December 13, 2005

Preserving Bond Coverage Most construction contracts require the general contractor to obtain a performance bond in order to protect the owner in the event that the contractor defaults and cannot, or will not, complete its contractual obligation. Many general contractors obtain performance bonds for some or all of the key subcontractors. Once a claim is made under the performance bond, it is an unlikely scenario that the surety will immediately take over the contractor’s responsibilities or pay another replacement contractor to complete the project. Thus, the question often arises: “What do I, as the claimant, need to know in order to protect my rights and trigger the surety’s obligations under the performance bond?” As illustrated by the recent decision in Seaboard Surety Co. v. Town of Greenfield, 370 F.3d 215 (1st Cir. 2004) (hereinafter “Greenfield”), the volume of the communications to the surety may be less important than the precise nature of the notification(s) provided to the surety.

Understanding Bond Conditions

A performance bond surety’s obligations are controlled by the specific terms of the bond and not just the terms of the contract. Just because a contractor or subcontractor has wholly failed to perform does not mean that the surety is absolutely and automatically obligated to take over the bonded contractor’s work. While the terms of the bond are tied to the underlying construction contract, most bonds contain conditions that must independently be fulfilled before the surety becomes obligated to perform. A potential claimant on a performance bond needs to read and understand those actions necessary to perfect its rights under the performance bond. If a condition precedent is not satisfied or excused, the surety may be excused from its obligations or liability under the bond.

One of the critical conditions to a surety’s liability is notice. Bond claimants need to appreciate that this notice requirement may apply to the default notice related to the principal’s performance and to any subsequent breach by the surety of its bond obligations.

Notice of Principal’s Default

One such condition is timely written notice. Once a claim is submitted, a surety will often avail itself of technical defenses such as lack of notice. When either the terms of the bond or the general contract require notice, a declaration of default to the surety must be clear, direct and unequivocal. See, L & A Contracting Co. v. Southern Concrete Services, Inc., 17 F.3d 106, 111 (5thCir. 1994). In L & A Contracting, the court stated that the notice must inform the surety that: (1) the principal has materially defaulted on its obligations under the terms of the general contract, (2) the owner has terminated the contract, and (3) the surety must begin to perform under the terms of the bond.

In addition, a bond claimant must also give the surety an opportunity to perform. Therefore, when the notice is given is critical. For example, in Insurance Co. of North America v. Metropolitan Dade County, 705 S.2d 33 (Fla. Dist. Ct. App. 1977), an owner sued the performance bond surety to recover for latent defects in construction work that had been performed ten years earlier. The defects were only first discovered when a hurricane blew off part of the roof. The problem was not, however, that the defects were not originally detectable, but rather that the owner did not give the surety notice of the defects until five months after the owner had made the repairs. The Florida Court of Appeals found that the owner’s failure to provide timely notice deprived the surety of its right under the bond to complete the contract. The court held that the lack of timely notice was a material breach of the terms of the bond which, in turn, relieved the surety of all liability.

Notice of Surety’s Default

In Town of Greenfield, Interstate Construction Company (“Interstate”) contracted with the Town of Greenfield, Massachusetts (“Town”) to renovate a middle school building. Seaboard Surety Company (“Seaboard”) was the performance bond surety furnished by Interstate. This bond was written on an AIA A-312 form, which set forth in paragraph 3 the procedures to trigger the surety’s obligations under the bond.

Interstate did not perform to the satisfaction of the Town, and the Town declared Interstate in default. The Town provided the proper notice to Seaboard, as required by paragraph 3 of the A-312 bond form. Seaboard investigated the Town’s allegations that Interstate was in default and requested that the Town provide documentation. The Town did so, but there was disagreement about whether Seaboard was responsible for correcting certain water damage to the building. Seaboard and the Town negotiated concerning responsibility for the water damage. While these negotiations were going on, Seaboard did not bring in a replacement contractor to complete its principal’s (Interstate’s) work. During this protracted process, the Town sent numerous letters to Seaboard describing the nature of the problems in the building and the critical nature to remedy defects and complete construction by the start of the upcoming school year.

Under the terms of the performance bond, once the basic notice obligations were satisfied, the surety obligations were set forth in paragraph 4 of the bond. That paragraph provides that the surety “shall promptly and at the Surety’s expense” take one of a list of specified “actions”. In Town of Greenfield, the action at issue was the surety’s obligation to “[u]ndertake to perform and complete the Construction Contract itself, through its agents or through independent contractors.”

Paragraph 5 of the bond provided that “[i]f the Surety does not proceed as provided in paragraph 4 with reasonable promptness, the Surety shall be deemed to be in default on the Bond fifteen days after receipt of an additional written notice from the Owner to the Surety demanding that the Surety perform its obligations under this Bond, and the Owner shall be entitled to enforce any remedy available to the Owner.”

Because of its concern that the renovation would not be complete in time for the beginning of the school year, the Town ultimately hired its own contractor to complete and correct Interstate’s work. Seaboard alleged that the Town had failed to give the fifteen-day notice required by Paragraph 5 of the bond before it brought in a replacement contractor. Seaboard claimed that the Town had breached its notice duty under the performance bond and therefore the surety was excused from liability.

The Town asserted that Seaboard had breached its bond obligations by failing to promptly provide a replacement contractor to complete the project. Although the First Circuit acknowledged that the Town had sent Seaboard a number of letters complaining about Seaboard’s failure to take action to promptly complete the project, the court held that these complaints did not meet the separate fifteen day notice requirements of paragraph 5 of the bond. The Town never said that Seaboard was in default of its bond obligations and its continued negotiation with Seaboard undercut the Town’s position that the surety was in default. The court held that the Town failed to carry out its obligation to provide a “clear and direct default notice” to the surety. The Town’s failure discharged the surety from all liability under the bond.

Comment

This case was different from the usual situation. Ordinarily, the dispute with the surety arises because of the obligee’s failure to expressly declare the contractor in default and terminate the contractor’s right to proceed. Until the contractor is declared in default, the surety’s obligation to complete the work or pay for the cost of completing is not triggered. This is particularly important when an A-312 bond form is used. Court decisions are split as to whether an express declaration of default is required under the A-311 bond form, but the A-312 bond form sets out specific events of default and does require notice of the principal’s default to the surety in writing.

The notice of default requirement of these bond forms is not the only pitfall, as the Greenfield decision illustrates. There are other specific provisions in the bonds with which the obligee must comply or risk the loss of bond coverage. In Greenfield, the surety’s actual knowledge of the Town’s dissatisfaction with its lack of action to carry out its bond obligation was not sufficient. The requirement for an express written notice of default and a fifteen-day period within which the surety could obtain its own contractor and limit its damages had to be followed to the letter to preserve the claim on the bond.

Hubert J. Bell, Jr.
404/582-8027
[email protected]
Member: Georgia, Florida and District of
Columbia State Bar Associations

Reginald M. Jones
404/582-8138
[email protected]
Member: Georgia, Virginia and District Of
Columbia State Bar Associations