Pan-American Surety Association Newsletter
"News@PASA 3/4 of 2006

The Surety's Various Options Under a U.S. Performance Bond

William J. Taylor, Esquire
Partner
White and Williams LLP
USA

In our last article we discussed the conditions precedent found in a typical U.S. construction performance bond. We noted that a simple demand for payment will not suffice to trigger the surety's performance obligations. But what happens when the conditions precedent of a U.S. performance bond are satisfied? Does the surety automatically have to pay the full penal sum of the bond to the bond obligee? The answer, in most U.S. bonds, is no. The surety has several different options available to it to satisfy its obligations under the bond.

Many construction performance bonds in the U.S. follow the A-312 form promulgated by the American Institute of Architects. Paragraph 3 of the A-312 bond sets forth the conditions precedent that the bond obligee must follow and satisfy before the surety's obligations arise. If those conditions precedent are satisfied, paragraph 4 of the A-312 bond then sets forth the various options available to the surety for fulfilling its obligations to the obligee.

Specifically, paragraph 4 of the A-312 bond form provides as follows:

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, to be secured with performance and payment bonds executed by a qualified surety equivalent to the bonds issued on the Construction Contract, 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 therefore to the Owner; or

.2 Deny liability in whole or in part and notify the Owner citing reasons therefore.

Each option entails different activities and different costs. The surety should study these different options carefully to determine how it can fulfill its obligations to the obligee in the most economical and efficient manner. These different options are discussed below.

Paragraph 4.1 - Arrange for the Bonded Principal to Complete the Project.

Sometimes, after a default, the best company available to complete the defaulted principal's work is the defaulted principal itself. Thus, the surety may choose to support its defaulted principal, usually by providing financing so that the principal can complete the work, rather than choosing to bring in another contractor. This option, set forth in Paragraph 4.1, is attractive to the surety if the principal's default was due primarily to its inability to obtain financing, and not because of poor workmanship or the principal's inability to do the work. While the reasons for the principal's insolvency must be fully explored, this option has numerous advantages, especially if the bonded project is close to completion. The defaulted principal is usually very familiar with the work that has been completed and the work that remains to be done, and has the forces available to complete this work. For this option to be successful, the surety must have complete cooperation from the principal, in addition to absolute confidence in the ability of the principal and its management to competently complete the project. The surety must also make sure that the principal still has good relationships with its subcontractors, creditors, and with the obligee itself. The surety must recognize that this option includes paying the principal's bills, possibly including both the job related invoices and the principal's general overhead costs.

Financing the principal may also be particularly appropriate where a shutdown of the job may result in substantial liquidated damages, or where the project is nearing substantial completion. Moreover, financing may be the only viable option when there are no other qualified contractors available to complete the work.

A major disadvantage to financing the principal is that it does not offer any limit on the surety's liability, because the surety is cast in the role of a lender and not a performance bond surety. This exposes the surety to a loss potentially in excess of the bond penal sum. In deciding whether to finance the principal, the surety should expressly reserve the right to exercise absolute discretion and control over the decision to discontinue financing. This reservation may prove crucial to protect the surety's interests if the principal is still unable to complete the work or if the initial projected cost of financing is short of the actual cost. In this event, the best interests of the surety may lie in resorting to other alternatives.

Paragraph 4.2 - Completion of the Contract with Its Own Forces.

This option entails the surety entering into a written agreement with the obligee pursuant to which surety, rather than the defaulted principal, agrees to complete the bonded contract. Under this option, the surety enters into a takeover agreement with the obligee to complete the project in accord with the construction contract requirements in return for the obligee's agreement to pay to the surety all remaining contract balances, including retainage. This option gives the surety greater control over the completion process. The surety can retain a contractor with whom the surety contracts to complete the remaining bonded work, or, if it has the resources, complete the job itself. It may, if it so elects, choose to "rehire" the defaulted principal or use certain of the principal's key employees in the completion process.

However, absent a specific contractual provision within the takeover agreement with the obligee, the surety that decides to take over and complete the project itself under Paragraph 4.2 assumes full responsibility to complete all of the work. Consequently, the surety may be responsible for the entire cost of completion, even if this cost exceeds the penal sum of the performance bond. The surety can attempt to write into the takeover agreement a provision whereby amounts paid in connection with completing the project will be credited against the penal sum of the bond. A sophisticated obligee, however, is likely to reject such an attempt, although it may agree if it believes that the cost to complete the work will never exceed the bond penalty.

The takeover agreement between the surety and the obligee should also expressly establish the contract balance remaining unpaid and the payment terms pursuant to which the contract balance will be paid to either the takeover surety or to its completing contractor. The takeover surety should also try to preserve in the takeover agreement whatever defenses it may have to the obligee's performance bond claims to further make sure that the surety's rights against its principal and indemnitors have not been impaired. The surety should also seek an agreement with the obligee that all work performed to date is in accordance with and meets contract requirements, except in regard to contractual warranties.

As part of the takeover process the surety should try to obtain the principal's written acknowledgement of default and agreement to the takeover agreement, if possible. The surety should also obtain formal assignments executed by the subcontractors and suppliers of the defaulted contractor so that work may proceed without interruption. Finally, the surety should attempt to negotiate with the obligee a resolution of liquidated damages up to the date of the takeover. Any remaining liquidated damage obligation should then be assumed by the completing contractor.

Paragraph 4.3 - Tender a New Contractor to the Obligee.

A performance bond surety may also obtain independent bids by other contractors to complete the work, and then tender to the obligee the lowest responsible bidder. This contractor will thereafter directly enter into a separate contract with the obligee to complete the work. In addition to tendering the completion contractor (with a new performance bond in favor of the obligee), the surety tenders the difference in price between the original contract amount and the completion contract amount, up to the performance bond penal sum. In exchange for this tender, the surety receives a release of all of its liability under the performance bond.

There are several advantages to tendering a completing contractor to the obligee. First, the surety's loss is fixed and certain, negating the surety's exposure for future unforeseen and uncontrollable events which may substantially increase its loss under the performance bond. This fixed and certain loss also potentially facilitates an early recovery from the indemnitors.

Tendering a new completion contractor also removes the surety from the day to day rigors of contract administration with the obligee, because the obligee communicates directly with the new completion contractor. The surety is, therefore, free to devote its resources and personnel to activities other than overseeing the completion process and managing the resolution of the default. Further, tendering a new contractor halts the expense of attorneys and consultants needed if the surety must stay involved in an on-going construction project.

However, there are also disadvantages to this option. For example, the process of preparing a bid package, obtaining bids, and awarding the completion contract can often be very time consuming, thereby exposing the surety to a potential delay damage claim by the obligee. Additionally, the costs of the completion contractor on a lump sum basis will probably include not only a full mark-up for overhead and profit, but also a sizable contingency amount for the unfamiliar but potentially defective work of the principal prior to default, as well as the quality of the subcontractors' work. Also, the performance and payment bond premiums for the new contractor will add to the cost of completion.

Paragraph 4.4 - Pay Money Damages or Deny Liability.

The standard AIA A-312 bond also gives the surety the "do nothing" option, which allows the surety to respond to a performance bond demand with the payment of money damages only (with the owner completing the work), conditioned only upon the surety first promptly investigating the claim and making payment "as soon a practicable" after the amount of the surety's liability to the obligee is determined. Thus the surety has the right to tender a cash payment in lieu of otherwise performing its principal's construction obligations.

This option has several advantages. First, it is simple. Allowing the owner to complete means that the surety will ultimately pay damages to the owner as measured by the difference between the cost of completion and the remaining contract balance. By taking this option, the surety avoids the cost of putting the project out to bid by a replacement contractor, monitoring the progress of the work, arranging for and monitoring a financing arrangement or otherwise becoming seriously involved in the project. This option also limits the surety's liability to the penal sum of the bond. However, by having the obligee complete the project, the surety loses all control over that process and the costs of completing the work. Further, the "do nothing" option often tempts a lawsuit by the obligee for breach of the performance bond, with accompanying claims of "bad faith" seeking to hold the performance bond surety liable for damages over and above the penal sum of the bond in addition to punitive damages.

Finally, the surety may also determine that it is not liable under its bond (because, i.e., the principal is not in default, or the obligee breached the contract). The surety can then deny liability under the bond, pursuant to Paragraph 4.4.2. In most instances the dispute will then end up in court or in arbitration, to determine ultimate liability under the bond.

Thus, when faced with a declaration of default and a defaulted principal, the surety on a US performance bond that follows the AIA A-312 form has several different performance options available to it. The surety has a great deal of flexibility, and can choose for itself its course of performance after investigating the declaration of default. If the surety makes sure it is aware of all of the facts and studies the various options available to it carefully it can usually decide which performance option will result in the smallest loss under the bond.