• Roles May Evolve under Performance Bond Defaults
  • September 11, 2009 | Author: Eric D. Foerg
  • Law Firm: - Office
  • With a dearth of active projects, contractors have become very aggressive on bids, leading to winning bids that leave much money on the table and that may not sustain the business long term. Over time, the decreased revenue from low bids combined with decreasing access to credit may lead to a tremendous number of defaults. Many such defaults will occur on projects with performance bonds. The triggering of obligations under performance bonds creates interesting dynamics and options for the surety, owner, and contractors.

    Defaulting contractors may leave behind them a series of obstacles for the surety, owner, and other contractors. The project may be delayed, certain work may be defective or in need of repair, and subcontractors and suppliers may be unpaid. In light of such obstacles, sureties are often afforded significant deference as to completion contractors.

    For instance, in one case, the surety, who hired an independent consultant to assist with claims, faced a bad faith claim in relation to its selection and use of a completion contractor. United States Fid. and Guar. Co. v. Stanley Contracting, Inc., 303 F. Supp. 2d 1169, 1174 (D. Or. 2004). The court determined that the surety’s “decision to only consider bondable contractors” a “reasonable” decision, particularly in light of the sizable risk of loss. Stanley Contracting, 303 F. Supp. 2d at 1174. The court also demonstrated an understanding attitude toward the surety’s consideration of an existing dispute between the owner and the defaulting principal. Stanley Contracting, 303 F. Supp. 2d at 1174. Rather than acting with bad faith, the surety “appeared to be trying to locate a completion contractor who could finish the project in the quickest and least contentious fashion.” Stanley Contracting, 303 F. Supp. 2d at 1174.

    As suggested by the above case language, sureties are afforded deference in part due to the need for quick action to remedy project problems and get the project completed. The goal of the performance bond regime is to address and remedy “the immediate consequences of a failure to perform by the original contractor” by requiring “the surety to promptly take over the contract, arrange for a new contractor, or pay,” with the owner acting “quickly if the surety fails to do so.” Int’l Fid. Ins. Co. v. County of Rockland, 98 F.Supp.2d 400, 423-24 (S.D.N.Y. 2000). In one case, the surety’s obligation to act promptly following default meant that the surety had to “either (1) promptly take one of the specified alternative steps necessary to initiate the steps necessary to resume construction, or (2) notify the Owner that it will not do so and that the Owner should step in.” Int’l Fid. Ins. Co. v. County of Rockland, 98 F.Supp.2d 400, 420-21 (S.D.N.Y. 2000). “The goal is to ensure that the resumption of construction will not be unduly delayed.” Int’l Fid., 98 F.Supp.2d at 421.

    As demonstrated above, courts keep the purposes of bonds in mind when assessing rights and obligations. “The purpose of the bond arrangement is not only to provide financial resources to reimburse any potential damage to the owner resulting from contractor default, but also to provide an effective mechanism and incentive for the surety -- or if necessary, the owner -- to step in and resolve a default promptly, so that there is the least possible waste due to ‘down-time’ before construction resumes.” Int’l Fid., 98 F.Supp.2d at 422. “Even if the surety chooses the option of denying liability, it is important, in order to protect the owner, for that decision to be communicated quickly, so that the owner may immediately undertake the steps necessary to find a replacement contractor.” Int’l Fid., 98 F.Supp.2d at 422.

    As suggested above, courts also expect owners to exercise their options quickly. “It is equally important to provide an incentive for the owner to act quickly, even where a surety has completely refused to act.” Int’l Fid., 98 F.Supp.2d at 422. Efficiency encourages “the owner -- who is in the best position to resume the project -- to (1) do so immediately (thereby reducing additional delay damage), and (2) simultaneously begin an action against the surety for the unavoidable excess construction costs (and contractor-caused delay damages) for which the surety is obligated under the bond.” Int’l Fid., 98 F.Supp.2d at 423.

    The surety and owner’s decisions have transformative roles on the project. “Once a new contractor has been hired -- whether that new contractor is the surety itself, or another construction company -- the bond relationship ends (except to the extent that the new takeover agreement specifically incorporates a particular provision of the bond), and a new contractual relationship (under a takeover agreement) supplants it.” Int’l Fid., 98 F.Supp.2d at 423-24.

    Because each project is different, bond language and case law provides sureties with a variety of options. In one case, an expert listed four options under a performance bond: “(1) to finance the bonded contractor in the bonded contractor’s completion of the bonded work; (2) to tender to the obligee another contractor along with a check for the difference between the contract balance and the cost to complete the bonded work as determined by the completion contract; (3) to do nothing and allow the bond obligee to complete the bonded work and look to the surety to be reimbursed pursuant to the terms of the performance bond; and (4) to take over the performance of the bonded work and enter into a completion contract with a relet contractor for the completion of the bonded work.” Mid-State Surety Corp. v. E. Bethlehem Twp. Mun. Auth., Civil Action 01-240, 2005 U.S. Dist. LEXIS 15447, at *26 (W.D. Pa. July 29, 2005). Other case law states the options more broadly. When a contractor defaults, “its surety generally chooses one of two options: (1) pay the penal sum of the performance bond; or (2) enter into a takeover agreement and perform the work of its principal.” Mid-State, 2005 U.S. Dist. LEXIS 15447, at *50-51.

    The exercise of particular options by the surety may impact its rights. When the surety does not complete construction, its equitable subrogation rights may be limited. Nat’l Fire Ins. Co. v. Fortune Constr. Co., 320 F.3d 1260, 1271-72 (11th Cir. 2003) (since surety “did not complete construction under its performance bonds, it has acquired equitable subrogation rights only with respect to its payment bonds”). “The touchstone of any right to subrogation under a performance bond is actual and full performance of the bond’s obligations.” Nat’l Fire, 320 F.3d at 1272. Certain authority suggests the surety that “entirely refuses to fulfill any of the options from which it may choose under a bond” can be liable in amounts exceeding those specified in the bond. Int’l Fid., 98 F.Supp.2d at 422 (noting that the Second Circuit rejects such authority).

    Given the amount of options afforded, failure to act at all may have particularly negative ramifications. In Nat’l Fire, the surety had three options: 1) remedy the default; 2) complete construction itself; and 3) arrange for the completion of construction by selecting, either by itself or jointly with the obligee, “a completion contractor and by making funds available to the completion contractor for completion costs in excess of the contract price.” Nat’l Fire, 320 F.3d at 1272. One option that the surety did not have was to “simply ‘do nothing’ and pay for any excess construction costs.” Nat’l Fire, 320 F.3d at 1273. There were, however, disputed issues of material fact as to whether the surety’s “failure to perform amounted to a breach of its performance bond obligations,” as there was a dispute as to whether a completion contractor was tendered. Nat’l Fire, 320 F.3d at 1273-74.

    Exercise of options (or failure to act) may lead to claims and arguments as to rights and obligations under the bond and as to project costs and funds. More fundamentally, the surety and owner’s choices as to how to complete the project can alter the relationships among the parties, with the surety or owner potentially stepping in to complete the project or relet the contract. In these trying times, such decisions are likely to occur more often and have greater effect.