Bond, Contractual and Statutory Provisions and the General Agreement of Indemnity
Chapter 1 of the Bond Default Manual 3d Ed. (ABA, D. Clore, R. Towle and M. Sugar, Eds. 2005)
Marchelle M. Houston is with St. Paul Travelers Company. Armen Shahinian is a member, and Joseph Monaghan is an associate, with Wolff & Samson PC in West Orange, New Jersey.
In the second edition of this Manual, the author of the opening chapter 1 analogized the surety claims professional to the ship's captain called upon to navigate a stormy sea created by circlUllstances over which the captain had no control. In the ten years since that edition was published, sureties have encountered an unprecedented level of claims activity and an increasing number of inventive bond and contract provisions seemingly designed to expand the traditional scope of the surety's liability. Like the sea captain, the surety and its representatives must navigate these ever changing waters. This opening chapter again seeks to provide an overview of the provisions contained in the bonds, construction contracts, indemnity agreements, and statutes that must be considered when evaluating the surety's rights, remedies, defenses and options upon assertion of a claim by a bond obligee.
II. Bond Provisions
Unlike insurance policies which are typically drafted by the insurer, the bond form is usually chosen by the obligee and, in the case of a public project, is often prescribed by, or designed to meet the requirements of, a statute or applicable administrative regulations.2 As a result, the provisions of a typical surety bond are favorable to the obligee and it is unusual for sureties to have the opportunity to negotiate the terms of a contract surety bond - i.e., either the bond is issued by the surety in the form presented by the obligee or the undelWriters decline Issuance.
Perhaps the most common bond forms in use today are those published by The American Institute of Architects, which promulgates forms of bid bonds, performance bonds and payment bonds. These forms are crafted by an association of architects, who, some might suggest, are primarily concerned with the interests of the owners who retain their services. Moreover, obligees sometimes modify these forms to further expand the surety's liability and/or restrict recourse by the surety to traditional common law defenses. As one author has recently noted:
An obligee promulgated bond form is often a product of that obligee's most recent bad experience. If the last surety on a default did not move fast enough, the time for performance is shortened. If some loss was not covered, the next bond is changed to include that element of damage. 3
For instance, obligees may seek to alter a bond form to enlarge the surety's liability or restrict its ability to mitigate its losses by, among other things: requiring the surety to perform the bonded contract upon assertion of a claim and thereafter litigate the propriety of the termination; . enlarging the obligations of the surety beyond the commitment to arrange and/or pay the net additional cost for performance of the balance of the contract work; varying the burden of proof applicable to its claim; precluding the surety from utilizing its defaulted principal in the performance of the contract; or unreasonably shortening the time frame within which the surety may assert any defenses.
In addition to changes wrought by owners by modification to bond forms, sureties are increasingly faced with requests by third parties for, not only traditional dual obligee status, but for expansive dual obligee riders that seek to increase the surety's exposure under the bonds. A traditional dual obligee rider grants rights to a third-party, ordinarily a lender,4 conditioned upon the satisfaction of the obligee's obligation to make timely payment to the principal in accordance with the terms of the contract. However, some lenders have recently begun to seek additional protections :trom the surety which alter the surety's rights and defenses.
For example, lenders may seek the right to receive independent notice and an opportunity to cure a default on the part of the obligee. Such a cure period, if unreasonably long, could effectively eviscerate any contractual right the principal may have to cease performance in the face of the obligee's non-payment, because -- in derogation of that contractual right -- the surety would have continuing exposure to claims by the dual obligee, and the principal would have a corresponding indemnity obligation with respect to such a claim. Moreover, by the time a principal has declared a default on the part of the owner for non-payment, there has already been a substantial gap in payment. Requiring the principal to continue to perform without compensation during an additional cure period could cause the principal's financial inability to perform the contract during the prolonged period of non-payment. Additionally, the surety would presumably have no control over whether the principal provided timely notice to the lender and yet might lose valuable defenses as to the lender under a bond form requiring such notice. Lenders may also seek to utilize the dual obligee rider to enlarge the surety's liability, calling for such damages as attorneys' fees or consequential damages not initially contemplated in the bond and not traditionally the surety's responsibility under a bond form requiring only that the surety either pay for or perform the work necessary to complete the bonded contract.
It has always been axiomatic that upon receipt of a claim, the surety claims professional should not assume the content of the applicable bond, contract or, for that matter, the indemnity agreement. Rather, each of those documents must be carefully reviewed at the inception of the claim, together with any applicable statute or regulations, in light of the disparity of rights and obligations often embodied therein and the potential impact to the surety of uncommon or obscure provisions. In more recent years, adherence to this axiom has become even more critical.5
The terms of the bond, like those of any other contract, establish the extent of the surety's liability. In most jurisdictions, the "liability of a surety should not be extended by implication beyond the terms of the contract, i.e., the performance bond" and "a surety on a bond does not undertake to do more than that expressed in the bond, and has the right to stand upon the strict terms of the obligation as to his liability thereon.”6 As one court has declared:
[T]he obligation of a surety is measured by the contract of surety. The surety's obligation cannot be extended by implication or enlarged by construction beyond the terms of the suretyship agreement, in a way to include any subject or person other than expressed or necessarily implied from the suretyship contract. In other words, a surety in Florida is bound to the extent and in the manner indicated in the undertaking, and no further. The Courts of Florida will not presume that the contracting parties intended to include in their agreement a provision other than, or different from, those indicated by the language used.7
This doctrine of contract interpretation is substantially different than that applicable to insurance policies where, as a rule, ambiguities are construed against the insurer. This disparity in the rules of contract interpretation is grounded in the fact that a surety bond, unlike an insurance policy, does not bear any of the elements of a contract of adhesion; notably, it is seldom drafted by the surety and the surety does not owe a fiduciary duty to either the principal or the obligee.8 The enforcement of the strict terms and limits of the surety's undertaking can often have very real practical effects and thus it is important to disabuse a claimant, or a reviewing court, of the notion that a surety bond is akin to an insurance policy for purposes of construing the surety's obligations and defenses.
Importantly, for instance, the bond may include notice or limitations provisions that, if not complied with, operate as a complete defense to any suit or claim. As a general rule, a reasonable contractual limitation is enforceable unless expressly prohibited by statute or contrary to public policy, even when a claimant had no knowledge of this bond provision.9 However, in some jurisdictions, specific statutes preclude parties from contractually limiting actions to a shorter time period than that established by the legislature. 10
A. Bid Bond
A bid bond typically provides that if the principal is the successful bidder, but does not enter into the contract and provide performance and payment bonds, the principal and the surety are bound to pay a stated sum to the obligee. The most common fonn of bid bond for private contracts imposes liability upon the principal and surety in the amount of the difference between the principal's bid and the bid of the next highest bidder, not to exceed the penal sum of the bid bond.11 In some jurisdictions, though, the penal sum of the bid bond is deemed liquidated damages which are recoverable regardless of the actual damages incurred.
In the private context, where a liquidated damages provision is not reasonably related to actual damages, it would be unenforceable as a penalty.12 However, with respect to public construction, bid bonds are usually required and designed in accordance with a statute, and where the penal sum of the bid bond is established as a liquidated damages provision by statute, it will be enforced as such regardless of the actual damages incurred by virtue of the principal's failure to execute the contract in accordance with its bid.
While the traditional surety defenses to a claim against a construction performance bond are seldom implicated by a claim against a bid bond, such a claim is nonetheless subject to any defenses the principal might have for relief from its obligation to enter into the contract. The most commonly litigated defense to a bid bond claim arises from the principal's error in its bid.13 While contract law disfavors rescission for unilateral mistakes, courts have allowed bidders to rescind their bids where it would be inequitable to require the principal to perform the contract at the bid amount; where rescission is appropriate, the surety is relieved of liability under its bond bond. The four factors which the surety must explore with the principal to determine whether the principal's mistake presents a viable defense are: (1) whether the mistake relates to a basic assumption on which the contract is made and is a mistake of fact rather than one of judgment; (2) whether enforcement of the bid would be inequitable; (3) whether the parties can be returned to the status quo, which often turns on whether the mistake was promptly discovered and communicated to owner; and (4) whether the mistake occurred regardless of the exercise of ordinary care. 14
The issuance of the bid bond does not in and of itself impose an obligation upon the surety to issue performance or payment bonds. However, some public entities, pursuant to statute, require that a bid bond be accompanied by, or serve as, a consent of surety to issue the final performance and payment bonds.15 In those circumstances, the bid bond and consent of surety serve as a guarantee to the project owner that the contractor's surety will furnish bonds in the amount required by the contract if the bid is accepted and the contract is executed by the successful bidder. 16
B. Performance Bond
A performance bond is conditioned upon the principal's full and faithful performance of the bonded contract. These bonds commonly contain provisions regarding such matters as: the conditions precedent to the surety's obligation; the time period for institution of suit against the surety under the bond; the relevant venue for any such suit; the timing for notice to be provided to the surety; the surety's performance options; the types and measure of damages for which the surety may be liable; and the surety's maximum liability - - the penal sum - - for damages under the bond.
Certain bonds set forth in detail the conduct required of -- or the options available to -- the surety in the event of a termination for default. For example, the current performance bond form published by The American Institute of Architects (the A312 bond form)17 expressly sets forth the conditions which the obligee must satisfy in the event of a default by the principal; and it then describes the surety's options in the event the obligee satisfies those conditions and asserts a claim on the performance bond, as follows:
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 Paragraph 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 Subparagraph 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….
4. When the Owner has satisfied the conditions of Paragraph 3, the Surety shall promptly and at the Surety's expense take one of the following actions:
4.1 Arrange for the Contractor, with consent of the Owner, to perform and complete the Construction Contract; or
4.2 Undertake to perform and complete the Construction Contract itself, through its agents or through independent contractors; or
4.3 Obtain bids or negotiated proposals from qualified contractors acceptable to the Owner for a contract for performance and completion of the Construction Contract, arrange for a contract to be prepared for execution by the Owner and the contractor selected with the Owner's concurrence, . . . and pay to the Owner the amount of damages as described in Paragraph 6 in excess of the Balance of the Contract Price incurred by the Owner resulting from the Contractor's default; or
4.4 Waive its right to perform and complete, arrange for completion, or obtain a new contractor and with reasonable promptness under the circumstances:
.1 After investigation, determine the amount for which it may be liable to the Owner and, as soon as practicable after the amount is determined, tender payment therefor to the Owner; or
.2 Deny liability in whole or in part and notify the Owner citing reasons therefor.
Courts have fairly consistently held that the provisions set forth in paragraph 3 of the AlA A312 performance bond are conditions precedent to the surety's liability and that the obligee's failure to comply with those provisions, or failure to permit the surety to exercise its performance options, discharges the surety from liability.18 Perhaps for that reason, wary obligees sometimes seek to modify the AlA A312 bond form to eliminate or diminish their notice and meeting obligations and/or the performance options available to the surety.
The surety claims professional must carefully review the bond to determine the obligations of the owner and whether those obligations have been met, as well as the scope of the surety's own performance obligations and the breadth of its performance options. Moreover, performance bonds invariably incorporate by reference the underlying bonded contract between the principal and the obligee, so that the surety must also thoroughly review the pertinent contractual provisions before considering its options and the risks associated with each of those options. Significant contractual provisions will be reviewed later in this chapter.
C. Payment Bond
The standard payment bond provides that the surety shall make payment to subcontractors, laborers and/or materials suppliers who are not paid by the principal. The provisions of the payment bond usually establish: who may assert a claim; the time for submission of a claim; the earliest point at which suit may be instituted; the limitations period beyond which suit may not be instituted; venue for any litigation; and the penal sum. Often the language of the payment bond is based upon, or even incorporates, relevant statutory provisions, which will be addressed later in this chapter.
In responding to payment bond claims, the surety has the right to assert all of the defenses. of its principal, as well as its own separate surety defenses,19 where applicable. Simply because a subcontractor or supplier is owed money by the principal, or may even have a judgment against the principal, does not establish liability under the payment bond. The claimant must also have complied with the notice and limitation provisions of the bond and prove that its work or materials were utilized on the bonded project or specially manufactured for the project. 20 The subcontract and/or purchase order must be carefully examined to confirm that the claimant has fulfilled its contractual obligations, including any warranty obligations. And where the claimant has performed work on multiple projects for the principal, the account between the parties should be reviewed to ensure that payments made by the principal on bonded projects were properly credited against the bonded obligations.
Finally, the definition of "claimant" contained in the bond may also serve as a defense to a claim. Not every vendor who is owed money from the principal will be covered by the definition of claimant set forth in the payment bond or in the statute controlling that bond. In addition, courts have consistently rejected attempts by obligees to assert claims against the payment bond.21
II. Contractual Provisions
The provisions set forth in the contract between the principal and the obligee are obviously significant. The contract guaranteed by the bond is often expressly incorporated by reference and, even if not expressly incorporated, the surety's obligation is typically to perform the bonded contract upon the principal's default, including all of its terms.
The surety must be alert to onerous or problematic contractual provisions set forth in the contract between the obligee and the principal. For instance, where the principal undertook responsibility for any contamination on the site, a surety may elect not to undertake completion to avoid undertaking that obligation. This is especially true because, in some jurisdictions, once the surety elects to respond to an obligee's demand by undertaking performance rather than making payment, the surety is held to have thereby abandoned the protection of the penal sum limit of its liability.22 Thus, potential catastrophic exposures must be identified and all risks assessed before a decision is made which may expand the surety's otherwise limited liability.
Sureties are also being increasingly confronted by "design build" contracts, which may greatly expand the responsibilities of the principal and the completing surety. The primary distinction between design build projects and traditional projects is that in a design build project the design professional is no longer the owner's representative, but rather is partnered with, or acts as a subcontractor to, the bonded principal. This is a distinction that can substantially impact the surety's liability. For instance, in traditional construction contracts, it is the owner which is responsible for design errors. Where such errors cause damage to the contractor, it is entitled to recover for such damages.23 Under a design build contract, it is the bonded contractor which bears responsibility for such errors; and by virtue of its bond, the. surety typically guarantees performance of such contractual obligation. As a practical matter, the extension of the surety's liability beyond the traditional "nuts and bolts" construction creates a need to identify and address potentially complex design issues at an early stage in the claims process.
Even under a traditional construction contract, a surety often encounters problematic contractual provisions which may require it to adjust the manner in which it responds to a performance bond claim. For example, the surety must be cognizant of the dispute resolution provisions of the underlying contract, which may: have short deadlines for submission of claims; dictate a mandatory arbitration or mediation proceeding; waive a right to a jury trial; impose onerous cure provisions; or preclude damage for delay claims.
To the extent any underwriting review of the bonded contract was undertaken at all, it would by and large have been limited to a determination as to whether the contractor possessed the expertise to perform the general scope of work set forth therein. The underwriter is often not equipped or called upon to thoroughly review all legal and technical aspects of the contract. And often the principal has merely entered into the contract including unfavorable terms, just as it was presented by the owner, without any negotiation. The surety must approach every contract with a wary eye for such terms, not merely in the body of the contract but in the often voluminous general and supplemental conditions and the Plans and Specifications which apply to the contract.
The general conditions contain important provisions, including the conditions under which either party may declare the other in breach and terminate their right or obligation of performance, as well as provisions governing notice, dispute resolution, payment, site protection and safety equipment, insurance coverage, changes to the work, time of performance and many other provisions which substantially impact the surety's exposure and options upon its principal's default. The specifications set forth how the work will be completed from a technical standpoint. Not only are such contractual provisions important from the standpoint of assessing the surety's potential liability and options, but any relet to a completion contractor must incorporate the applicable provisions of the underlying contract, unless the surety and obligee negotiate to the contrary.
The bonded contract invariably contains provisions for termination of the contract. Where the termination is for convenience, the owner/obligee cannot call upon the surety to complete the contract and/or to assume responsibility for any damages incurred by the owner/obligee because no default has occurred triggering any obligation on the part of the surety. However, a termination for convenience often signals a problematic project, which may mean that a principal may be experiencing financial difficulties and/or payment bond claims have been or may be asserted with respect to the project. As a result, the financial resolution of a termination for convenience may interest the surety, and the surety may seek to protect itself by utilizing the consent of surety requirement, if one is included in the bonded contract. Many owners, in any event, seek the surety's consent before releasing the retainage under the contract.
The surety, of course, is more concerned with a declaration of a default or a termination for cause of the contract. The bonded contract often imposes certain obligations upon the owner and/or its representatives in order to properly declare a default or terminate the contract. It is important to review those requirements, because the failure of the owner to comply with those requirements may constitute a breach of the contract by the owner and may also provide defenses to the performance bond claim against the surety. 24
Bases for a termination for cause often include the following:
1. the contractor's commission of a substantial violation of the contract and, after notice from the owner, architect, or construction manager, failure to cure the violation within the time period set forth in the contract;
2. failure to supply adequate materials and/or properly skilled workers;
3. failure to promptly pay subcontractors and/or material suppliers and/or its workers;
4 persistent failure to comply with applicable laws, regulations, directives, etc., of a public agency or authority with jurisdiction over the project;
5 failure to complete the project in a timely fashion; and 6.adjudication of the principal to be a bankrupt or general assignment by the principal for the benefit of its creditors or appointment of a receiver due to the principal's insolvency.25
When a contractor is terminated for cause, the owner normally has the contractual right to take possession of all materials and equipment on the site and may proceed to finish the remaining work and to withhold any further funds from the contractor until the work has been completed. As a general rule, the principal will be liable under the contract to the owner for any excess costs to complete the project over and above the monies remaining in the contract.26 These termination provisions, and the remedies of an owner upon termination, provide the framework for the claim against the surety. They may also provide a completing surety with important rights against competing claims by third-parties to unpaid contract funds and/or to the materials and equipment on site, because the completing surety stands in the shoes of the owner following the principal's default under the bonded contract.
Many general conditions provide for the method to resolve disputes, which vary widely by contract. Contracts may provide for an initial means to resolve disputes, such as a decision by the architect, meeting of representatives of the two parties, or a formal decision by a contracting officer or a designated public official with respect to public projects. When one of these initial procedures does not resolve the dispute, the dispute clause may then provide for resolution by mediation, arbitration or litigation. Where mediation or arbitration are set forth, the contracts frequently designate a certain association or organization, such as the American Arbitration Association, as the binding decision maker. Where litigation is designated, the general conditions often set forth requirements such as venue and whether or not a jury may be requested by a party. Regardless of which mode of dispute resolution is designated, the contract often contains the notice, conditions precedent and time parameters in connection with the commencement of a dispute resolution proceeding. Failure to adhere to these provisions can result in a waiver or forfeiture of rights.
Some courts have indicated that an arbitration or litigation as to which the surety has notice may be binding upon the surety regardless whether the surety participates, at least as to the scope of the principal's liability under the contract.27 In addition, courts have held that when a bond provides for dispute resolution in court and a contract provides for arbitration, the surety may be compelled to arbitrate.28 Nonetheless, the better reasoned approach binds the surety to the results of the arbitration of the contract dispute, but allows the surety to reserve its right to litigate any separate bond defenses. 29
C. Payment Provisions
Virtually all contracts between principals and owners/obligees provide contain provisions governing the means, method and timing of requests for payment and the making of payment. Usually, the contract will provide for periodic payments based on the progress of the principal. Often the payments are to be made on a monthly basis with the principal being required to submit monthly requisitions or requests for payment. Following a termination of the principal, these requisitions provide the surety with information critical to a determination of the amount of contract funds remaining versus the estimated cost of completion, which often lies at the heart of a surety's evaluation of its completion options.
The surety should carefully review the owner/obligee's compliance with the contract's payment provisions, because overpayment to the principal by the obligee may provide a partial or complete defense for the surety.30 Indeed under paragraph 3.3 of the AlA A312 performance bond, it is a condition precedent to any obligation on the part of the surety that the obligee shall have agreed to pay to the surety the balance of the contract price. Moreover, in calculating such balance of the contract price, the owner is only entitled to credit against the contract price for payments properly made, and not all payments made. This provision implements the common law rule that the surety is discharged from its obligation to the extent of the obligee's improper or premature release of collateral it holds to secure the principal's performance.31 In the context of a construction contract, the contract balance and retainage comprise that collateral.
Additionally, most contracts provide for a review procedure with respect to the principal's requests for payment. The surety may have some defenses/affirmative claims if it is determined that work for which the principal has been paid was not performed properly. However, the majority of contracts, including those published by The American Institute of Architects, exculpate the architect-engineer from any responsibility for determining the quality or propriety of the work performed by the principal. Nevertheless, the surety may still have recourse with respect to the actions of the architect or engineer where the architect or engineer assumed responsibility for coordination, supervision and/or inspection, or the contract is silent as to the .architect's or engineer's liability.32
Finally, many payment provisions require that the contractor utilize, or certify that it has utilized, the contract funds paid by the owner to pay subcontractors and/or material suppliers. These provisions are often consistent with trust fund acts33 enacted in some states. Fals