You Have to Be Kidding Me!

You Have to Be Kidding Me! What Is the Extent of the Performance Bond Obligee s Obligations to the Surety? David D. Gilliss Pike & Gilliss LLC 600 Washington Ave Ste 303 Towson, MD 21204 Bruce W. Kahn Berkley Surety Group 412 Mt. Kemble Ave Ste 310N Morrristown, NJ 07960

David D. Gilliss is a founding member of the law firm of Pike & Gilliss, LLC located in Towson, Maryland. His practice focuses on surety, construction, and fidelity related claims on behalf of sureties, contractors, and fidelity carriers. His practice also includes litigation of general commercial and regulatory claims and administrative actions. Mr. Gilliss co-authored Surety Bonds and Insurance in the Construction Industry, Arbitration of Construction in Commercial Cases and Maryland Construction Law: What Do You Do When and has written numerous articles and papers on surety, fidelity and construction-related issues. Bruce W. Kahn is a commercial attorney whose practice focuses on the construction, surety, and real estate industries. He presently heads the claims department as a vice president at Berkley Surety Group, a W.R. Berkley Company. He is a graduate of Albany Law School and he also holds a master of business administration degree from Cornell University s S.C. Johnson School of Business. The authors would like to thank Alexander Kahn of Pike & Gilliss, LLC, for his assistance in drafting this paper.

You Have to Be Kidding Me! What Is the Extent of the Performance Bond Obligee s Obligations to the Surety? Table of Contents I. You Have to Be Kidding Me! What Is the Extent of the Performance Bond Obligee s Obligations to the Surety?...5 Endnotes...9 You Have to Be Kidding Me! What Is the Extent of the Performance... Gilliss and Kahn 3

You Have to Be Kidding Me! What Is the Extent of the Performance Bond Obligee s Obligations to the Surety? I. You Have to Be Kidding Me! What Is the Extent of the Performance Bond Obligee s Obligations to the Surety? Sureties and their claims counsel often see situations where a bonded principal may have failed, at least by some measure, to properly perform its contractual obligations, resulting in a claim on the performance bond. There is a corresponding scenario that we have observed, however, where the bonded obligee has failed in the discharge of its obligations under the construction contract, as much if not more so, than the principal. This may be due to a lack of proper project oversight, a failure to properly manage a schedule, or an inability or unwillingness to address project problems early when they may fixable or at least less expensive to fix, and before they metastasize into bigger and more material problems. Under these circumstances, we see the obligee looking to the bond as insurance against its own incompetence in project administration rather than as security for the principal s performance, which is the bond s intended purpose. This observation, in turn, led to our ideas for this DRI Fidelity and Surety Roundtable discussion point summarized as follows: Is there a duty of competent project administration owed to the surety? Surety counsel often frame arguments based on an obligee s actions as a defense to the claim. Such an approach is not wrong. Nonetheless, framing the issue as a defense colors the entire claims process. 1 It may even limit a claims analysis unintentionally so. This may have something to do with the very nature of the three-party bond relationship structure. The surety enters into a three-party agreement where the bond principal pays a premium to the surety, enters into a general agreement of indemnity in favor of the surety, and by definition the bond principal is the primary obligor to the obligee. In exchange, the surety is secondarily liable to the obligee. What is often forgotten, presumably due in large part to the fact that the dictionary definition of obligee is one to whom another is obligated, is that the obligee has obligations of its own. And therein is the focus of our discussion. We want to engage in a discussion of what specific affirmative obligations a general contractor owes the surety when it requires a particular subcontractor on one of its jobs to obtain a performance bond. For instance, consider the following: A surety receives a claim on its performance bond from an obligee. The allegations are of defective or omitted work, or longstanding delays. An elevator jack was improperly welded, a back-up battery system was missed, and patio doors in an entire luxury high rise building were put in with a one inch gap between the floor and frame. As the surety s investigation proceeds, it becomes apparent that the obligee knew or should have known that there were problems with the principal s performance and that the obligee might have been negligent or incompetent in its project oversight. Now the obligee is looking to the surety to fix the problem. One reason why we are intrigued by a duty of competent project administration is because the question turns the focus of a dispute from that of the principal s conduct on the project to the obligee s own conduct on the project. Of course, many construction contracts have provisions which act to shift risk from the obligee onto the principal, for example no damages for delay clauses, or provisions that insulate the obligee from a duty of oversight, or for other areas of project administration. Another example of a risk shifting mechanism, in the context of where the bond obligee is the project general contractor, is the so-called Pay-If-Paid You Have to Be Kidding Me! What Is the Extent of the Performance... Gilliss and Kahn 5

payment provision. In states where such a clause is enforceable, the bond obligee can effectively transfer the risk of non-payment downstream to its bonded subcontractors. By way of further example, it has often been said that the sometimes onerous terms contained in many public construction contracts serve as a means to protect the public from its own sometimes weak project management. Onerous contract provisions may serve to protect, and even encourage, poorly managed projects, to the detriment not only of all parties to the contract, but also to subs and suppliers, and even (on public projects) the taxpayers who funded the project. From the perspective of the surety, under these circumstances we think it is reasonable for the surety to ask if the obligee owes the surety any duties of competent project administration separate from either the underlying contract or through the bond itself. This argument may well fall under the obligee s duty to mitigate damages, to protect the surety s collateral, or perhaps the defense of overpayment (which itself is based on the obligee s duty to preserve the contract balances as the surety s collateral). Perhaps the argument falls under the obligee s implied duty of good faith and fair dealing included in any contract, the breach of any material part of which might provide the surety with a defense under the performance bond. At a conceptual level, it could be argued that the defenses of mitigation of damages, the duty to preserve contract balances, and the duty of good faith all add up to a duty to competently administer the project that runs through the bond to the surety. We submit as a matter of basic contract law and as a matter of fundamental coverage, that the performance bond guarantees the principal s completion of the contract. When our underwriters assess a risk, they are primarily looking at the principal s capital, capacity, and character. While the obligee s reputation may factor into the credit analysis as to whether to issue a particular bond, underwriters attempt to perform their financial risk analysis by examining the principal s ability to complete the project. They also focus on, among other considerations, whether the principal fairly priced the project. It s fair to say that the obligee s good faith and competence is probably treated as a given under usual circumstances. The underwriters certainly do not look at the bond as insurance against the obligee s own incompetence or negligence in project administration. When investigating a performance bond claim, a surety sometimes discovers that the bond principal encountered unexpected cash flow problems which led to the contractor s eventual inability to complete the project. In such a situation, the surety, as part of its bond claim investigation, will seek to analyze the project bid spread to determine whether the bond principal significantly underbid the job. If so, the obligee may have breached its obligation to determine whether the contractor could have reasonably been expected to perform the work for the amount bid on the project. Take for instance a case with the following facts. A general contractor receives three sealed bids from several plumbing subcontractors. The bids received are for $2,150,000, $2,050,000 and $900,000. Assuming the general contractor chooses the low bid, it is choosing a subcontractor which is offering a price that is less than half of the next lowest bid. Then, assume the general contractor requires the subcontractor to obtain a performance bond without notifying the subcontractor or the surety that an excessively large bid spread exists, and without giving the bidder the opportunity to examine the integrity of its bid. If all that occurs, the general contractor may well have withheld material information from both the subcontractor and the surety. Such a decision may be determined to have had a material impact on the subcontractor s ability to perform the work, and may even serve to at least partially relieve the surety from any obligation to perform under the bond. In fact, when a general contractor receives a bid that is substantially lower than the other bids received, that general contractor is on inquiry notice that the bid may be erroneous and under-bid. Pickus Construction and Equipment v. American Overhead Door, 761 N.E. 2d 356 (Ill. Ct. App. 2001)( It is generally 6 Fidelity and Surety Roundtable May 2017

true that a general contractor that receives a bid that is substantially lower than other bids it receives is on notice that the bid may be erroneous. ); U.S. v. Sabin Metal Corp., 151 F.Supp. 683 (D.N.Y. 1957)( If the party receiving the offer or the bid knows or has reason to know because of the amount of the bid, or otherwise, that the bidder made a mistake, the contract is voidable by the bidder. ). 2 Courts from around the country have consistently held that when a general contractor receives a bid that is substantially lower than the other bids received, that general contractor is on inquiry notice that the bid may be erroneous and that the general contractor should not rely on the bid without further inquiry. For example, in S. N. Nielsen Co. v. National Heat & Power Co., a general contractor sued a subcontractor under a theory of promissory estoppel, arguing that it detrimentally relied on a bid which the subcontractor eventually withdrew. 32 Ill. App. 3d 941 (Ill. App. Ct. 1st Dist. 1975). The court, however, affirmed the trial court s decision that the general contractor should not have relied on the bid because it should have known the bid was mistaken in light of the fact that the bid was $286,000 (or nearly 50%) less than the only other contractor who bid on the same scope of work. The court also noted that while a 50% difference in bids is plainly egregious, smaller percentage differences can also be unreasonable to rely on. Id. at 946 citing Union Tank Car Co. v. Wheat Bros., 15 Utah 2d 101 (Utah 1964)(held that the doctrine of promissory estoppel did not apply where there was a 35% difference between the low price and the next lowest bid). If the obligee does not investigate the bid spread, and does not notify the surety, then the bond is likely voidable by the surety. The Restatement (Third) of Suretyship and Guaranty 12(1) states that if a surety s assent to the issuance of a surety bond is induced by a material misrepresentation, the surety bond is voidable by the surety. The Restatement further sets out at 12(3) that if before the surety bond becomes binding, the obligee: (1) knows facts unknown to the surety that materially increase the risk beyond that which the obligee has reason to believe the surety intends to assume; and (2) has reason to believe that these facts are unknown to the surety; and (3) has a reasonable opportunity to communicate them to the surety, the obligee s nondisclosure of the facts to the surety constitutes a material misrepresentation. If the obligee is aware of the disparate bid spread but does not notify the surety, the surety might also raise the obligee s lack of good faith. As stated by the Fifth Circuit, if an obligee knew of facts unknown to the surety and which he had reason to believe were not known to the surety, the facts materially increased the obligor s risk and the creditor had adequate time to disclose them but failed in his responsibility then the obligee loses its ability to call on the bond. St. Paul Fire & Marine Ins. Co. v. Commodity Credit Corp., 646 F.2d 1064, 1073 (5th Cir. 1981). This defense, however, is not absolute. Some courts hold that the obligee must have a duty to inform the surety created by some sort of relationship between the parties. See Rachman Bag Co. v. Liberty Mut. Ins. Co., 46 F.3d 230 (2d Cir. 1995). Others hold that the surety must investigate on its own and if it does not, then the surety is without recourse even if the obligee withheld information. Turner Constr. Co. v. First Indem. of Am. Ins. Co., 829 F. Supp. 752, 761 (E.D. Pa. 1993), aff d 22 F.3d 303 (3rd Cir. 1994). In short, the bid spread is one of the most important pieces of a surety s investigation into a performance failure. A low bid puts the obligee on notice that it should explore why the bid was so low and if it did not do so, the surety should conduct its own investigation, including determining whether the contract is voidable, and whether the surety can assert that the oblige has lost its right to demand that the surety perform under the bond. Assuming that a low bid is not at issue, under the terms of most performance bonds, the Surety has two options after the obligee declares a default. The surety must either 1) undertake to complete or correct the work or arrange for its completion or correction at its sole expense; or 2) pay the obligee to complete or correct the work up to the full penal sum of the bond. Typical performance bonds do not contain language that You Have to Be Kidding Me! What Is the Extent of the Performance... Gilliss and Kahn 7

would permit the obligee to unilaterally complete performance. Likewise, under the common law, a surety has a right to choose to either complete performance or finance the obligee s completion. See, e.g., Granite Computer Leasing Corp. v. Travelers Indem. Co., 894 F.2d 547, 551 (2d Cir. 1990); Island Co. v. Hawaiian Foliage & Landscape, Inc., 288 F.3d 1161, 1170 (9th Cir. 2002); Aetna Cas. & Sur. Co. v. United States, 845 F.2d 971, 975 (Fed. Cir. 1988); Morrison Assurance Co., Inc. v. United States, 3 Cl. Ct. 626, 632 (1983); Morgenthau v. Fid. & Deposit Co. of Md., 94 F.2d 632, 635 (D.C. Cir. 1937). In light of the surety s clear options on how to handle its obligations under a performance bond, an obligee must permit the surety to mitigate its damages. This right to mitigate damages is a well-established right held by sureties. For instance, in Int l Fid. Ins. Co. v. Americaribe-Moriarty JV, the Eleventh Circuit affirmed summary judgment in favor of a surety on a subcontract performance bond. 2017 U.S. App. LEXIS 3628 (11th Cir. Fla. Feb. 28, 2017). In that case, the bond principal gave notice of default to the subcontractor and surety and the surety responded that it would need to investigate the claim. The bond principal then engaged a replacement subcontractor and, over the surety s objection, negotiated a contract with the replacement subcontractor. The trial court granted summary judgment because the bond principal failed to satisfy the conditions precedent set forth in A312 bonds that the surety has an opportunity to determine performance. Similarly, in St. Paul Fire & Marine Ins. v. City of Green River, the obligee, the State of Wyoming Joint Powers Water Board, refused to permit the surety to complete performance of the project after the obligee declared the principal in default. 93 F. Supp. 2d 1170 (D. Wy. 2000). The obligee s rationale was that the surety s planned performance was unacceptable as the surety would not finish the project within the time set forth in the original contract and that the surety intended to use the principal s employees in furtherance of performance. However, the court held the obligee materially breached the contract because the surety has a right to mitigate damages. The court stated: The effect of the Board s termination of [the surety] was to divest [the surety] of its ability to minimize its liability by selecting the lowest cost option and 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. Id. at 1178. Likewise, in Seaboard Sur. Co. v. Town of Greenfield, the obligee notified the surety of their contractor s default, the surety offered to complete the work but the obligee refused, completing the work without the surety. 266 F. Supp. 2d 189 (D. Mass. 2003). The surety sued and the court held that the obligee s refusal to allow the surety to complete the project rendered the bond null and void and discharged the surety from any and all liability under the bond. Id. at 198. In some instances the obligee will completely fail to notify the surety of a performance default at all until performance is already undertaken by the obligee. In those instances the bond is null and void. For example, in Hunt Constr. Group, Inc. v. Nat l Wrecking Corp., a general contractor waited until after the subcontractor s excavation work was done to make a claim under the bond for the general contractor s additional expenditures caused by the subcontractor s default. 542 F. Supp. 2d 87, 95 (D.D.C. 2008). The court, however, held that when an obligee fails to notify a surety of an obligor s default in a timely fashion, so that the surety can exercise its options under the controlling performance bond, the obligee renders the bond null and void. The court reasoned that any other interpretation would transform a surety into a commercial guarantor for the obligee. Id. at 92. 8 Fidelity and Surety Roundtable May 2017

The Hunt decision was anything but novel as many other cases also stand for the proposition that the failure of an obligee to notify the surety of a default until after performance is completed renders a performance bond null and void. See e.g., CC-Aventura, Inc. v. Weitz Co., LLC, 492 F. App x 54, 56-57 (11th Cir. 2012); Seaboard Sur. Co. v. Town of Greenfield, ex rel. Greenfield Middle Sch. Bldg. Comm., 370 F.3d 215, 219-20 (1st Cir. 2004). In fact, the Fifth Circuit created the standard that an obligee must not only notify the surety of a default but that the notice must be clear and unequivocal. L & A Contracting Co. v. S. Concrete Servs., Inc., 17 F.3d 106, 111 (5th Cir. 1994). In L&A Contracting, the letters from the obligee to the surety never contained the word default which signaled to the court that the obligee failed to make an unequivocal declaration of default. Id. In sum, an obligee must notify the surety in clear and unequivocal language that its principal has defaulted prior to taking any actions. The surety is then allowed the opportunity to perform and mitigate its own damages. If the obligee fails to provide notice, or provides improper notice, then the surety may be within its rights, following an investigation, to declare the bond null and void. 3 This paper only discusses two of the many duties which the obligee owes to the bond principal; the duty to properly administer the contract (including assessing the validity of any bids received), and the duty to mitigate damages. As previously stated, the obligee has certain of its own obligations when administering a contract, and its own failures may well lead to a defense by a surety to a performance bond claim. In sum, the obligee does in fact have important and material obligations on any construction contract, and those obligations begin prior to entering into a contract with the principal, and end only after completion of the project. If the obligee fails in its responsibilities, the surety may very well have the right to assert that the obligee s actions led to a discharge of the surety s performance bond obligations. Endnotes 1 This paper is not a thorough review of all available defenses to a surety (nor is it intended to be). For a comprehensive review of the established suretyship defenses available to the surety, see The Law of Performance Bonds, Second Edition, Chapter 12 by Julia Blackwell Gelinas and Genise W. Teich. 2 See also Alta Electric & Mechanical Co. v. United States, 90 Ct. Cl. 466, (1940); White v. Berrenda Mesa Water Dist., 7 Cal. App. 3d 894 (Cal. App. 5th Dist. 1970)(Where the low bidder realized it had made a mistake prior to the obligee accepting or rejecting any of the nine total bids, the obligee was not permitted to keep the surety bond worth 10% of the contract price as compensation for choosing the next lowest bidder). 3 Some, but not all, jurisdictions require that the surety show that it was prejudiced by the obligee s failure to give notice. See Town of Plainfield v. Paden Engineering Co., Inc., 943 N.E.2d 904 (Ind. Ct. App. 2011)(under Indiana law late notice late was presumptively prejudicial) but see Wise Invs. Inc. v. Bracy Contr., Inc., 232 F. Supp. 2d 390 (E.D. Pa. 2002) (under Pennsylvania law, surety must show that late notice resulted in prejudice to its position as surety). You Have to Be Kidding Me! What Is the Extent of the Performance... Gilliss and Kahn 9