COMPLY WITH THE CONDITIONS OF THE PERFORMANCE BOND

If you are bargaining for a contracting party to obtain a performance bond, it is imperative that you honor the conditions precedent to the bond in the event you need to trigger the bond’s obligations.  If you do not, then you will breach the terms of the performance bond and lose the benefit of the bond.  This is definitely NOT what you want because if you are looking to the performance bond than you are dealing with the default of its bond-principal and an incurred or anticipated loss.   This is particularly true if dealing with an AIA performance bond form where the surety can rely on good case law that failing to comply with the conditions of the bond discharges the obligations under the bond.

To exemplify, in a recent opinion out of the District of Columbia Circuit, Western Surety Co. v. U.S. Engineering Construction, LLC, 2020 WL 1684040, (D.C. Cir. 2020), a performance bond surety filed a lawsuit seeking declaratory relief that it had no liability under the bond because the obligee failed to comply with a condition precedent to trigger the bond’s obligations.

In this case, a subcontractor hired a sheet metal subcontractor.  The sheet metal subcontractor  (principal of bond) obtained an AIA A312 performance bond for the subcontractor (obligee of bond).  During construction, the prime contractor notified its subcontractor that it was causing delays. The delays were caused by the sheet metal subcontractor.  The subcontractor, in turn, notified its sheet metal subcontractor that it had 72 hours to cure.  The sheet metal subcontractor did not cure and the subcontractor formally terminated its sheet metal subcontractor.  Prior to the termination, the subcontractor did NOT notify the surety that it was considering declaring the sheet metal subcontractor in default and terminating the subcontract. In fact, the surety was not notified of the default termination until the subcontractor sent a claim under the bond to the surety many months after the sheet metal subcontractor was terminated.

Notably, section 3.1 of the AIA performance bond required the obligee (subcontractor) to notify the principal  (sheet metal subcontractor) and surety that it was considering declaring the principal in default.  Section 4 excused the failure to do this except if the surety demonstrated actual prejudice by the lack of notice.   Section 3.2, however, required the obligee, if ending the relationship with the principal, to declare the principal in default, terminate the contract, and notify the surety.  Section 3.3 provided that the obligee must agree to provide the balance of the contract price to the surety or to a contractor selected to perform the contract. Section 5 provided that when the obligee satisfies the conditions of section 3, the surety shall promptly and at its expense take one of the actions in sections 5.1 through 5.4.

The subcontractor-obligee failed to comply with any of the obligations in the bond, which resulted in a harsh outcome to the subcontractor:

The A312 bond at issue in this case states that, in order to trigger Western Surety’s [surety] obligations under the bond, U.S. Engineering [subcontractor-obligee] must declare a United Sheet Metal [sheet metal subcontractor-principal] default, terminate the subcontract, and notify Western Surety. Similar to the A311 [AIA performance] bond, the A312 [performance] bond provides four alternative methods by which the surety can respond to the default [per Section 5 of the bond]. By unilaterally completing United Sheet Metal’s remaining contract obligations before notifying Western Surety [per Section 3.2 of the performance bond], U.S. Engineering deprived Western Surety of its contractually agreed-upon opportunity to participate in remedying United Sheet Metal’s default [per Section 5 of the bond].

In other words, despite the bond’s lack of an explicit timely notice requirement [as to when the surety must be notified of the default and termination], the performance bond is properly read as requiring U.S. Engineering to notify Western Surety of the default before engaging in self-help remedies. Otherwise, “the explicit grant to the surety of a right to remedy the default itself would be operative only if the obligee chose to give it notice,” thereby rendering the options in section 5 “nearly meaningless.” Accordingly, because the bond expressly provides the surety with the opportunity to participate incurring the subcontractor’s default, we hold that it is a condition precedent to the surety’s obligations under the bond that the owner must provide timely notice to the surety of any default and termination before it elects to remedy that default on its own terms. In light of U.S. Engineering’s failure to provide such timely notice, Western Surety was not obligated to perform under the bond.

Western Surety Co., 2020 WL at *4.

The morale is that if you are bargaining for a performance bond, do not neglect to comply with the very bond conditions you need if defaulting and terminating the principal of the bond.  Otherwise, you may wind up with a similar harsh result, as the subcontractor did in this case by looking to the surety many months after it default terminated the bond-principal, and started remediating the default.

Please contact David Adelstein at dadelstein@gmail.com or (954) 361-4720 if you have questions or would like more information regarding this article. You can follow David Adelstein on Twitter @DavidAdelstein1.

 

PERFORMANCE BOND SURETY’S EQUITABLE SUBROGATION CLAIM AGAINST OWNER

There are circumstances where a performance bond surety will pursue a claim against an owner – such as a government owner—and assert an equitable subrogation claim.  A performance bond surety may assert an equitable subrogation claim to recover contract funds that are still in the government’s control after the contract is completed or to recover from the government when the government improperly disburses progress payments to the defaulted contractor (principal of the performance bond).   Capitol Indemnity Corp. v. U.S., 2020 WL 877687, n.7 (Fed.Cl. 2020).  As to the improper disbursement of progress payments, a performance bond surety is asserting a claim against the owner in this fashion when it has had to pay under the bond and believes certain rights of it were prejudiced based on improper payments by the owner — it would have had to pay less based on the contractors’ default had the owner not impermissibly paid the defaulted contractor.

[A]n equitable subrogation claim is based on the theory “that the triggering of a surety’s bond obligation gives rise to an implied assignment of rights by operation of law whereby the surety ‘is subrogated to the [principal obligor’s] property rights in the contract balance.’ ” “[A] legally enforceableduty can arise between the government and a surety if the surety notifies the government that its principal is in default of the bond agreement.” Thecourt in a case affirmed by the Federal Circuit has also recognized that notice to the government that the contractor “is in danger of defaulting under the bond” from other sources besides the surety may be adequate to trigger the assignment of rights to the surety.  Finally, a surety’s equitable subrogation rights can be triggered where the government “had knowledge of the default … and so informed the surety.”

Capitol Indemnity Corp., supra, at *7 (internal citations omitted).

An example of a performance bond surety asserting an equitable subrogation claim against the government can be found in Capitol Indemnity Corp.   Here, a contractor was hired to renovate a building and complete the renovation by September 30, 2015.    After numerous letters to the contractor including cure notices relating to non-conforming work, on December 30, 2015, the government notified the contractor’s performance bond surety that the contractor’s work was not complete and the surety should be receiving payment bond claims from unpaid subcontractors.  A few days later, the government suspended the contract and copied the surety.   The surety claims that after this date, the government impermissibly made payment to the contractor even though the surety requested any such payment to the contractor be in the form of joint checks to the contractor and corresponding subcontractor.  A couple of months later, in March 2016, the government declared the contractor in default.  The surety entered into a takeover agreement with the government to complete the defaulted contractor’s work, which reserved certain rights of the surety to pursue claims against the government.

Around the time the takeover work was complete, the surety sued the government.  One of the arguments the surety raised was equitable subrogation as to impermissible payments the government made to the contractor.  Stated differently, the surety claimed that the government abused its discretion (and prejudiced the surety) in making payment to the contractor when it knew the contractor was in default.  The government moved to dismiss the surety’s equitable subrogation claim.

Initially, as to a jurisdictional argument, the US Court of Federal Claims held that the surety can sue the government in equitable subrogation without having to first raise this issue to the contracting officer through submitting a claim under the Contract Disputes Act.

Next, the US Court of Federal Claims found that the alleged facts raised by the surety as to payment to the contractor shortly before the contractor was defaulted was enough to trigger a surety’s equitable subrogation claim against the government.  The surety raised facts to support that its equitable subrogation rights were triggered on December 30, 2015 when (i) the government notified the surety that the contractor’s work was not complete and the surety should expect to receive payment bond claims, (ii) the government then suspended the contractor’s performance a few days later, (iii) the surety requested that the government issue joint checks to the contractor and unpaid subcontractors, and (iv) the government refused to issue joint checks and paid the contractor directly only to default the contractor a couple of months later.   The direct payment to the contractor was an impermissible payment, and through equitable subrogation, the government may owe the surety the amount of that payment irrespective of the fact that the government already paid that amount to the defaulted contractor.

Please contact David Adelstein at dadelstein@gmail.com or (954) 361-4720 if you have questions or would like more information regarding this article. You can follow David Adelstein on Twitter @DavidAdelstein1.

 

INDEMNIFICATION PROVISIONS DO NOT CREATE RECIPROCAL ATTORNEY’S FEES PROVISIONS

shutterstock_121868692In a good, recent decision, the Eleventh Circuit in International Fidelity Insurance Co. v. Americabe-Moriarity, JV, 2018 WL 5306683 (11th Cir. 2018), held that Florida Statute s. 57.105(7) cannot be used to shift attorney’s fees in a contractual indemnification clause in a dispute between a general contractor and subcontractor’s performance bond surety, when the dispute does not involve an actual indemnification claim stemming from a third-party.

 

In this case, a prime contractor terminated a subcontractor and looked to the subcontractor’s performance bond surety to pay for the completion work.  The subcontractor had a standard AIA A312 performance bond that requires the prime contractor to comply with the terms of the bond, as well as the incorporated subcontract, in order to trigger the surety’s obligations under the bond.  The surety filed an action for declaratory relief against the prime contractor arguing that the prime contractor breached the terms of the performance bond through non-compliance thereby discharging the surety’s obligations.  The trial court agreed and the surety moved for attorney’s fees. 

 

The surety’s argument for attorney’s fees was threefold: (1) the indemnification provision requiring the subcontractor to indemnify the prime contractor required the subcontractor to indemnify the prime contractor for, among other things, attorney’s fees; (2) Florida Statute s. 57.105(7) provides that one-sided contractual attorney’s fees provisions must apply to both parties (and treated reciprocally), hence the inclusion of attorney’s fees in the indemnification provision means that the surety should be entitled to attorney’s fees; and (3) since the subcontract was incorporated into the performance bond, the surety should be entitled to attorney’s fees since it steps in the shoes of the subcontractor under principles of surety law.

 

Surprisingly, the trial court agreed with the surety.  However, thankfully, the Eleventh Circuit held that the indemnity provision in the subcontract was an indemnity clause that applies only to third-party claims and not suits between the general contractor and subcontractor.  Thus, the requirement of reciprocity for attorney’s fees provisions pursuant to Florida Statute s. 57.105 does not apply.  The Eleventh Circuit, however, did not enter a ruling as to whether even if s. 57.105 did apply such that attorney’s fees must be reciprocal in an indemnification clause, whether such rationale would allow the performance bond surety to recover attorney’s fees under principles of surety law. 

 

This decision is useful for a few reasons:

 

(1)  If a contractor, subcontractor, etc. is trying to create an argument for attorney’s fees based on an indemnification clause, this decision is helpful to put that issue to bed since the indemnification provision applies in the context of third-party claims, and is not related to independent claims between the contracting parties;

(2) A party looking to take advantage of a performance bond must, and I mean, must, make sure to properly comply with the terms of the bond.  Certain sureties will raise any argument to avoid obligations under a performance bond hoping that the beneficiary of the bond undertakes an act that allows the surety to discharge its obligations; and

(3) General (prime) contractors should explore subcontractor default insurance, which is a first-party insurance policy, as an alternative to performance bonds to avoid the issues associated with delays and other arguments a surety may raise in furtherance of avoiding obligations under the bond.

 

 

Please contact David Adelstein at dadelstein@gmail.com or (954) 361-4720 if you have questions or would like more information regarding this article. You can follow David Adelstein on Twitter @DavidAdelstein1.

 

PROPERLY TRIGGER THE PERFORMANCE BOND

unknownA performance bond is a valuable tool designed to guarantee the performance of the principal of the contract made part of the bond.   But, it is only a valuable tool if the obligee (entity the bond is designed to benefit) understands that it needs to properly trigger the performance bond if it is looking to the bond (surety) to remedy and pay for a contractual default.  If the performance bond is not properly triggered and a suit is brought upon the bond then the obligee could be the one materially breaching the terms of the bond.  This means the obligee has no recourse under the performance bond.  This is a huge downside when the obligee wanted the security of the performance bond, and reimbursed the bond principal for the premium of the bond, in order to address and remediate a default under the underlying contract.

 

A recent example of this downside can be found in the Southern District of Florida’s decision in Arch Ins. Co. v. John Moriarty & Associates of Florida, Inc., 2016 WL 7324144 (S.D.Fla. 2016).  Here, a general contractor sued a subcontractor’s performance bond surety for an approximate $1M cost overrun associated with the performance of the subcontractor’s subcontract (the contract made part of the subcontractor’s performance bond).  The surety moved for summary judgment arguing that the general contractor failed to property trigger the performance bond and, therefore, materially breached the bond.  The trial court granted the summary judgment in favor of the performance bond surety.  Why?

 

The performance bond in this case appeared to be an AIA performance bond (the AIA Document A312 Performance Bond or modified version thereof).   This appears clear from the following finding by the court:

 

Under the bond in this case, Arch’s [performance bond surety] obligations are not triggered unless Moriarty [general contractor-obligee]: (1) first provides notice to R.C. [subcontractor-principal of bond] and Arch that it is “considering declaring a Contractor Default”; (2) “declares a Contractor Default, terminates the Construction Contract and notifies [Arch]”; and (3) “agree[s] to pay the Balance of the Contract Price … to [Arch] or to a contractor selected to perform the Construction Contract.” …Once Moriarty complies with those three conditions precedent, the bond then requires Moriarty to allow Arch to mitigate its damages by arranging for the completion of the subcontract itself. Lastly, before Moriarty may properly make a demand under the bond, it must provide seven days’ notice to Arch.”

 

The general contractor, as commonly done, notified the subcontractor and subcontractor’s surety that it was considering declaring the subcontractor in default, but never (i) formally declared the subcontractor in default, (ii) terminated the subcontractor, or (iii) agreed to pay the subcontract balance to the performance bond surety.  Thus, the general contractor (obligee) never allowed the surety to mitigate damages by arranging completion of the subcontract upon the subcontractor’s (bond principal) default.

 

Remember, in order to preserve a performance bond claim it is important to properly trigger the performance bond and the surety’s role under the bond.  This means dotting your i’s and crossing your t’s when it comes to declaring the bond principal in default under the specific terms of the bond.   Moreover, if you are the obligee, consider preparing the performance bond form so that you can remove some of the underlying notice provisions in the bond to make the bond more favorable to you.

 

 

Please contact David Adelstein at dadelstein@gmail.com or (954) 361-4720 if you have questions or would like more information regarding this article. You can follow David Adelstein on Twitter @DavidAdelstein1.