Pan-American Surety Association Newsletter
"News@PASA 4/4 of 2005

So You've Written a Construction Performance Bond in the United States - For What Damages Can You Be Liable?

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

If you are writing or reinsuring a construction performance bond for the first time in the United States, you may be surprised at the damage claims you will possibly face if your principal goes into default. Of course, you would expect to pay the increased construction costs incurred in completing the project after a default. But you may find that you are liable under the performance bond for other types of damages, too.

The typical American construction performance bond (for example, the American Institute of Architects Form A312 Bond) provides the surety with several different options in the event of a principal's default, including completing the project itself or tendering a new contractor to the obligee. The bond form also affords the surety the option of denying liability. If the surety does so, it subjects itself to a claim by the obligee. While the obligee will always make a claim for the direct costs of completing unfinished or repairing defective construction, obligees now often bring additional claims for numerous types of consequential damages. For example, the obligee may seek to recover escalated costs of construction, lost revenue, increased overhead costs, additional financing fees, attorneys fees, other consultant and expert fees, and damages for breach of warranty and for latent and patent defects in the project. These damages go far beyond the typical "brick and mortar" costs of a construction project.

Of course, damages recoverable against a surety depends, in the first instance, upon the bond language. Limits on the types of damages allowed that are set forth in the bond are usually enforced. However, courts in the United States have continued to expand the damage liability of sureties in instances where the bond language is silent.

The damage claims that a surety may face in the United States are as follows:

Incomplete or Defective Performance - These are direct damages resulting from the principal's default. The general formula for direct damages in connection with a construction project is the reasonable amount it costs, over and above the remaining project balance, to remedy the defective work and/or complete the project. Usually the recovery of direct damages against the surety is limited to the penal sum of the bond. Further, the surety is usually not responsible for costs incurred by the obligee for the completion of work outside the scope of the original construction contract of its principal.

Delay Damages - Many courts in the United States have interpreted the language found in standard performance bond forms to include liability for delay damages, because either the bond incorporates the language of the contract (by express reference thereto) or because delay damages are considered to be part of the costs of construction. Damages that obligees seek to recover from a performance bond surety due to unexcused delays in the completion of a project most commonly include increased interest costs, loss of profits, loss of rents, increased home office and field overhead costs, escalated labor and material costs, and other increased costs due to delays in the completion of construction.

Increased interest costs pertain to loans taken out by the obligee to finance the project. If the completion of the project is delayed, the obligee will incur additional interest expense in regard to these loans, and may be able to recover these increased expenses from the surety. Further, if the project is one from which the obligee would have derived profit, the obligee may be entitled to recoup from the performance bond surety its damages for lost profits during the period of delay. However, lost profit damages can only be recovered if they were foreseeable at the time the parties entered into the contract, and if they can be proven with reasonable certainty.

If the obligee is a general contractor, additional costs that may be recoverable against the surety for delay may include extended home office overhead costs, increased equipment costs, premium or overtime pay expended on the project as a result of the delay, increased labor costs due to labor inefficiencies occasioned by the principal's delay, additional job site costs for supervision, utilities and security, costs of winterizing the project if the delay pushes construction into a bad weather season, additional storage costs, additional insurance premiums, and additional architectural and engineering fees. These are all generally recognized damages for delay in the U.S., and the surety may be liable for them.

Liquidated Delay Damages - Since it is often difficult to prove actual delay damages, parties to a contract sometimes stipulate in advance to an amount of damages to be paid in the event of a breach by the other party. These are commonly referred to as liquidated damages, and liquidated damages clauses are often inserted into construction contracts in regard to delay. A surety may be liable for liquidated delay damages in the amount specified in its principal's contract. However, under U.S. law, if the liquidated damages provision of a contract is construed to be a penalty rather than a remedy for delay, the liquidated damages clause will not be enforced and thus a surety will not be liable for liquidated delay damages to the obligee.

Negligence and Other Insurance Claims - Typically, a construction contract will require that the contractor obtain liability insurance to protect itself and the owner from negligence and other liability claims. Sureties have been held liable for damages that would normally be covered by the liability insurance policy of the principal, where the principal was contractually required to obtain liability insurance but failed to do so. However, in a few jurisdictions in the United States, statutes exist that prohibit obligees from imposing liability for the negligence of the principal upon a performance bond surety.

Breach of Warranty and Latent Defect Claims - Generally, the incorporation of the contract of the principal into the performance bond exposes the surety to liability for warranty claims for patent defects and for subsequent claims for undiscovered defects, i.e., latent defects. The bond itself may also expressly provide that it covers the warranty obligations of the principal. Under U.S. law, latent construction defects discovered outside the warranty period have resulted in liability for the principal, and thus the surety, where the defects resulted from the principal's noncompliance with the project's plans and specifications. However, an obligee who discovers a latent construction defect after the warranty period has expired bears the burden of proving that the defect was, in fact, latent and could not have been discovered within the warranty period.

Attorneys Fees - The general rule in the United States is that attorneys fees are not recoverable unless they are provided for by contract, by statute, or, in limited situations, where a party acts in bad faith, vexatiously, wantonly, or for oppressive reasons. Usually a surety will not be responsible for attorneys fees incurred by an obligee in bringing a claim against it unless the bond expressly so provides. However, a number of U.S. states have implemented statutes that provide for the recovery of attorneys fees against a performance bond surety.

Bad Faith Claims - The majority of jurisdictions in the United States recognize a common law duty of good faith and fair dealing in the performance and enforcement of all contracts, including contracts of insurance and suretyship. The breach of this duty will give rise to a tort action for bad faith, and thus sureties, as well as all insurers, have become wary of allegations of bad faith in the handling of claims. Damages allowed for bad faith claims include attorneys fees and sometimes even punitive damages. In some U.S. states, bad faith actions are governed by statute, not by common law. However, these statutes usually apply to "insurance," and under U.S. law suretyship is usually not considered to be insurance. Thus, several courts in the United States have held that sureties are not liable under insurance bad faith statutes.

Tax and Benefit Obligations of the Principal - Contractors and subcontractors in the United States almost always incur obligations for taxes, including state and federal income taxes and state unemployment taxes, and for benefits, usually health and pension benefits owed to labor unions. If the principal defaults, is the surety liable for these obligations? Usually, yes. For example, suretyship for construction projects of the United States government are covered by the federal Miller Act. A Miller Act performance bond surety is liable for the unpaid federal withholding taxes of its principal. A Miller Act payment bond surety can also be held liable for interest and penalties on the unpaid federal withholding taxes. Under various state statutes, a performance bond surety may also be liable for state taxes such as unemployment insurance taxes, and sales and use taxes. Under some situations, the government may set off unpaid taxes owed by the principal against unpaid contract balances owed to a completing surety.

Thus, the damages claimed by an obligee after a principal defaults in the United States often go far beyond the direct costs of the completion of the defaulted contract. These damages can be substantial, and it often costs a great deal to disprove them. A surety should be aware of this potential for damages when issuing, or reinsuring, a performance bond in the United States.