TWENTY EIGHTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS

TWENTY EIGHTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS CONFERENCE Nashville, Tennessee th st APRIL 20 & 21, 2017 RISKY BUSINESS: IMPAIRMENT OF SURETYSHIP, AND THE RESTATEMENT PRESENTED BY: GREGORY R. VEAL Bovis, Kyle, Burch & Medlin LLC 200 Ashford Center North Suite 500 Atlanta, Georgia 30338-2668 JIMMY SPARKS International Fidelity Insurance Company 4965 Preston Park Blvd Plano, Texas 75093

RISKY BUSINESS: IMPAIRMENT OF SURETYSHIP, AND THE RESTATEMENT INTRODUCTION Suretyship involves acceptance of certain risks of loss in return for a premium and promise of indemnification. It is, by nature, a risky business. When the obligee changes the risks from those voluntarily accepted by the surety, though, it is the surety s business to object and assert impairment as a defense. The RESTATEMENT (3D) OF SURETYSHIP AND GUARANTY speaks to impairment and its consequences; can it be understood in plain English? The impairment defenses of overpayment, material change, release of principal, and breach of bond all rest on preserving the surety s undertaking and responding reasonably when the obligee s conduct increases the surety s undertaken risk. I. What is the Surety s Risk? Suretyship is the voluntary assumption of risk, by the surety s issuing its bond and undertaking to be the secondary obligor for the principal s obligations to the obligee. The starting point is the scope of the principal s obligations as established by the principal s contract with the obligee. The surety knows when it chooses to bond the contract what obligations the principal has agreed to fulfill. Occasionally, and disconcertingly, the underwriter may not have read the contract, but at least the surety then knows that it doesn t know all of the contract provisions and makes its decision to bond anyway. Even then, the surety knows that a contract exists and describes the principal s obligations being backed by the bond. The underwriter also knows that the principal believes the price sufficient to cover the cost of the work plus overhead and profit, believes the time for performance adequate to complete, and believes the type of work suited to its capacity to perform. Ideally, the underwriter also conducts enough inquiry to be confident that the principal s beliefs are correct. If the principal is wrong on any of these beliefs, a default is much more likely, in which case the surety will be left to rely on the principal s financial capability to hold harmless or indemnify the surety. The contract bond surety accepts the risks that the principal s beliefs about the job are mistaken and that the principal cannot insulate the surety from loss. What does the surety know about its risks, and how much control does it have over them? A. Statutory Bonds One might think, initially, that sureties can control the risks they face by the terms of the bonds they issue. One would be only partially correct, especially with regard to

statutory bonds. The Miller Act performance bond is a creature of statute. 1 It is facially simple and merely states that it is void if the principal contractor performs and fulfills all the undertaking and pays specified taxes owed; the form does not mention any specific duties of the obligee or the surety. 2 The Federal Acquisition Regulations and case law, however, are gap-fillers in establishing the rights and obligations of the surety and the government under this statutory bond. 3 The risks undertaken by the surety are subject to many regulations that shape the surety s risk, in one commentary s view, to be whatever the government [contracting officer] agrees to accept. 4 Little Miller Act and other statutory bonds similarly may govern the surety s risk without expressly addressing it in the bond form. Courts generally look to the statute under which a bond is issued to determine the scope of the surety s duties. In General Insurance Company of America v. City of Colorado Springs, 5 the obligee argued that the defeasance bond actually was a penalty bond entitling the city to recover the full penal sum even without proving damages. The supreme court correctly concluded that the statute required only payment of the cost to install the bonded work if the principal failed to do so. 6 Unfortunately, the court did not require the city to prove it had incurred the costs it claimed. The correct result, consistent with the Colorado court s own reasoning, was reached in Westchester Fire Insurance Co. v. City of Brooksville. 7 There, the statutory bond required the surety to pay if the principal failed to perform, but the court required the city first to incur a loss completing the work because the statute required the city to proceed with the work and... hold the... bonding company responsible. 8 Again, the bond form was not dispositive the statute governed. Many jurisdictions read in statutory provisions not stated in the bond or permit the surety to expand but not reduce its statutory obligations, and some even read out 1 40 U.S.C. 3131 et seq. 2 BOND DEFAULT MANUAL, vol. II, Form 1.1 (Mike F. Pipkin, Carol Z. Smith, Thomas J. Vollbrecht, and J. Blake Wilcox, eds., 4 th ed., ABA 2015) (hereinafter BOND DEFAULT MANUAL). 3 See Gregory L. Daily & Todd C. Kazlow, Takeover and Completion, BOND DEFAULT MANUAL 3D, 223-241 (Duncan L. Clore, Richard E. Towle & Michael J. Sugar, Jr., eds., ABA 2005); 48 C.F.R. 53.301-25 (2009). 4 Charles W. Langfitt, Bennett J. Lee, and Robert C. Niesley, Performance Options Available to the Surety, Chapt. 3, pp 148-150, THE LAW OF PERFORMANCE BONDS 2 nd (Lawrence R. Moelmann, Matthew M. Horowitz, Kevin L. Lybeck, eds., ABA 2009). 5 638 P.2d 752 (Colo. 1981) (en banc). 6 Id. 7 731 F. Supp. 2d 1298 (M.D. Fla. 2010). 8 Id. at 1308-1309. - 2 -

bond terms inconsistent with the statute regardless of their effect. 9 For these reasons, the surety issuing a statutory bond must look beyond the form itself to assess its risks. B. The Bond Provisions Private or common law bonds offer a better opportunity for the surety to set forth in some detail risks it is unwilling to accept. Two prevalent examples are the AIA A311 and A312 performance bonds. 10 The A311 performance bond, for instance, sets out the conditions and options for completion: Whenever Principal shall be, and declared by Owner to be in default under the Contract, the Owner having performed Owner s obligations thereunder, the Surety may promptly remedy the default, or shall promptly (1) Complete the Contract in accordance with its terms and conditions, or (2) Obtain a bid or bids for completing the Contract in accordance with its terms and conditions.... The A312 performance bond goes further in detailing precisely what obligee and surety must do in the event of a default. After setting out the obligee s requirements (substantial compliance, notice, meeting, declaration of default, agreement to pay) to trigger the surety s obligations, the bond then states the options available to the surety. New Section 4, however, expressly requires actual prejudice caused by the obligee s failure to comply with the bond s notice condition before the surety is discharged. 11 The A311 and A312 bonds, while widely accepted and familiar, are far from the only versions in use. Both contract bonds and subcontract bonds routinely are manuscripted, or customized, with language generally drafted by owners, architects, and contractors to restrict the surety s rights or expand its obligations. 12 If an underwriter agrees to issue bonds on such forms, at least the conditions and restrictions are evident and can be evaluated for the risks assumed. 9 See Gregory R. Veal, "All That the Law Allows, But Maybe More or Less Than You Thought: Statutory Contract and Fidelity Bonds," unpublished paper, Southern Surety & Fidelity Claims Ass n (2008). 10 BOND DEFAULT MANUAL, vol. II, Forms 1.2 (A311) and 1.4 (A312-2010). These bond forms are promulgated by the American Institute of Architects 11 AIA A312 Performance Bond (American Institute of Architects, 2010): Failure on the part of the Owner to comply with the notice requirement in Section 3.1 shall not constitute a failure to comply with a condition precedent to the Surety s obligations, or release the Surety from its obligations, except to the extent the Surety demonstrates actual prejudice. 12 See, e.g., Bossier Med. Props. v. Abbott & Williams Constr. Co., 557 So. 2d 1131 (La. App. 1990) (bond with broad indemnity language held to cover lost rent during delay). - 3 -

Indemnity bonds allow the surety to pay, or to elect either payment or performance, in the event the principal is terminated. The surety may choose reimbursement after completion by the obligee, distinguishing the undertaking from true performance bonds. 13 Two significant limitations on the surety s risk are (1) indemnity bonds create no rights in third parties, such as unpaid subs and suppliers, because the bond expressly reimburses only the obligee, 14 and (2) the surety s election not to complete the work cannot be deemed a breach exposing the surety to voiding of the penal sum limit 15 or imposition of punitive damages. 16 Again, the form of the bond allows the surety some control over the broad outlines of its risk. Beyond the bond, though, is the underlying contract that establishes the principal s duties, which are the heart of the surety s exposure. C. The Underlying Contract Virtually every contract surety bond incorporates by reference the underlying contract between the principal and the obligee. That express incorporation of the principal s contract with the obligee in large part defines the surety s obligation. For example, in Village of Northview v. International Fidelity Insurance Co., 17 the incorporated contract required the contractor to provide a bond for the performance of this Agreement, so the court construed the bond, which facially required only indemnity, to be a performance bond and made the surety liable to the obligee even absent a showing of pecuniary loss. Because of the incorporated contract language, the obligee in effect was allowed to prove potential damages even though it might never actually incur them. Similarly, in Fisher v. Fidelity & Deposit Company of Maryland, 18 the surety sought to avoid delay damages and penalty for claims-handling delays by arguing that the defeasance bond form did not require the surety s performance. The court, however, noted that the incorporated contract required the contractor, not the owner, to 13 See American Motorists Ins. Co. v. Club at Hokuli a, Inc., 2011 WL 4411580 (D. Haw. Sept. 20, 2011); Treasure State Industries, Inc. v. Welch, 567 P.2d 947 (Mont. 1977). For an interesting discussion of the pros and cons of performance bonds and indemnity bonds, see Cataract Disposal, Inc. v. Town Bd. of Town of Newfane, 423 N.E.2d 390 (N.Y.A.D. 1981). 14 See, e.g., Treasure State Industries, Inc. v. Welch, 567 P.2d 947 (Mont. 1977); Bourrett v. Bride Constr. Co., 84 N.W.2d 4 (Iowa 1957); BOND DEFAULT MANUAL 146. 15 See Continental Realty Corp. v. Andrew J. Crevolin Co., 380 F. Supp. 246 (S.D. W. Va. 1974). 16 See Transamerica Premier Ins. Co. v. Brighton School Dist., 940 P.2d 348 (Colo. 1997); but see BOND DEFAULT MANUAL 162 & n. 120 (excellent discussion of why punitive damages is not a remedy available for breach of contract, including breach of bond). 17 No. 82C4073, 1986 WL 10625, at *2 (N.D. Ill., Sept. 24, 1986). 18 466 N.E.2d 332 (Ill. App. 1984). - 4 -

perform the work. Extrapolating, the court held that the surety likewise had a duty to perform. 19 The court effectively allowed the contract to override the bond. At the same time, though, the incorporated contract has provisions benefiting the surety. The contract establishes a price, usually to be paid as the work is completed properly. If the contract sum is paid to the principal in accordance with a contract requirement of percentage completion, in theory the remaining work at all times should correspond to the remaining funds. If the obligee defaults and terminates the principal, the surety s risk should be only the pricing differential to have a different contractor complete the work. Likewise, the obligee should not allow the principal to fall behind schedule without declaring a default and thereby preserving the remaining contract time for the surety s completion effort. Of course, theory and reality often diverge. The surety s risk is increased if the obligee deviates from the contract requirements in a material way. Incorporation of the contract into the bond connects the obligee s duties in that contract to the surety s duty, under the bond, to perform if the principal defaults. The surety has the right to proper contractual performance by the obligee and should be discharged if the obligee impairs the surety s rights. II. Impairment: Disappointed Expectations The RESTATEMENT (3D) OF SURETYSHIP & GUARANTY addresses conduct of the obligee that violates the surety s reasonable expectations based on the underlying contract and the suretyship relationship. Section 37 is entitled Impairment of Suretyship Status and describes the circumstances under which the obligee s conduct discharges the surety in whole or in part. That section cross-references to other sections detailing specifics: Section 39 (release of principal), Section 40 (extension of time), Section 41 (modifications), and others. 20 The Restatement language can appear strange within the surety industry because the terminology was chosen to apply both to that industry and the financial world of lending and guaranties. Substituting principal for principal obligor, surety for secondary obligor, and bond for secondary obligation simplifies the provisions without affecting the meaning. 21 So translated, Section 37, subsections (1) (3) state: 19 See also Maine Bonding & Cas. Co. v. Foundation Constructors, Inc., 202 A.2d 481 (N.H. 1964) (defeasance bond s incorporation of contract, with obligation to pay subs and suppliers, became de facto performance bond and required payment). 20 Referenced provisions include Sections 42 (impairing security), 43 (failing to sue the principal within the statute of limitations), and 44 (catchall for actions impairing the principal s duties to perform or reimburse or the surety s recovery rights). 21 See George J. Bachrach, Jason R. Potter, and William P. Pearce, A Primer for the Restatement of the Law Suretyship and Guaranty, unpublished paper, 27 th Annual Northeast Surety and Fidelity Claims Conference (Sept. 22, 2016). See also The Restatement of Suretyship and Guaranty: A Translation for the Practitioner (T. Scott Leo and Daniel Mungall, Jr., eds., ABA 2005). - 5 -

(1) If the obligee acts to increase the surety s risk of loss by increasing its potential cost of performance or decreasing its potential ability to cause the principal to bear the cost of performance, the surety is discharged as described in subsections (2) and (3), and the surety has a claim against the obligee as described in subsection (4). An act that increases the surety s risk of loss by increasing its potential cost of performance or decreasing its potential ability to cause the principal to bear the cost of performance is an impairment of suretyship status. (2) If the obligee fundamentally alters the risks imposed on the surety by: (a) releasing the principal from a duty other than the payment of money ( 39(c)(iii)); or (b) agreeing to a modification of the duties of the principal that either amounts to a substituted contract or imposes risks on the surety fundamentally different from those imposed on the surety prior to modification ( 41(b)(i)); the surety is discharged from any unperformed portion of the bond as more fully set forth in those sections. (3) If the obligee impairs the surety s recourse against the principal by: (a) releasing the principal from a duty to pay money ( 39(c)(ii)); (b) granting the principal an extension of time for performance of its duties pursuant to the underlying obligation ( 40(b)); (c) agreeing to a modification of the duties of the principal, other than a release or an extension of time, that does not amount to a substituted contract or impose risks on the surety fundamentally different from those imposed on the surety prior to modification ( 41(b)(ii)); (d) impairing the value of an interest in collateral securing the underlying obligation ( 42); (e) failing to institute an action before expiration of the statute of limitations governing the underlying obligation ( 43); or (f) any other act or omission that impairs the principal s duty of performance, the principal s duty to reimburse, or the surety s right of restitution or subrogation ( 44); - 6 -

the surety is discharged from its duties pursuant to the bond to the extent set forth in those sections in order to prevent the impairment of recourse from causing the surety a loss. The overall structure and import of these sections break down into two types of obligee conduct that impairs the surety s rights and two degrees of consequences for such impairment. The obligee may fundamentally alter the surety s risk, in which case the surety is totally discharged, or the obligee may increase the surety s risk to a lesser extent, in which case the surety is discharged only to the extent necessary to prevent a loss. The focus is on protecting the surety from loss caused by risks the surety never agreed to undertake, whether entirely or simply by degree. Sureties routinely deal with three potential causes of discharge: mishandling of contract funds, unconsented changes, and breach of bond conditions. A fourth, release of the principal, is less common. A. Contract Funds Section 37(2)(b) and (3)(c), (d), and (f) all are in play when the obligee mishandles contract funds. Those funds usually are the surety s first concern and often its only true recourse by the time of a default. Improper payment almost always prejudices the surety, but courts sometimes miss this truth. In Mt. Vernon City School District v. Nova Casualty Co., 22 the contractor earned over $800,000 but owed the department of labor for wage violations on other jobs. At the DOL s request, the city obligee diverted $214,000 of the amounts owed to satisfy the wage claims. Months later, the contractor defaulted, and Nova refused to perform based on the diversion of contract funds. The surety did not establish that the remaining contract funds were inadequate to complete the job or that any subs or suppliers were unpaid at the time of default. Nova argued simply that diverting funds from the bonded contract was a breach of the contract and bond that discharged the surety. A majority of the court disagreed, based on a finding of no prejudice because Nova failed to demonstrate increased risk of loss. The two dissenters considered prejudice inevitable under the circumstances and would have discharged Nova. 23 While not expressed, the implication from the majority opinion was that the city, without violating the contract, bond, or law, could have paid the diverted funds to the contractor, which could have paid DOL, and the obligee would not have breached any 22 945 N.Y.S.2d 202, 968 N.E.2d 439 (2012). 23 Id. at 448-451. The dissent characterized the majority decision as inexplicable and stated that the obligee s diversion of contract funds, in violation of the bond and the lien laws, matters a great deal. - 7 -

duties. Instead, the obligee skipped the interim step and paid DOL directly at a time when the surety s future involvement was not apparent. The court did not consider paying the contractor s debt to DOL sufficiently different from paying the contractor itself, so the majority could not justify discharging the surety. Had Nova shown that subs and suppliers were not paid because of the diversion, that proof of prejudice should have changed the result of the case. In Penn National Mutual Casualty Insurance Co. v. City of Pine Bluff, 24 slightly different facts and a full appreciation of the surety s impairment defense led to the opposite result. Although the bonded contractor had been defaulted and left bills unpaid, and despite notice from Penn National to hold any funds otherwise owed, the city obligee reached a settlement with and paid the contractor, or its creditors, almost $2 million. That left the surety facing over $870,000 in payment bond claims that it resolved, with assignment of the claimants rights. Penn National sued, the city defended successfully in the district court, but the Eighth Circuit reversed due to the impairment of the surety s subrogation rights. Citing the Restatement repeatedly, the court of appeals walked through each principle: In contracts for services that include payment in installments or upon completion, unearned progress payments and retainage are security, or collateral, ensuring discharge of the obligations created by the underlying contract. Restatement (Third) of Suretyship and Guaranty 31 cmt. a; Transamerica, 32 Fed. Cl. at 313. Moreover, [t]he surety bond embodies the principle that any material change in the bonded contract, that increases the surety's risk or obligation without the surety's consent, affects the surety relationship. Nat'l Sur. Corp., 118 F.3d at 1544; Hawkins v. Mims, 36 Ark. 145, 1880 WL 1599, at *2 (1880) ( Of course, if the obligee releases any of his securities, or enters into a new contract with the principal, varying the terms of the original agreement... the non-assenting surety will be discharged, for such acts increase the surety's risk. ). By settling with the general contractor and releasing payments and retainage before they are due or not due at all, the obligee increases the surety's risk and impairs the surety's ability to be made whole through subrogation if the surety is later called upon to discharge the underlying obligation. Restatement (Third) of Suretyship and Guaranty 31 cmt. c; see also Kurrus v. Priest, 342 Ark. 434, 29 S.W.3d 669, 676 (2000) ( [W]here collateral which has been pledged to secure the repayment of bonds is removed, then the obligation of the contract between the bondholder and the bond issuer has been impaired ); Myers v. First State Bank, 293 Ark. 82, 732 S.W.2d 459, 461 (1987) (Under Arkansas general suretyship law, a creditor must preserve a surety's right of recourse in collateral.) 24 354 F.3d 945, 953 (8 th Cir. 2004). - 8 -

... If, after appropriate notice of default, the government chooses to pay funds to the general contractor that are or become equitably owed to the surety, the government is liable for the actual loss visited upon the surety. Nat'l Sur. Corp., 118 F.3d at 1548;Transamerica, 32 Fed. Cl. at 314; Restatement (Third) of Suretyship and Guaranty 31 cmt. c. 25 Discharge by impairment is distinct from violation of the surety s equitable subrogation rights. Equitable subrogation does not arise unless the principal is in default so that the surety s obligations under its bonds may be triggered, and courts have required notice by the surety to the obligee if the principal has not yet been defaulted. 26 In contrast, the obligee can discharge the surety by impairing its rights even if the principal is not in default and regardless of any notice from the surety. For example, in National Surety Corp. v. United States, 27 the government released retainage prematurely, thereby depleting the contract funds available to the surety. Citing Section 37 of the Restatement, the court rejected the government obligee s argument that it had no duty to withhold the funds absent notice from the surety: the contract itself required retainage to be held, and the surety was entitled to rely on that provision for its protection. Even the infamous case of Lumbermens Mutual Casualty Co. v. United States 28 recognizes that impairment of the surety s right to contract funds discharges the surety. There, the government overpaid the principal approximately 18% without ever even receiving a schedule of values, progress schedule, or certification of pay requests. While the opinion and result turned on questions of jurisdiction and sovereign immunity, the court had no difficulty acknowledging the surety s right to be discharged by the government s prejudicial actions in disregarding the contract. Without ancillary issues to complicate the analysis, the municipal obligee was required to pay the completing surety amounts previously paid improperly to the contractor in Continental Insurance Co. v. City of Virginia Beach. 29 The contract required inspection of the work before payment, as do most construction contracts, but the city inspector approved payment for defective work and for work not even 25 Id. The court relied heavily on Nat'l Sur. Corp. v. United States, 118 F.3d 1542, 1544 46 (Fed. Cir.1997), and Transamerica Premier Ins. Co. v. United States, 32 Fed. Cl. 308, 313 14 (1994). 26 See National Surety Corp. v. United States, 118 F.3d 1542 (Fed. Cir. 1997); Firemen s Fund Ins. Co. v. United States, 909 F.2d 495 (Fed. Cir. 1990); 27 118 F.3d 1542 (Fed. Cir. 1997). See also Prairie State Nat l Bank v. United States, 164 U.S 227, 17 S. Ct. 142, 41 L. Ed. 412 (1896) (deviating from retainage provision discharged surety). 28 654 F.3d 1305 (Fed. Cir. 2011) (refusing to allow an affirmative recovery by the surety for overpayments under the Tucker Act because of lack of notice as required under equitable subrogation or under the Contract Disputes Act because the surety did not submit its claim to the contracting officer before suing). 29 908 F. Supp. 341 (E.D. Va. 1995). - 9 -

performed, both of which would have been discovered had inspections occurred. The surety had to pay almost $235,000 for work previously paid by the city, and the court awarded that amount to Continental due to such variations in the terms of the contract as will discharge the surety from its obligations. 30 Overpayment by the obligee, involving precise sums that can be shown to have been unearned, is the easiest example of impairment increasing the surety s loss. The strength of the defense, though, depends on the language of the bonded contract defining the risk. If the contract gives the obligee the right to make the overpayment, or requires the obligee to make any payment certified by an architect or inspector, then a court may find the surety undertook that risk when it bonded the contract. 31 The surety should be able to rely, however, on the usual contract language limiting the obligee s duty to pay only for work determined to be completed and conforming. B. Changes Consented and Otherwise Going beyond the contractual payment provisions, any deviation from the contract as bonded has the potential to impair the surety s position. Changes in the amount or type of work, changes in the schedule, changes in how disputes are to be resolved, or any other changes in terms increasing the risk of default or loss affect the bargain the surety struck when bonding the contract. Years ago, even the slightest change in the underlying contract was held to discharge the surety. Nowadays, the surety almost always is asked to consent in advance to changes by the contracting parties under procedures established in the bonded contract. The surety, by the act of issuing a bond containing such terms, waives notice of and consents to changes in the contract. For example, Section 10 of the 2010 AIA A312 performance bond states, The Surety hereby waives notice of any change, including changes of time, to the Construction Contract or to related subcontracts, purchase orders and other obligations. The A311 bond form has similar, albeit briefer, language: The surety hereby waives notice of any alteration or extension of time made by the Owner. 30 Id. at 347. 31 See RLI Ins. Co. v. Indian River School Dist., 556 F. Supp. 2d 356 (D. Del. 2008) (allowing obligee to rely on inspector certifications even though negligent); see also Argonaut Ins. Co. v. Town of Cloverdale, 699 F.2d 417 (7th Cir.1983); Balboa Ins. Co. v. Fulton Co., 251 S.E.2d 123 (1978); Continental Casualty Co. v. Public Building Authority of City of Scottsboro, 381 F.2d 10 (5th Cir.1967). - 10 -

The AGC and CONSENSUSDOCS forms are nearly identical. The standard bonds agree in advance that the principal and obligee can make material changes without notifying the surety or obtaining consent. The right to deviate from the surety s expectations is limited, though, by the cardinal change doctrine. A cardinal change is one outside the contemplation of the parties to the contract at the time of signing and not reasonably anticipated by the surety at the time of issuing the bond. 32 From the surety s perspective, even if the contractor accepted the change, and even if the bond waived notice of normal-course changes in advance, a cardinal change goes so far beyond the surety s reasonable expectations that a court will discharge the bond. The difference must be significant, such as adding work explicitly excluded from the bonded scope, greatly increasing the amount of work (even if commensurately increasing the price), materially changing contract administration (e.g., arbitration instead of litigation, shortening the cure period, etc.), or changing the bonded principal. 33 An excellent summary of the cardinal change doctrine and its applicability to sureties appears in the district court decision in Hartford Casualty Indemnity Co. v. City of Marathon: 34 Initially, the cardinal change doctrine was conceived in the United States Court of Federal Claims. See generally Am. Line Builders, Inc. v. United States, 26 Cl.Ct. 1155, 1177 (Cl.Ct.1992) (providing historical background of the doctrinal development of the cardinal change doctrine). The doctrine was created as a check on the government's ability to circumvent the competitive-bidding process by ordering drastic changes beyond those contemplated in the contract... J.A. Jones Const. Co. v. Lehrer McGovern Bovis, Inc., 120 Nev. 277, 89 P.3d 1009, 1020 (2004); see also L.K. Comstock & Co., Inc. v. Becon Const. Co., Inc., 932 F.Supp. 906, 937 (E.D.Ky.1993) ( The power of the owner, be it a federal agency or a private developer, to order changes is subject to abuse. ). A successful cardinal change doctrine defense serves to relieve a contractor (and its surety) of performance liability when a government entity orders a change to the underlying construction contract that effectively requires the 32 Julia Blackwell Gelinas & Genise W. Teich, Defenses Available to the Surety, Chapt. 11, pp. 599-603, THE LAW OF PERFORMANCE BONDS 2 nd ed. (Lawrence R. Moelmann, Matthew M. Horowitz, Kevin L. Lybeck, eds. ABA 2009). 33 Id. 34 825 F. Supp. 2d 1276, 1285-1286 (S.D. Fla. 2011) (footnotes omitted), rev d in part and vacated in part, Hartford Cas. Ins. Co. v. Intrastate Const. Corp., 501 Fed. Appx. 929 (11 th Cir. 2012). While the cardinal change doctrine has not been adopted expressly in all jurisdictions, it is the overwhelming majority rule. Two federal courts have predicted that Mississippi would not subscribe to the doctrine: Jackson v. Sam Finley, 366 F.2d 148 (5 th Cir. 1966) and Litton Systems, Inc. v. Frigitemp Corp., 613 F. Supp. 1377 (S.D. Miss. 1985). After examining several examples, both courts concluded that Mississippi would enforce a contractual changes clause literally, no matter how unintended, unexpected, or substantial the change. - 11 -

contractor to perform duties materially different from those originally bargained for. Allied Materials & Equip. Co. v. United States, 569 F.2d 562, 563 64, 215 Ct.Cl. 406 (Ct.Cl.1978). Although there is no caselaw in Florida on the cardinal change doctrine, many state and federal courts throughout the nation accept the doctrine as a valid defense in the context of both public and private construction contracts. See generally L.K. Comstock & Co., Inc., 932 F. Supp. at 937 (providing an accounting of the adoption of the cardinal change doctrine in state and federal courts around the country). In addition, courts have acknowledged specifically a surety's prerogative to raise the cardinal change doctrine as a defense to bonding a contract that has been materially altered by the owner and the contractor. See, e.g., United States ex rel. Sun Const. Co., Inc. v. Torix Gen. Contractors, LLC, Case No. 07 cv 01355 LTB MJW, 2009 WL 3348287, at *3 (D.Colo. Oct. 15, 2009) [hereinafter Sun Const. Co. ]; In re Tech. for Energy Corp., 140 B.R. 214, 217 (Bankr.E.D.Tenn.1992); United States v. Seaboard Sur. Co., 622 F.Supp. 882, 887 (E.D.N.Y.1985). In that case, the district court found a cardinal change, discharging the surety, when the city obligee by change order added a second wastewater treatment plant to the principal s contract. A variety of complicating factors, combined with a misapprehension of the effects of the change, led the court of appeals to reverse, but not because the district judge was wrong on the doctrine of cardinal change. 35 C. Breach of the Bond s Conditions The Restatement technically does not include breach of the bond s conditions as impairment of suretyship, which Section 37 defines as the obligee s conduct affecting the principal, the bonded contract, or collateral such as contract funds. However, the general language of subsection (1) is more inclusive than subsections (2) (4): An act that increases the secondary obligor s [surety s] risk of loss by increasing its potential cost of performance or decreasing its potential ability to cause the principal obligor to bear the cost of performance is an impairment of suretyship status. When the bond establishes rights belonging to the surety directly (as contrasted with those arising under the bonded contract), violation of those rights certainly increases the surety s risk as described in Section 37. 35 For an in-depth discussion, see Gregory R. Veal, Better a Friendly Refusal than an Unwilling Consent: Surety Consent to Changes and Effect on the Penal Sum, unpublished paper, 24 th Annual Southern Surety & Fidelity Claims Conference (2013). - 12 -

For example, in L&A Contracting Co. v. Southern Concrete Services, Inc., 36 the standard form bond required, as a condition of the surety s obligation, that the principal be and be declared to be in default. Because the obligee never clearly declared the principal to be in default, it never triggered the surety s obligation and could not recover under the performance bond. The court recognized the importance of a clear declaration of default: Serious legal consequences attend a declaration of default, particularly in cases such as this case involving multi-million-dollar 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. 37 Put in Restatement terms, without a declaration of default, action by the surety runs the risk of decreasing its potential ability to cause the principal obligor to bear the cost of performance by giving the principal a potential defense under the indemnity agreement and possibly a claim for tortious interference. Another example of impairment is conduct by the obligee that strips the surety of its right to complete or choose among the options for responding to a bond claim. In St. Paul Fire & Marine Insurance Co. v. City of Green River, 38 the city refused St. Paul s election to complete using the principal s employees, and the court discharged the surety: The effect of the Board's termination of St. Paul was to divest St. Paul of its ability to minimize its liability by selecting the lowest cost option and by directing the construction or participating in the contractor selection process. Courts have consistently held that an obligee's action that deprives a surety of its ability to protect itself pursuant to performance options granted under a performance bond constitutes a material breach, which renders the bond null and void.... Because the Court concludes that St. Paul would not have entered the performance bond in the absence of its performance options under Paragraph 4, the Board's action depriving St. Paul of those options was a material breach, which discharged St. Paul from any further duty of performance under the bond. Where a surety has issued its bond on the condition that it is allowed to choose how to complete, an obligee s breach of that condition increases the surety s risk of loss by 36 17 F.3d 106 (5 th Cir. 1994). 37 Id. at 111. 38 93 F. Supp. 2d 1170, 1178-1179 (D. Wyo. 2000), aff d 6 F. App x 828 (8 th Cir. 2001) (footnotes omitted). - 13 -

increasing its potential cost of performance. 39 Breach of the bond fits perfectly into the Restatement s description of impairment of suretyship status, although not spelled out in later subsections. D. Release of the Principal Section 39 of the Restatement addresses the effect of the obligee s release of the principal. It is a compromise between the views of the financial community and the surety industry and therefore the uneasy result of trying to state one legal rule equally applicable to both. 40 Conforming the terminology to contract suretyship, Section 39(b) and (c) state: To the extent that the obligee releases the principal from its duties pursuant to the bonded contract: (b) the surety is discharged from any unperformed duties pursuant to the bond unless: (i) the terms of the release effect a preservation of the surety s recourse ( 38); or (ii) the language or circumstances of the release otherwise show the obligee s intent to retain its claim against the surety; (c) if the surety is not discharged from its unperformed duties pursuant to the bond by operation of paragraph (b), the surety is discharged from those duties to the extent: (i) of the value of the consideration for the release; (ii) that the release of the duty to pay money pursuant to the bonded contract would otherwise cause the surety a loss; and (iii) that the release discharges a duty of the principal other than the payment of money.... Subsection (b) essentially allows the obligee to reserve its rights against the surety if it does so explicitly (or if it preserves the surety s rights against the principal, which therefore remains liable through its indemnity obligations). 39 RESTATEMENT (3D) OF SURETYSHIP AND GUARANTY, 37(1). See also Fidelity & Deposit Co. of Md. v. Jefferson County Comm n, 756 F. Supp. 2d 1329 (N.D. Ala. 2010) (obligee s rejection of surety s election for completion discharged surety). 40 James A. Black and T. Scott Leo, Chapt. IV, Suretyship Defenses, The Restatement of Suretyship and Guaranty: A Translation for the Practitioner 56 (T. Scott Leo and Daniel Mungall, Jr., eds., ABA 2005). - 14 -

Subsection (c), though, limits the rights that the obligee can reserve. Even with a reservation of rights by the obligee, releasing the principal releases the surety to the extent of the value given by the principal for its release, to the extent that the release of the principal s duty to pay prejudices the surety, and to the extent that the principal is discharged from any duty other than the payment of money. The obligee cannot recover twice, cannot increase the surety s obligation, and cannot strip the surety of the principal s duty to perform (beyond the payment of money). 41 Given the lack of case law, obligees likely do not often attempt to release the principal and still reserve rights against the surety, but the Restatement avoids the worst potential results of such an attempt. III. The Extent of the Remedy for Impairment A. Complete Discharge Section 37(2) provides for a total discharge of the surety if the bond obligation is fundamentally altered by either a change to or release of a principal s performance duty. No showing of prejudice is required in such cases, but what is fundamental to the undertaking will be subject to the court s view of the facts. An example is Southwood Builders, Inc. v. Peerless Insurance Co. 42 The obligee advanced unearned funds to enable the principal to accelerate the work, but the process excluded the architect from inspecting the work, allowed the principal to misrepresent the quantity of stored materials, and ultimately led to default. Under Virginia law, the surety was discharged without having to quantify the amount of prejudice, which clearly extended beyond just the overpayments. A separate showing of prejudice to the surety is unnecessary because a material deviation, in itself, establishes sufficient prejudice. See Stearns 6.3. In this case, the material deviation is established by proof that the subcontractor was paid money before it was due and without approval by the architects. Such a procedure diminishes funds that should have been available to the surety in case of default, eliminates the architects' assurance that payments to the contractor are being used for the job, and undermines the inducement to the contractor to finish the work on schedule in order to be paid. 43 To obtain a complete discharge, the surety must be prepared to explain how the change or release the variance from its reasonable expectations altered its undertaking in a fundamental way. The consequences of prepayment, overpayment, modifications, and other obligee conduct can ripple through a construction project, as demonstrated in 41 See Kiski v. Mid-State Surety Corp., 967 A.2d 368, 373 (Pa. 2008) ( the Restatement states that there can be no reservation where the owner releases the contractor from performance ). 42 366 S.E.2d 104 (Va. 1988). 43 Id. at 108. - 15 -

Southwood Builders. In such cases, the unquantifiable increase in the surety s risk supports a complete discharge. B. Pro Tanto Discharge More commonly, the principal and surety s obligations are not fundamentally altered, but the risk may increase nonetheless. The Restatement, in subsection 37(3) and those cited therein, contemplates a pro tanto discharge to the extent of the prejudice in those cases. In particular, most courts are reluctant to go beyond a pro tanto discharge due to payment irregularities, perhaps because the amount of the improper payments can be quantified exactly. While such a limited consideration of the prejudice to the surety ignores many of the negative consequences of improper payments (noted in Southwood Builders), pro tanto discharge is far more common than complete discharge. Courts tend to overlook subsection 37(2) of the Restatement, with its standard of fundamentally alters, and instead consider the pro tanto discharge of subsection 37(3) to be the modern rule. 44 Even where courts acknowledge the surety s risk has been increased so that the bond should be discharged to the extent of the prejudice, their view of the degree of prejudice often is very narrow. In Mergentime Co. v. Washington Metropolitan Area Transit Authority, 45 the principal and obligee materially altered the payment provisions of the contract as bonded by a memorandum of agreement. The court relied on the former Restatement of Security, 128(b), for the proposition that any discharge should be pro tanto only. Although the former Restatement distinguished material alterations from those that only caused the surety a loss, even that section s comment states, The compensated surety, however, should not be held to his obligation if the creditor and principal have so modified the contract as to impose a risk of loss substantially different from the one covered by his obligation. If the change imposes a danger of loss upon the surety which cannot fairly be measured, the surety is discharged entirely. 46 Despite quoting this proviso, the court refused to consider payment irregularities important enough to result in a complete discharge of the bond. Fundamentally, even the pro tanto discharge rule can be applied to reach a complete discharge if the record supports sufficient prejudice. The surety must be able to demonstrate the negative effects of whatever changed on the job or between the principal and obligee that was beyond the surety s contemplation at the time of bonding. The obligee s failure to inspect the work as it is being done, for instance, can result in 44 See, e.g., National Union Indemnity Co. v. G.E. Bass Co., 369 F.2d 75, 77 (5 th Cir. 1966). 45 775 F. Supp. 14 (D.D.C. 1991). 46 Id. at 20-21, quoting RESTATEMENT OF SECURITY, 128(b), cmt. f. See also North American Specialty Ins. Co. v. Chichester School Dist., 2000 WL 1052055 (E.D. Pa. July 20, 2000). - 16 -

failure to discover and mitigate substantial defective work that the principal cannot remedy. Allowing the principal to violate the project schedule not only deprives the surety of completion time but also may affect the availability of the intended subcontractors and suppliers, exacerbating the completion costs. Each default will come with its own facts, but the surety soon will discover whether or not the obligee departed from the contract terms to an extent justifying either a complete or a pro tanto discharge. IV. The Burden of Persuasion on Impairment Equally important as the standard for discharge is where the burden of persuasion rests. The Restatement also addresses this question; Section 49 (translated) provides: (1) A surety asserting discharge from a bond due to the obligee's impairment of the surety s suretyship status ( 37) has the burden of persuasion with respect to the occurrence of the act constituting the impairment. (2) Except as provided in subsection (3), the burden of persuasion with respect to loss or prejudice caused by an obligee's act impairing the surety s recourse against the principal obligor is allocated as follows: (a) the burden of persuasion is on the surety if: (i) the surety is in the business of entering into bonds, received a business benefit for entering into the bond, or otherwise was induced to enter into the bond by separate consideration that directly benefits the surety; or (ii) the act impairing recourse is a modification of the bonded contract, unless the surety establishes that the modification is material; (b) otherwise, it is presumed that the act impairing recourse caused a loss of impairment equal to the surety s liability pursuant to the bond and the burden of persuasion as to the nonexistence or lesser amount of such loss is on the obligee. (3) Notwithstanding subsection (2)(a), if: (a) the surety demonstrates prejudice caused by the impairment of recourse; and - 17 -

(b) the circumstances of the case indicate that the amount of loss is not reasonably susceptible of calculation or requires proof of facts that are not ascertainable, it is presumed that the act impairing recourse caused a loss or impairment equal to the surety s liability pursuant to the bond, and the burden of persuasion as to any lesser amount of such loss is on the obligee. The surety must show conduct by the obligee constituting an impairment of suretyship status. If the surety is compensated, it also must show the extent of prejudice unless, as stated in subsection (3)(b), the type of prejudice makes the amount unreasonably difficult to quantify or demands proof that is not available. In those two situations, the obligee must show that the surety s prejudice is less than the total claim, i.e., less than a complete discharge is proper. An example of the importance of allocating the burden of persuasion is Will H. Hall & Son, Inc. v. Ace Masonry Construction, Inc. 47 The basis for the discharge argument in that case was the obligee s release of the bonded subcontractor just after the surety received a directed verdict in its favor. Sadly, that favorable directed verdict was reversed. On remand, the surety argued that the release of its principal discharged the surety, and the court agreed. The record contained no indication of whether the release included a reservation of rights against the surety, so the court presumed no such rights were reserved. The dissent argued the surety had the burden to establish that the obligee failed to reserve its rights under the bond and that, in the absence of such evidence, the release should not discharge the surety. Referring to Section 49 of the Restatement, the dissent asserted the surety s burden of persuasion: It was open to Capitol [Indemnity], before moving for summary disposition, to have taken depositions of persons involved in the release, and otherwise knowledgeable regarding Ace and Hall, with a view to establishing that there was no language nor were there circumstances evidencing an intent by Hall to retain its claim against Capitol, and that Ace was solvent and that the release caused loss or prejudice to Capitol. Because Capitol did not so claim or show in moving for summary disposition, genuine issues of material fact remained unaddressed on the summary disposition record, and it was error to grant summary disposition. 48 The outcome may well be determined by who has the burden of persuasion on issues of prejudice, and the Restatement generally places that burden on the surety. Fortunately 47 677 N.W.2d 51 (Mich. App. 2003). 48 Id. at 64. - 18 -

for Capitol Indemnity, the majority did not impose the burden regarding the possibility of a reservation of rights or of a lack of prejudice to the surety resulting from the obligee s release. CONCLUSION Contract suretyship involves risks, defined principally in the bonded contract and the bond. The surety reasonably expects that its liability will fall within those risks and will not be altered to its prejudice without its consent. Under the Restatement, impairment of suretyship status resulting in material prejudice entitles the surety to be discharged, in whole or in part, depending on the degree of prejudice and the burden of persuasion. These general principles, though, require full development of the facts in each particular case to avoid the risk that a court will fail to vindicate the surety s rights. Gregory R. Veal - 19 -