associated with the final completion and acceptance of the bonded contract. Consequently, no latent defect discovered after final completion and acceptance should be considered a material breach of the bonded contract unless that defect renders the completed construction unfit for its intended purpose. In other words, any latent defects discovered after final completion and acceptance, which do not render the completed construction unfit for its intended purpose (such as aesthetic or nonstructural defects), should be deemed unimportant, minor, trivial, slight, or immaterial as a matter of law. In any event, the phrase the surety s liability is co-extensive with its principal s liability simply has no place in the analysis. 4. Grounds for Termination Under Bonded Contracts as Defaults Although the permutations of what constitutes a material breach are boundless, three of the most common grounds are failure to make payment, failure to follow design drawings or specifications and a lack of timely performance. When the principal possesses contractual obligation to pay its subcontractors, a principal s failure to pay may constitute a material breach. For instance, in Manganaro Corp. v. HITT Contracting, Inc., the court held that a 4
principal s failure to honor the payment requirements of an underlying subcontract within a reasonable time constituted a material breach by the principal. The subcontractor, therefore, possessed the right to terminate the subcontract with the principal due to the material breach. A limitation on the failure to make payment as a material breach exists when the principal possesses a good faith basis to challenge the propriety of the payments. In Pack v. Case, the court held that a material breach did not occur when a good faith dispute existed between the principal and the subcontractor regarding the amount owed to the subcontractor, the principal tenders the amount it believes that it owes the subcontractor and the principal possessed the unquestioned ability to pay the entire sum alleged by the subcontractor. The subcontractor, therefore, could not terminate the contract and assert that the principal had defaulted on the underlying contract. However, a principal s failure to deliver a finished property conforming to the designs of the obligee denies the obligee the benefit of the bargain and constitutes a material default. Although the common-law required perfect tender, including conformance to the obligee s designs, the doctrine of substantial performance, as outlined above, provides that a failure to conform to a design that still allows use for the intended purpose does not constitute a material breach. Lastly, a delay in timeliness of completion does not typically occasion a material breach unless the time of performance was an essential term or time was specified as of the essence in the underlying contract, which has been incorporated by reference into the bond. Obligees may also default under the underlying bonded contract with the principal and consequently discharge the surety. Any material breach of the bonded contract by the obligee may exonerate both the principal and the surety from liability and allow the principal and the surety to recover damages under either the bonded contract or in quantum meruit. For instance, in Stonington Water Street Associates, LLC v. Hodess Building Co., Inc., the court held that the obligee s decision to release the entire contract balance after the principal defaulted but before notifying the surety constituted a material default because the release of payment eliminated the surety s right to determine the use of the contract balances. The material breach constituted a sufficient basis for exoneration of the surety. 5. Default Under the AIA 311 and A1A 312 Performance Bonds Under the AIA A311 performance bond (the A311 Bond ), the surety s liability arises [w]henever Contractor shall be, and declared by Owner to be in default under the Contract. Many courts have held that a surety s liability under an A311 Bond is conditioned upon the principal s default under the bonded contract and the obligee s declaration that the principal is in default. The AIA A312 (1984 Version) performance bond (the A312 1984 bond ) does not adhere to the common-law distinction between a breach and a default. The A312 1984 bond s definition of Contractor Default may eliminate the common-law distinction between a simple breach of the bonded contract and a material breach of the bonded contract that can give rise to a default. Paragraph 12.3 of the A312 1984 bond defines Contractor Default as [f]ailure of the Contractor, which has neither been remedied nor waived, to perform or otherwise to comply with the terms of the Construction Contract. This definition makes no distinction between a minor failure to comply with the terms of the construction contract (a common law breach) and a material failure to comply with the terms of the construction contract (a common law default). 5
The AIA A312 (2010 Version) bond (the A312 2010 bond ) moved toward adherence to the common law distinction between a breach and a default. Paragraph 14.3 defines a Contractor Default as a [f]ailure of the Contractor, which has not been remedied or waived, to perform or otherwise to comply with a material term of the Construction Contract. The addition of the word material to the A312 1984 bond definition potentially signals that the A312 2010 bond distinguishes between a minor default and a material default. B. What is a Declaration of Default and When is it Necessary Prior to Using Self Help Remedies 1. Declaration of Principal s Default of under AIA 311 Performance Bond The A311 bond provides less facial protection to a surety than the A1A 312 bonds because it contains no explicit provision requiring a notice of default as a condition precedent to any legal action on the bond. The A311 provides that: NOW, THEREFORE, THE CONDITION OF THIS OBLIGATION is such that, if Principal shall promptly and faithfully perform said subcontract, then this obligation shall be null and void; otherwise it shall remain in full force and effect. Only later in does it state: Whenever Principal shall be, and be declared by Obligee to be in default under the subcontract, the Obligee having performed Obligee's obligations thereunder: (1) Surety may promptly remedy the default subject to the provisions of paragraph 3 herein, or; (2) Obligee after reasonable notice to Surety may, or Surety upon demand of Obligee, may arrange for the performance of Principal's obligation under the subcontract subject to the provisions of paragraph 3 herein; (3) The balance of the subcontract price, as defined below, shall be credited against the reasonable cost of completing performance of the subcontract... Relying upon the lack of facial notice requirements, a minority of courts have held that notice of default is not required under the A311 bond and the only precondition to termination was the failure of the principal to faithfully perform its contract. The Court of Appeals of New York has held that a formal declaration of default is not a condition precedent to the surety s potential liability under an AIA A311 Performance Bond in Walter Concrete Constr. Corp. v. Lederle Laboratories. The Court held that the AIA A311 Performance Bond contains no explicit provision requiring any notice of default as a condition precedent to any legal action on the bond.... In so holding, the Court noted that [h]ad the parties to the contract desired notice of default as a precursor to liability under the Bond, they could have elected to issue the more specific AIA-312, which by its terms requires pre-default notification be given to the contractor and surety by the owner. The Court further reasoned that the AIA A311 Performance Bond clearly anticipates liability for damages caused by [the principal] even if those damages could have been avoided by assumption of [the principal s] obligation under the subcontractor. Some courts, most notably the Fifth Circuit, Second Circuit and D.C. Circuit, have read the A311 as requiring a notice of default by the obligee because a surety would otherwise only have the right to perform for the principal if the obligee gave it notice. L&A Contracting Co. v. 6
S. Concrete Serv., Inc. is the seminal case in this category of cases. In L&A Contracting, the United States Court of Appeals for the Fifth Circuit expressly held that the surety s potential liability was conditioned upon the principal being in default of its performance obligations and the obligee having declared the principal to be in default. Although the Fifth Circuit did not expressly acknowledge that it was construing an AIA A311 Performance Bond, the Court noted the surety s potential liability under the performance bond would be triggered [w]henever Principal shall be, and shall be declared by Obligee to be in default under the subcontract, the Obligee having performed Obligee s obligations thereunder. The Fifth Circuit stressed the importance of a formal declaration of default by stating: Serious legal consequences attend a declaration of default, particularly in cases such as this case involving multi-million-dollars construction projects. Before a declaration of default, sureties face possible tort liability for meddling in the affairs of their principals. After a declaration of default, the relationship changes dramatically, and the surety owes immediate duties to the obligee. Additionally, as explained by the Texas Court of Appeals in Nova Casualty Company v. Turner Construction Company, the AIA bond 311 form may provide further protection by incorporating an underlying contract that requires a declaration of default or termination by the obligee. Although some courts have held that the A311 does create a notice of default requirement prior to the exercise of self-help remedies by the obligee and the underlying construction contract may provide further notice requirements, sureties should be cognizant of the local law regarding these issues. 2. Declaration of Principal s Default under AIA 312 Performance Bond (1984 Version) Unlike the A311, the A312 1984 bond specifically provides that a surety s obligations do not arise until the obligee satisfies the requirements of paragraph 3 of the A312 1984 bond. Paragraph 3 requires that: 3.1 The Owner has notified the Contractor and the Surety at its address described in Paragraph 10 below that the Owner is considering declaring a Contractor Default and has requested and attempted to arrange a conference with the Contractor and the Surety to be held no later than fifteen days after receipt of such notice to discuss methods of performing the Construction Contract. If the Owner, the Contractor and the Surety agree, the Contractor shall be allowed a reasonable time to perform the Construction Contract, but such an agreement shall not waive the Owner s right, if any, subsequently to declare a Contractor Default; and 3.2 The Owner has declared a Contractor Default and formally terminated the Contractor s right to complete the contract. Such Contractor Default shall not be declared earlier than twenty days after the Contractor and the Surety have received notice as provided in Subparagraph 3.1; and 7
3.3 The Owner has agreed to pay the Balance of the Contract Price to the Surety in accordance with the terms of the Construction Contract or to a contractor selected to perform the Construction Contract in accordance with the terms of the Contract with the Owner. Consequently, the surety must (1) notify the contractor and the surety that the obligee is considering declaring the contractor in default; (2) attempt to arrange a conference with the contractor and surety within fifteen days of the receipt of the notice to discuss methods of performing the construction contract; (3) wait at least twenty days after the contractor and the surety have received notice as provided in subparagraph 3.1; (4) declare a contractor default and formally terminate the contractor s right to complete the construction contract; and (5) agree to pay the balance of the contract price. Failure to satisfy these prerequisites should vitiate coverage under the bond. Additionally, the A312 also expressly incorporates the underlying contract. Consequently, an obligee must also comply with any further preconditions outlined in the underlying contract. 3. Declaration of Principal s Default under AIA 312 Performance Bond (2010 Version) The A312 2010 bond reversed the course of adding further notice requirements set by the 1984 version by eliminating or weakening some of the A312 1984 bond s preconditions. The A312 2010 bond no longer required that the obligee attempt to arrange a conference with the contractor and the surety. Section 3.1 now only provides that an obligee may request such a conference when making its notice of intent to declare contractor default. The obligee is not required to request the conference prior to exercising its rights under the bond. However, pursuant to Section 3.1, the surety may also request a conference within five business days after receiving the obligee s Section 3.1 notice. If the surety requests a conference, the obligee must attend and the conference must be held within ten business days of the receipt of the obligee s notice of potential default, unless the obligee agrees to different timing. Section 3.2 eliminated the twenty day waiting period between the obligee s Section 3.1 notice of intent to default and the obligee s Section 3.1 declaration of contractor default and formal termination. Moreover, the A312 1984 bond s requirements that the obligee wait fifteen days (after providing an additional demand for performance of its obligations under the performance bond) before declaring the surety to be in default, has been reduced to seven days. 8