Originally posted Tuesday, 30 October 2012

Written by John Sier

Performance bonds are intended to protect the project Owner, and payment bonds are generally intended to protect the subcontractors and suppliers. However, in order to obtain the benefit of that “protection” under either bond, the beneficiary needs to be aware of the notice requirements stated in the bond or the applicable statute. Several states consider the notice requirements to be conditions precedent to the surety’s obligations under the bond. Failure to comply with the notice requirements can result in discharging the surety’s liability under the bond.

In Stonington Water Street Associates v National Union Fire Insurance, the parties used the AIA A121 Construction Management Agreement together with the AIA A201 General Conditions as the basic contract documents, and the contractor provided a performance bond using the AIA A312 form. Construction was to commence in May 2003 with substantial completion in November 2004. The project was delayed for various reasons, and the Owner met with the contractor and surety in early 2005 to discuss the deteriorating financial condition of the contractor. The contractor continued until March 2006, when the Owner requested a meeting with the surety under Section 3.1 of the performance bond because the Owner was considering defaulting the contractor. At that time, the contractor informed the Owner and surety that it did not have the necessary funds in order to complete the work. However, the Owner opted not to terminate the contractor at that time “so as not to disrupt the already-delayed job.” The surety asked the Owner to provide a status of the project relative to the contract balance, disbursements, claims, and offsets, but the Owner did not respond.

In August 2006, the contractor ceased working on the project, and the Owner hired some of the contractor’s employees to complete the remaining work. In November 2006, the Owner notified the surety that it was terminating the contractor and declaring the contractor in default under Section 3.2 of the performance bond. The Owner requested the surety to complete the remaining contractual obligations, including warranty work and the reimbursement of the Owner for additional expenses incurred. The surety denied the claim, and the Owner sued to enforce the bond.

The trial court dismissed the Owner’s claim and discharged the surety because the Owner’s delay in providing the notice and unilateral action in hiring replacement workers prejudiced the surety’s ability to protect itself and mitigate its risk. By failing to comply with the terms of the bond, regarding notice and precluding the surety from participating in determining a course of corrective action, the Owner released the surety from its obligations under the performance bond. The Second Circuit Court of Appeals affirmed the dismissal, effectively leaving the Owner with no relief. As has been stated a number of times, a surety bond is not a standby insurance policy. The Owner must understand the terms of the bond and comply with the notice requirements in order to obtain the protections intended.

John Sier, with the firm of Kitch Drutchas Wagner Valitutti & Sherborook in Detroit, Michigan, is Associate Counsel to COAA.