Terminations from the Surety’s Perspective

Terminations are extreme remedies.  In order for an obligee to benefit from a performance bond, it must first fulfill its obligations under the contract and the bond.  A failure to understand the business of suretyship and the ways in which to preserve an obligee’s rights under the bond could prove detrimental.

While it may not be entirely intuitive, sureties are in the profit business. Sureties are not in the business of, nor do they intend to incur, losses. Many in the construction industry make the mistake of treating sureties as “insurers.” The distinction between suretyship and insurance is generally understood “in that an insurance contract undertakes to indemnify another against loss, damage, or liability arising from an unknown or contingent event, whereas a contract of suretyship answers for the debt, default, or miscarriage of another.”

Unlike with insurance, a surety’s obligation to act is not wholly dependent upon the existence of a covered event. Rather, as set forth in the bond, the surety is only obligated to act if and when its principal fails to perform as required by the underlying construction contract, and the conditions precedent, if any, in the bond have been satisfied. Thus, in order for an obligee to reap the benefits of a performance bond, it is imperative that all the I’s are dotted and T’s are crossed when taking steps to terminate a contractor. The failure to do so, may excuse a surety’s performance.

1. Has the Contractor Defaulted?

As a general rule, a surety’s liability is coextensive with that of its principal. Stated differently, the surety is unlikely to be liable to complete its principal’s work, in the absence of the principal’s material breach of the underlying contract. In deciding whether to terminate the principal, the obligee must be certain that the principal is in default of its performance obligations and that the obligee has complied with all procedural requirements within both the contract and bond to trigger the liability of the surety.

In determining whether to terminate the principal, the obligee should consider, at a minimum:

1. Has the obligee fulfilled all of its obligations under the contract?
2. Has the obligee complied with the payment procedures under the contract?
3. Has the obligee provided accurate plans and specifications for the contractor’s use?
4. Has the obligee caused any delays or impediments to contractor’s performance of its work?
5. Has the obligee responded in a timely fashion to requests for information, proposed change order requests and/or claims for impacts to the contract time and/or sum?

An obligee may find itself unsuccessful in calling upon the performance bond surety if the obligee is the party first to breach the contract. Once the obligee has carefully considered its own performance under the bonded contract, it must assess whether the principal has actually defaulted.

In that regard, before terminating a contractor, the performance bond obligee should analyze whether and to what extent the obligee is able to prove that the contractor failed to perform substantially under the bonded contract. The decision to terminate is made even more difficult when one considers that not all breaches are equal. Typically, insignificant or minor breaches may not rise to the level of a breach that warrants the drastic decision to terminate a contractor and prevent it from performing its work under the bonded contract.  This issue is often fact specific and may be dependent upon the terms of the parties’ contract.

An obligee will have little chance of recovery under a performance bond if it has failed to follow the bonded contract’s termination procedures, which often require the obligee to issue notice and provide the contractor an opportunity to cure. Even if the bonded contract does not contain specific steps to follow before terminating the contractor, it is likely a best practice to notify the contractor and provide an opportunity – even a short one – for the contractor to remedy its default, if it is even possible. Obligees considering termination should keep in mind that the law does not favor forfeiture; as such, a terminating obligee will put itself in a better position to successfully call upon the surety and, ultimately recover its losses, if it does not terminate the contractor hastily and without a record that reflects the merits of the termination.

2. Has the Obligee Triggered a Surety Response?

All sureties undertake some sort of an underwriting or prequalification process prior to issuing bonds on behalf of a contractor. The purpose of the surety’s underwriting process is to assess the degree of risk involved in issuing surety bonds to the bond applicant. Commonly referred to as the “three C’s,” surety underwriters examine a host of books, records and additional information concerning the contractor’s character, capacity and capital. The “character” of the contractor concerns, among other factors, its experience, the history of the company’s management and key personnel. It is anticipated that a contractor with good character is unlikely to engage in misconduct that could result in a claim against the bond. With regard to capacity, the underwriting analysis focuses on the fitness of the contractor, including its skill, knowledge and resources, to perform and complete the work required by the underlying contract, and, importantly, to avoid claims against the bonds. Finally, the contractor’s capital, including its assets, credit score and ability to borrow money as necessary to pay claims, is closely analyzed before the surety agrees to issue bonds.

Fundamentally, surety bonds do not transfer the financial risk of paying claims to the surety. Virtually all bonds are issued in conjunction with a general agreement of indemnity (“GAI”) that provides financial protection for the surety. The GAI memorializes myriad rights of the surety to ultimately be reimbursed or made whole for losses incurred as a result of claims made against the bond. The surety will not overstep or act at the mere request of an obligee for fear of being a “volunteer” that may jeopardize its ability to enforce its rights against its principal under the GAI.  Consequently, an obligee that fails to follow the procedures for triggering the surety’s obligations to act under the bonded contract and express terms of the bond, is unlikely to receive the response it seeks – if it receives a response at all.

What is the best way to trigger action by the surety? The obligee should review the bond and comply – strictly. The failure to comply with applicable notice requirements, may prove fatal to a claim against the performance bond. This was the result in International Fidelity Insurance Co. v. Americaribe-Moriarty JV, in which the Eleventh Circuit Court of Appeals held that the general contractor’s failure to comply with the notice requirements set forth in the underlying contract and the bond resulted in the general contractor’s inability to assert a viable claim against the bond for excess costs to complete its defaulting subcontractor’s scope of work. Indeed, the contractor’s failure to follow the notice requirements constituted a material breach of the performance bond, rendering it null and void.

The most frequently used industry bond forms are issued by the American Institute of Architects (“AIA”). Of those forms, the AIA A312-1984 and the AIA A312-2010 are perhaps the most commonly used performance bond forms. The 1984 AIA A312 performance bond form sets forth conditions precedent to the surety’s obligation to perform under the bond. Section 3 of the bond form states:

§ 3       If there is no Owner Default, the Surety’s obligation under this Bond shall arise after:

§ 3.1    The Owner has notified the Contractor and the Surety at its address described in Section 10 below that the Owner is considering declaring a Contractor Default and has requested and attempted to arrange a conference with the Contractor and the Surety to be held not later than fifteen days after receipt of such notice to discuss methods of performing the Construction Contract. If the Owner, the Contractor and the Surety agree, the Contractor shall be allowed a reasonable time to perform the Construction Contract, but such an agreement shall not waive the Owner’s right, if any, subsequently to declare a Contractor Default; and

§ 3.2    The Owner has declared a Contractor Default and formally terminated the Contractor’s right to complete the contract. Such Contractor Default shall not be declared earlier than twenty days after the Contractor and the Surety have received notice as provided in Section 3.1; and

§ 3.3    The Owner has agreed to pay the Balance of the Contract Price to the Surety in accordance with the terms of the Construction Contract or to a contractor selected to perform the Construction Contract in accordance with the terms of the contract with the Owner.

Under Section 3 of 1984 AIA, in order to trigger surety performance under an AIA A312-1984 performance bond, the obligee must:

1. not be in default under the construction contract;
2. provide written notice to the contractor and surety of obligee’s intent to declare a default and request a meeting to occur within 15 days of the notice;
3. if agreed to by the parties, provide contractor a reasonable opportunity to perform;
4. declare the contractor in default and terminate the contract no sooner than 20 days after the first notice; and
5. agree to pay to the surety the remaining contract balance.

The notice requirements in Section 3 of the 1984 AIA A312 performance bond, and similar bonds, are routinely enforced as conditions precedent to the surety’s obligations to perform.

The 2010 version of the AIA A312 performance bond removes the obligee’s obligation to request a pre-default meeting and the 20-day waiting period before termination. In addition, unlike its predecessor, the 2010 AIA A312 performance bond in Section 4 makes clear that, unless the Surety can demonstrate “actual prejudice,” “[f]ailure 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....”

3. Will the Surety Assert Defenses?

Once the surety’s obligation under the performance bond is triggered, the surety will perform an investigation, the purpose of which is to determine whether a viable claim exists requiring the surety to perform. In addition to evaluating its principal’s performance, with the assistance of its principal, the surety will focus on whether the obligee complied with the terms of the contract, followed the termination procedures and whether any acts or omissions of the obligee may operate to excuse the surety’s obligation to provide coverage under the bond.

When deciding whether to terminate the contractor, it should be noted that the surety will be entitled to assert the defenses of its principal, for example:

1. wrongful termination (e.g., failure to provide notice and opportunity to cure as required by the contract);
2. failure to pay as required by the contract;
3. breach of the implied covenant of good faith and fair dealing;
4. interference with the principal’s performance;
5. defective design; and
6.  impossibility of performance.

The surety may also discover in its investigation that it possesses additional defenses independent of its principal, including, among others:

1. material alteration of the underlying contract to the surety’s prejudice;
2. prepayment or overpayment to principal;
3. failure to mitigate its damages; and
4. release or discharge of principal.

In addition to exploring whether legal and/or factual defenses exist, the surety will evaluate the status of the project, including, the scope of work remaining to be completed, any applicable project deadlines (e.g., project milestones, dates for substantial and final completion), amount of the remaining contract funds available to defray the cost of completion, and open payables. These matters will inform the surety’s decision as to which performance option it may pursue, if any.

4. What are the Surety’s Options?

The performance bond form often identifies the options available to the surety when a claim is asserted properly against the performance bond. In that regard, Section 5 of the AIA A312-2010 performance bond provides options for the surety, including to:

• Arrange for the Contractor, with the consent of the Owner, to perform and compete (“finance”);
• Undertake to perform and complete with another contractor ( “takeover”);
• Provide proposals from qualified contractors acceptable to the Owner to complete with new performance and payments bonds and pay to the Owner the costs of completion in excess of the terminated contractor’s contract balance incurred by the Owner as a result of the Contractor Default (“tender”); or
• Waive other performance options and “with reasonable promptness” either make payment to obligee or deny liability.

Whether the surety determines to finance its principal, to take over the work or tender a replacement contractor, the surety’s involvement on the project will be most successful if the obligee provides clear and early notice to the surety that its principal is experiencing difficulties on the project. Even if the surety is not at liberty to step in and perform per the terms of its bond, notice that its principal is possibly experiencing difficulties may cause the surety to seek assurances of project performance from its principal, with substantiating documentation. This early evaluation and/or intervention will benefit all parties as it may help to avoid contractor termination, or at least pave the way for a smooth transition.

In a termination or potential termination scenario, communication and “notice” to the surety is essential.  While an obligee may not be able to dictate whether and how a surety will respond to a performance bond claim, when there is an open line of communication among obligee, contractor and surety, the sky is often the limit with regard to fashioning an amicable path forward to remedy the contractor’s default and complete the project.