Pan-American Surety Association Newsletter
"News@PASA 2/4 of 2006

Conditions Precedent in U.S. Construction Bonds - A Simple Demand for Payment Will Not Work

By: William J. Taylor, Esquire
White and Williams LLP
Philadelphia, Pennsylvania USA

Unlike surety bonds issued in many other countries, the surety construction bonds that are commonly used in the United States are not on-demand cash bonds. Before a surety's obligations arise, the bond obligee must satisfy certain conditions precedent that are spelled out in the language of the bonds. Thereafter, the surety has several different performance options, in addition to simply paying the penal sum of the bond.

This article will discuss the conditions precedent found in the typical U.S. surety construction bond. Our next article will discuss the construction performance bond surety's various performance options that are available once the conditions precedent of the bond are satisfied.

Many construction performance bonds in the U.S. follow the A-312 form promulgated by the American Institute of Architects. The A-312 bond form sets forth a series of conditions precedent that the bond obligee must follow and satisfy before the surety's obligations arise.

The first of the conditions precedent are set forth in Paragraph 3 of the A-312 Bond, which 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 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 Surety agree, the Contractor shall be allowed a reasonable time to perform the Construction Contract, but such 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 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 or to a contractor selected to perform the Construction Contract in accordance with the terms of the Contract with the Owner.

The A-312 bond expressly provides, at Paragraph 4, that the surety's obligations do not arise until "the Owner has satisfied the conditions of Paragraph 3."

After the conditions precedent of Paragraph 3 of the A-312 bond are satisfied, Paragraph 4 of the bond form sets forth the difference performance options available to the surety to satisfy its obligations to the obligee. These options include the right to perform and complete the contract work, arrange for completion, or obtain a new contractor. The surety can also waive these performance rights and either pay the obligee or deny liability.

Finally, Paragraph 5 of the bond sets forth the notice/default procedure for the obligee to follow if the surety fails to proceed as provided in Paragraph 4. This includes a fifteen day written notice requirement of a surety default.

The conditions precedent in the A-312 performance bond are valid and enforceable under U.S. law, and an obligee's failure to satisfy these conditions precedent will often result in the dismissal of its claim. Under U.S. law, a surety is bound only in the manner set forth in its bond, and assumes no liability beyond the terms expressly set forth therein. U.S. courts have held repeatedly that obligations not imposed by the terms of the bond cannot be created by any judicial construction or interpretation which extends the bond terms beyond their normal meaning. Thus, it has been firmly established, in cases throughout the U.S., that an obligee's failure to adhere to the conditions precedent of a performance bond constitutes a material breach of the bond, relieving the surety of liability.

Further, while sometimes there is debate as to how strictly an obligee must comply with the conditions precedent of the A-312 bond, the trend in recent cases has been to insist upon very strict performance. This is seen most often in regard to the requirement of an obligee's declaration of default. Courts in the U.S. now require that the obligee's default declaration be clear and unambiguous. The court in a leading U.S. case held:

A declaration of default sufficient to invoke the surety's obligations under the bond must be made in clear, direct, and unequivocal language. The declaration must inform the surety that the principal has committed a material breach or a series of material breaches of the subcontract, that the obligee regards the subcontract as terminated, and that the surety must immediately commence performing under the terms of its bond.

Thus, a letter from the obligee that does not make absolutely clear that a default has occurred and that the principal has been terminated, or that in any way indicates that the obligee is not terminating the principal's performance, will not be considered a valid declaration of default. The court explained its reasoning as follows:

Serious legal consequences attend a "declaration of default", particularly in cases such as this case involving multi-million dollar construction projects. Before a declaration of default, sureties face possible tort liability for meddling in the affairs of their principals. After a declaration of default, the relationship changes dramatically, and the surety owes immediate duties to the obligee. Given the consequences that follow a declaration of default, it is vital that the declaration be made in terms sufficiently clear, direct, and unequivocal to inform the surety that the principal has defaulted on its obligations and the surety must immediately commence performing under the terms of its bonds. Sureties deprived of a clear rule for notices of default would be reluctant to enter into otherwise profitable contracts.

U.S. courts apply the same strict requirements with regard to the surety default provisions contained in Paragraph 5 of the A-312 bond. Paragraph 5 requires the obligee to provide the surety with notice of a surety default and a fifteen day cure period during which the surety can attempt to cure the alleged breach of its own obligations under the bond. Courts have held that this additional written notice required by Paragraph 5 of the bond must demand performance in a manner sufficient to alert the surety to a presumed surety default. Thus, a letter that only complains about inadequate performance, delays in performance or the shaky financial status of the principal are not considered sufficient notice under Paragraph 3 or Paragraph 5 of the A-312 performance bond. Courts have repeatedly held that an obligee's failure to adhere to a performance bond notification requirement is a material breach, resulting in the loss of an obligee's rights under the bond.

The reason for strict performance of the conditions precedent of the A-312 performance bond is not to make things difficult for the obligee, but rather to protect the rights of the surety and also to possibly facilitate a quick and amicable resolution of a potential default. For example, the purpose of the condition precedent set forth in subparagraph 3.1 is to get the surety involved in a potential default situation as soon as possible, and give the surety (and the principal) an opportunity to resolve a problem before it mushrooms into a much larger problem. Sometimes the surety will use the opportunity provided by this pre-default notice to finance or provide for financing for the contractor/principal if there is a cash flow problem, or provide engineering consulting assistance to the contractor/principal if the problem is technical in nature.

The reason for the strict requirement of Paragraph 3.2 of the bond is to make absolutely clear to the surety that the principal's contract has been terminated as a result of the principal's default, and the sureties performance obligations have now ripened. This protects the surety, who otherwise may be liable to the principal for interfering with a contract between a principal and obligee before there is an actual default. This requirement of a clear and unambiguous declaration of default also is meant to protect the surety's right to select its own performance option, as outlined in Paragraph 4 of the performance bond.

Finally, the requirement set forth in Paragraph 3.3 of the A-312 performance bond, that the obligee pay the balance of the contract price to either the surety or another contractor selected to complete the principal's work, protects the surety by assuring that bonded contract funds are properly used to complete the project in question. This condition also protects the obligee from charges that it is using contract funds for purposes other than completing the project.

The prudent surety practitioner will be sure to be familiar with the conditions precedent set forth in the bond form that is being used. The conditions precedent are not merely technical defenses to surety liability, but rather have been included in the bond form to reflect the day to day realities of surety practice and the issues that are confronted when a potential default arises. The surety that takes its responsibilities seriously, investigates owner complaints, attends meetings, and promptly arranges for completion where indicated knows that these conditions precedent are included in the bond for everybody's protection.