TWENTY-SIXTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS CONFERENCE APRIL 23-24, 2015

TWENTY-SIXTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS CONFERENCE APRIL 23-24, 2015 LOSS CONTROL STRATEGIES FOR THE SURETY PRIOR TO FORMAL NOTICE OF DEFAULT OR TERMINATION TAMMY N. GIROUX, ESQUIRE Shumaker, Loop & Kendrick, LLP 101 E. Kennedy Boulevard, Suite 2800 Tampa, Florida 33602 CHERIE RONDINELLI Senior Claims Examiner II Amtrust Group 100 Second Avenue South, Suite 704 South St. Petersburg, Florida 33701

LOSS CONTROL STRATEGIES FOR THE SURETY PRIOR TO FORMAL NOTICE OF DEFAULT OR TERMINATION I. INTRODUCTION This paper provides an overview of loss control strategies a surety can employ in situations where a surety has received a notice of material breach of a contract by the contractor, or notice of its principal s inability to complete, but the owner of the project has not yet issued a formal default of the contractor or a formal notice of termination of the contract. 1 Situations arise where an owner may be seemingly dissatisfied with the contractor even from the inception of physical construction work on a project and yet the owner never declares the contractor in default under the contract or never terminates the contract. The owner may declare the contractor in material breach of the contract in order to preserve a date from which damages can accrue, but simultaneously refrain from declaring a formal default or issuing a formal termination of the contract. In those situations, the contractor continues as the contractor of record on the project. In addition, situations may arise where the contractor the principal on the surety s bond seeks financial assistance from the surety so that the contractor can complete its contractual scope of work. The surety should evaluate numerous factors from a loss control perspective when the surety s role on a project initially commences at the request of its principal, and not at the request of the owner. II. THE SURETY S INVESTIGATION A. Determine Status of the Project, Any Communicated Breaches of Contract or Any Communicated Performance Issues Many important issues exist from the surety s perspective if a bonded construction project has reached a point where the owner and the general contractor (or a subcontractor) have reached an impasse of sorts, even in the absence of a formal default or formal termination of the construction contract. Occasions arise where an owner will allow the contractor to continue as the contractor of record even though the owner has notified the contractor that the contractor is in material breach of the construction contract. Depending on the form of the bond, the owner may not be 1 For an in depth discussion of performance options available to the surety both prior to and after notice of default, see Charles W. Langfitt, Bennett J. Lee, and Robert C. Niesley, Performance Options Available to the Surety, in THE LAW OF PERFORMANCE BONDS, 2D ED. 59-160 (Lawrence R. Moelmann, Matthew M. Horowitz & Kevin L. Lybeck, eds. 2009). 2

required to notify the surety of the breach or the purported issues plaguing the progression of the construction project. 2 If the project is suffering from purported performance issues, then the surety will likely receive payment bond claims, even in the absence of communication provided by the owner or the contractor. In some circumstances, the contractor will provide regular updates to its surety, including information regarding potential problems with ongoing construction. In addition, in some circumstances, the contractor will contact the surety and request financial assistance completing the contractor s scope of work on the project. Under all scenarios, the surety should immediately undertake a comprehensive investigation. The surety must ascertain the status of completion of the project, the status of payments and claims on the project, the factual basis for any breach of contract claimed by the owner, the existence or non-existence of claims against the owner for breach of contract, the likelihood of the owner declaring the contractor in default, and the likelihood of the owner terminating the contract. In addition, the surety must evaluate its principal, in terms of other bonded and non-bonded work, and potential issues or concerns on other projects. The surety, once informed on the critical and time sensitive issues, should focus on loss control strategies that will result in a completed project, but also mitigate the surety s exposure to damages if the surety is called upon to fulfill its bond obligations. 3 B. Review the Contract, the Bond and Key Project Documentation In connection with its investigation, the surety will need access to not only its own files, but also those of its principal, and preferably the owner. The surety will review the contract, the bond and all key project documentation. There are various bond forms, and a discussion of those bond forms exceeds the scope of this paper; however, the surety must review the form of the bond in connection with its review of the contract documentation in order to best position itself for loss control strategies. 4 2 Some courts have held that even where the bond does not require notice of default, the obligee may not delay before notifying the surety and then insist the surety's liability includes escalated costs arising between default and demand. See, e.g., Continental Bank & Trust Co. v. American Bonding Co., 605 F. 2d 1049, 1057 (8th Cir. 1979); Blackhawk Heating & Plumbing Co., Inc. v. Seaboard Sur. Co., 534 F. Supp. 309, 315 (N.D. Ill. 1982) ( to the extent that Seaboard could have remedied the delays, and thereby avoided the additional costs, if it had been given an opportunity to do so, Seaboard is not liable to Blackhawk for such delays. ); Sys. Components Corp. v. FDOT, 14 So. 3d 967, 982 (Fla. 2009) (holding that party does not actually have a duty to take any particular action, but a party is prevented from recovering damages that could have reasonably been avoided). Case law supports a contention that an owner is not permitted to sit back, remain silent, and run up its damages claim with the intent of recovering an inflated claim against the performance bond. 3 For additional discussion of the surety s handling of performance bond claims, see George J. Bachrach, A Primer for the Surety s Handling of Performance Bond Claims (unpublished paper submitted at the Nineteenth Annual Northeast Surety and Fidelity Claims Conference, September 18-19, 2008). 4 For a more in depth discussion of the varying types of bonds, see Thomas J. Vollbrecht and Jacqueline Lewis, Creation of the Relationship, in THE LAW OF PERFORMANCE BONDS, 2D ED. 1-20 (Lawrence R. Moelmann, Matthew M. Horowitz & Kevin L. Lybeck, eds. 2009). 3

Initially, the surety will review and analyze the critical provisions of the construction contract governing substantial completion, final completion, payment applications, change order processing, time extension procedures, damages, and conditions precedent for submittal of final payment. The surety will want to determine the percentage of completion of the project, the remaining scope of work to be performed, and the status of pending payment applications. Furthermore, the surety will analyze the contractor s ability to complete the project with its current personnel and subcontractors, if the surety elects to provide financial assistance. As mentioned above, the surety s investigation particularly in a financing situation should include an evaluation of the principal s other bonded and non-bonded work, receivables and payables, and ability to post collateral. The surety must carefully review the bond form utilized on the project. If the bond form is an indemnity bond, for example, then the performance bond will obligate the surety to indemnify the owner from any loss suffered by the owner arising out of the contractor s breach of contract. Many bond forms set forth the surety s options, one of which often is the ability to complete using the contractor or a new contractor, following a notice of default or termination. In the performance bond, the construction contract is often referenced in a prefatory WHEREAS paragraph; however, the surety s performance obligation under the bond is also identified and defined. The mere incorporation of a construction contract into a bond should not modify the express obligation and conditions of the bond. Surety bonds should be treated like any contract, and construed according to the terms set forth therein. 5 In all circumstances where the surety s involvement on a project commences at the request of the contractor, and not the owner, the surety should be sensitive to arguments that could be raised later, including but not limited to, the following: (i) the surety failed to clearly inform the owner of its role on the project, and the owner then asserts claims against the surety under theories of volunteer, alter ego or domination; (ii) the surety became a volunteer with regard to completion even where the performance bond does not expressly require completion; and (iii) the surety acquiesced to obligations beyond the scope of its performance bond. In addition, the surety must review and carefully consider whether an owner could or would interfere or refuse to cooperate, thereby creating a situation where the surety is precluded from efficiently facilitating contractual conditions precedent, especially with regard to seeking final payment. 5 See, e.g., American Home Assurance Co. v. Larkin General Hospital, Ltd., 593 So. 2d 195, 197 (Fla. 1992) (noting that Florida courts have long recognized that the liability of a surety should not be extended by implication beyond the terms of the contract, i.e., the performance bond); United States Fidelity & Guaranty Co. v. Gulf Florida Development Corp., 365 So. 2d 748, 751 (Fla. 1st DCA 1978) (holding the terms of the bond control the liability of the surety); 4A Bruner & O'Connor Construction Law 12:18 (citing Quinn Const., Inc. v. Skanska USA Bldg., Inc., 2008 WL 5187391 (E.D. Pa. 2008) (construing liability under an indemnity subcontract bond that required the subcontractor and its surety to indemnify and hold harmless [contractor and owner] from any loss, liability, cost, damage, or expense, including attorney's fees, by reason of the failure of performance as specified )). 4

In undertaking the review of the status of completion of the project, the contractor or surety may conclude that the contractor substantially performed the contract given that it delivered to the owner a project that was substantially performed such that the building could be occupied by tenants and put to use for its intended purpose. The surety will need to review the contract and bond for the contractual provisions governing substantial completion and final completion. Where a contractor has substantially performed a contract between the parties, some jurisdictions may recognize that the contractor is entitled to payment of the full contract price diminished only by damages which the owner has suffered as a result of such contract breaches, as may be established by competent evidence. 6 C. Select Consultants and Attorneys The surety may handle the investigation in-house, or the surety may require the assistance of a consultant and outside counsel. The surety often does not have resources in-house to dedicate to the comprehensive investigation, or to allocate to oversight of the day-to-day operations of a construction project. Thus, the surety often retains a consultant to assess (i) the status of the project and the percentage of completion, (ii) the contractor s ability to complete construction if the surety provides financing assistance, (iii) delays, if any, to the project, and claimed damages, (iv) claims of incomplete or defective work, (v) the contractor s claims for pending change orders, (vi) payment applications and pending contract balances, (vii) the contractor s overall financial stability, and (viii) related issues. The consultant customarily serves as the eyes and ears of the surety. 7 In a financing situation, the consultant often monitors payments made pursuant to a collateral assistance agreement, the work performed directly by the contractor or through subcontractors, and the ongoing progression toward completion of the construction. In addition to a consultant, the surety often retains outside counsel to assist with the review and analysis of the claim and damage exposure. 6 See, e.g., Fleming v. Urdl s Waterfall Creations, Inc., 549 So. 2d 1057 (Fla. 4th DCA 1989); Berkowitz v. Anderson & Wallace Construction Co., Inc., 260 So. 2d 551 (Fla. 3d DCA 1972) (holding contractor entitled to payment for the proportion of the contract performed, but with a set-off to owner for defects in the work). Substantial performance is typically a question for the trier of fact, although a court may determine the issue as a matter of law if it is sufficiently clear from the evidence. See, e.g., Grant v. Wester, 679 So. 2d 1301 (Fla. 1st DCA 1996). 7 When the consultant acts as the functional equivalent of the surety s employee, some jurisdictions have acknowledged that the communications between the consultant s employees and the surety, or the surety s outside counsel, will be protected as attorney-client privileged communications; however, the communications may not be privileged if they do not deal with issues that have legal ramifications or are seeking advice that has legal implications. The following factors are considered by courts when deciding whether an independent contractor was the functional equivalent of an employee : (i) whether the consultant had primary responsibility for a key corporate job; (ii) whether there was a continuous and close working relationship between the consultant and the company's principals on matters critical to the company's position in litigation; and (iii) whether the consultant is likely to possess information possessed by no one else at the company. See, e.g., American Manufacturers Mutual Ins. Co. v. Payton Lane Nursing Home, Inc., 2008 WL 5231831 (E.D. N.Y. Dec. 11, 2008). 5

From a loss control perspective, the surety should proceed with caution in order to minimize its exposure to after-the-fact arguments by the owner such as (i) the surety took control of the project and became a volunteer, (ii) the surety acted in self-interest and failed to properly or timely undertake to complete purported defective or incomplete items, and (iii) the surety focused on minimizing funds spent on a project failed to fulfill the obligations of the contract and bond. III. Preparation and Use of a Loss Analysis In a financing situation, or one where the surety anticipates a loss under the payment and performance bonds, the surety often directly, or through its consultant, performs what is commonly referred to as a loss analysis. The surety will need the cooperation of its principal, and access to project records and key project personnel. In a loss analysis, the surety reviews and analyzes sometimes specific to one project and other times inclusive of all bonded and non-bonded projects the overall financial status of the bonded contractor, including but not limited to, a review of the receivables, payables, contract balances, approved change orders, pending change orders, payment applications submitted, paid or pending, percentages of completion, asserted claims by any party, the remaining scope of work to be performed, and the estimated cost of remaining scope of work. If the owner has asserted claims, the surety will identify any damages quantified to date, or will estimate the range of potential damage exposure. If the contractor has asserted claims, the surety will identify the corresponding actual or approximated amounts. If the contractor has not yet asserted claims, but the surety intends to so assert on behalf of its principal, the surety will identify the corresponding approximated amounts. The surety uses this analysis for many purposes, including its evaluation of a contractor s request for financial support. Once the data is gathered, the surety can better assess the likelihood of recovering contract balances versus the likelihood of advancing payments for completion without any recovery of funds from owners on projects. The applicable contract(s) may allow the owner to effectuate an offset for claimed damages, such as claimed damages for delay. In addition, the applicable contract(s) may allow the owner to hold back a certain percentage of contract balances for the completion of claimed incomplete or defective work. The written loss analysis provides an illustration of the potential gains or losses on a project. As mentioned above, the surety often utilizes its surety consultant to prepare the loss analysis. Since this analysis is often performed early in the surety s involvement on a project, or prior to the surety agreeing to provide financing assistance to its principal, the loss analysis may be subject to further refinement and development. If the facts warrant, the surety should seek to protect the loss analysis under an attorney-client or work product privilege. In addition, the document itself should include qualifying language illustrating that the analysis is preliminary, is intended solely for the surety s review and internal use, and was prepared in connection with matters that may be critical to the surety's ultimate positions in litigation. 6

Preparation of the loss analysis and maintenance of the same in the books and records of the surety s consultant could potentially expose the analysis to production to the opposing party if litigation commences. If a court were to view the consultant as an entity providing only construction management services versus the functional equivalent of an employee of the surety, then an owner could seek to compel production of the surety s early loss analysis. IV. Surety s Performance Options Prior to Formal Notice of Default or Termination In general, after formal declaration of default, the surety has several performance options. 8 Most options are triggered when the owner formally declares a default or terminates the contract, and communicates a performance bond claim. 9 However, occasions arise where a surety s involvement commences prior to formal default or termination. In those situations, a surety will evaluate performance options in connection with loss control strategy decisions, and the most common options are (i) financing the principal, or (ii) accepting an assignment of the bonded contract(s) from the principal or facilitating the assignment of a bonded contract from the principal to a third party contractor. 10 A. Financing the Principal A surety s principal may experience temporary or permanent financial difficulty while bonded projects are ongoing. The surety may evaluate financing its principal in order to prevent a formal default or termination from occurring. 11 When a principal requests financing assistance from its surety, the surety initially evaluates whether the project is at or near completion, whether the contractor has remaining personnel for oversight of completion, and whether the contractor has maintained a good working relationship with the subcontractors essential to facilitating completion. 12 If the decision is made to provide financing assistance, the surety should then memorialize the agreement in a document often identified as an Assistance and Collateral Agreement, or more simply an Assistance Agreement. The surety documents that it is acting out of a legal obligation, and not as a volunteer. In addition, the surety often requires the principal to execute voluntary letters of default for each 8 See supra fn. 1, for in depth discussion and analysis of the surety s various performance options when an owner has declared a default takoever, tender, financing, obligee completion, buy-out and denial of the claim. 9 For a discussion of conditions precedent to asserting a performance bond claim under various bond forms, see Benjamin D. Lentz and Kim McNaughton, Conditions Precedent to Asserting a Performance Bond Claim, in THE LAW OF PERFORMANCE BONDS, 2D ED. 21-56 (Lawrence R. Moelmann, Matthew M. Horowitz & Kevin L. Lybeck, eds. 2009). 10 See supra fn. 1, at 154-160. 11 See supra fn. 1, at 90, fn 38, for a detailed list of books, articles and papers that discuss the surety s financing of its principal option. 12 See Id. at 95-98. 7

project, and the surety then holds the letters in escrow and utilizes the letters only if deemed necessary at some later date. Both the surety and the principal should notify the owner(s) of this development, and direct the owner(s) to remit all further payments under the contract(s) to the attention of the surety. There are benefits to a surety financing the principal, such as the elimination of costs and delays associated with hiring a new contractor, and the timely preservation of claims that the contractor may have against the owner. 13 However, there are many detriments and dangers, and the surety should proceed with caution. 14 The surety should evaluate the effect of financing on its subrogation rights, since the surety s subrogation rights may be challenged if the surety elects to finance absent a formal default or termination by the owner. 15 In Florida, for example, the right of equitable subrogation is defined as the substitution of one person in the place of another with reference to a lawful claim or right. 16 The Supreme Court of Florida explained the breadth of a performance bond surety's right of equitable subrogation in Transamerica Insurance Company v. Barnett Bank of Marion County, N.A., 17 providing that:... the surety in cases like this undertakes duties which entitle it to step into three sets of shoes. When, on default of the contractor, it pays all the bills of the job to date and completes the job, it stands in the shoes of the contractor insofar as there are receivables due it; in the shoes of the laborers and material men who have been paid by the surety who may have had liens; and, not least, in the shoes of the government, for whom the job was completed. Consistent with Transamerica, courts across the country have held that a surety that performs its obligations under a performance bond is subrogated to the rights of the obligee, as well as the rights of its principal, including the obligee s rights to the bonded contract funds. 18 In addition, a surety who finances its principal is deemed a performing surety even if the contractor has not formally been declared in default by the obligee, the contractor s bonded contract has not been terminated by the obligee, or the surety has not assumed primary responsibility for the completion of the bonded contract. 19 The surety and principal, in the assistance and collateral agreement, can identify the de facto default where the principal was unable to fulfill its obligations under the bonded contract and the surety agreed to provide financing assistance in order to facilitate 13 See Id. at 90-92. 14 See Id. at 92-95, 154-158 15 See Id. at 99-101, 154-158. 16 See, e.g., In re Cone Constructors, Inc., 265 B.R. 302, 306 (M.D. Fla. 2001) (citation omitted). 17 Transamerica Insurance Company v. Barnett Bank of Marion County, N.A., 540 So. 2d 113,115-16 (Fla. 1989). 18 See, e.g., National Fire Insurance Co. v. Fortune Construction Co., 320 F. 3d 1260 (11th Cir. 2003); Mass. Bonding & Ins. Co. v. New York, 259 F. 2d 33 (2d Cir. 1958). 19 See, e.g., Aetna Casualty and Surety Co. v. United States, 845 F. 2d 971 (Fed. Cir. 1988); Great American Insurance Company v. United States, 481 F. 2d 1298 (Cl. Ct. 1973). 8

completion of a project. Moreover, no distinction exists between a performing surety that discharges its obligations by taking over and completing a project, and one that finances its contractor in order to allow its contractor to complete the project. 20 By providing a contractor with financing assistance prior to a formal default, a surety minimizes the delay in completion of the project and protects the interests of the contractor, obligee, and the surety. 21 An owner, however, may argue that the surety is not entitled to subrogation; however, the surety can argue that a surety's right of equitable subrogation arises at the time of the suretyship agreement, not later. 22 In addition, any requirement for a surety to fully perform before invoking its subrogation rights only arises when facts demonstrate that full performance is necessary to prevent the surety from competing with the owner s rights against the contractor. 23 Furthermore, there is an exception to a requirement for full performance by the surety if the owner has engaged in prejudicial conduct toward the contractor. 24 For all the reasons discussed above, if the surety decides to finance its principal prior to a declaration of default by an owner, the surety should finalize and execute a carefully prepared financing, assistance and control agreement just as the surety would if it was agreeing to provide financing after a default had been declared. The agreement should memorialize the principal s inability to complete its bonded obligations, in order to best protect and preserve the surety s subrogation rights. B. Assignment of Bonded Contracts Another option utilized by a surety in a pre-formal default situation is to accept an assignment of the bonded contract(s) from the principal, or to facilitate the assignment of bonded contract(s) from the principal to a third party contractor. 25 In this situation, the surety negotiates with not only its principal, but also the owner. Here, the surety takes over completion of the work without a formal termination. Typically, the surety arranges for the project to be completed by a licensed completion contractor. This option is utilized most often where the construction work has not commenced or is in its initial phases, or where the work is substantially complete or approaching substantial completion. 26 However, the assignment of the bonded contract(s) may be subject to an anti-assignment clause in the construction contract, so again, the surety must review the contract carefully when evaluating the loss control strategy options, and determine if consent and approval of the owner is required. 20 See, e.g., Morgenthau v. Fidelity and Deposit Company of Maryland, 94 F. 2d 632 (D.C. Dir. 1937). 21 See Morrison Assurance Company, Inc. v. United States, 3 Cl. Ct. 626 (1983). 22 See Travelers Cas. & Sur. Co. of Am. v. Colonial Sch. Dist., 2001 WL 287482, at *3 (Del. Ch. Mar. 16, 2001). 23 Id.; RESTATEMENT (THIRD) OF SURETYSHIP AND GUARANTY 27 cmt. B. See also, Transamerica Ins. Co. v. Barnett Bank of Marion Cnty., N.A., 540 So. 2d 113, 115 (Fla. 1989). 24 Travelers Cas. & Sur. Co. of Am., 2001 WL 287482, at *3; RESTATEMENT (THIRD) OF SURETYSHIP AND GUARANTY 27(2). 25 See supra fn. 1, at 158-160. 26 Id. 9

The surety may be able to facilitate the assignment directly from the principal to the third party contractor. The surety usually simultaneously seeks to assume the right to receive payments from the owner. The surety can select and hire a new construction company to serve as the general contractor, and often also hires its own surety consultants to oversee and manage the project on behalf of the surety. Given the likelihood of additional expenses, the surety will often incur a loss by the time the project concludes. However, when utilized in a pre-default notice situation, the surety may be able to hold the principal s subcontractors to the pricing stated in the original subcontracts, thereby avoiding increases in pricing. Thus, based on the foregoing, the benefit to this option is that the surety may be able to minimize and control costs and damages in comparison to other performance options. The surety should always proceed with caution, especially if the situation involves the issue of anti-assignment clauses or uncooperative owners. V. CONCLUSION As discussed, the surety may be faced with performance obligations even when its principal has not received a formal declaration of default or termination. The surety must proceed with caution, but proceed timely and efficiently. The surety must carefully consider all factual and legal consequences of its options and choices. 10

About the Authors Tammy N. Giroux is a partner in the Surety & Fidelity Practice Group at Shumaker, Loop & Kendrick, LLP in Tampa, Florida. Ms. Giroux obtained her B.S. in Finance, cum laude, from Florida State University, and her J.D., cum laude, from Stetson University College of Law. Ms. Giroux practices extensively in the area of surety and fidelity claims and commercial litigation. Cherie Rondinelli is a Senior Claims Examiner II for Amtrust Group, based out of St. Petersburg, Florida. Ms. Rondinelli obtained her B.A. in History from William Jewell College and her MBA from the University of Phoenix. Ms. Rondinelli also holds two insurance designations - an INS series and an ARe. She has practiced extensively in the area of surety claims for 22 years. TAMMY N. GIROUX, ESQUIRE CHERIE RONDINELLI Shumaker, Loop & Kendrick LLP Senior Claims Examiner II 101 East Kennedy Blvd., Suite 2800 Amtrust Group Tampa, Florida 33602 100 Second Ave. S., Suite 704 South (813) 227-2327 St. Petersburg, Florida 33701 tgiroux@slk-law.com Cherie.Rondinelli@amtrustgroup.com www.slk-law.com SLK#2280077v3 11