Surety Bond Penalty Waivers in Takeover Situations1
July 2001
Courts recognize that the performance bond
surety's limit of liability is the amount stated in its bond. There are a number
of courts which have found that a performing surety waives its limited liability
under the bond simply by taking over the principal's work. The prudent surety
should, if at all possible, insist on an express limitation of liability when
it takes over. However, creative arguments exist for the performing surety's
liability to be limited to its bond amount, unless the surety expressly waives
such limitation in writing.
by Marilyn
Klinger
Sedgwick,
Detert, Moran & Arnold LLP
Numerous cases around the country recognize that the performance bond surety's
limit of liability is the amount stated in its bond.2 One of the best examples of that recognition is In Re
Technology for Energy Corp., 123 BR 979 (Bankr ED Tenn, 1991), where
the court dismissed an obligee's creative attempt to exceed the bond penalty.
The obligee issued numerous change orders to increase the bond principal's total
contract amount to twice the original contract amount as well as the penal limit
stated in the bond. After the principal's default, upon the surety's refusal,
the obligee completed the principal's obligations at costs in excess of the
contract balance of more than double the amount of the penal limit.
The obligee attempted to recover from the surety all of its excess costs.
First, it argued unsuccessfully that the term "penalty" meant all of the obligee's
damages. It also argued that the bond required the surety to complete the project,
irrespective of the cost of completion, and the surety's refusal to complete
subjected it to all of the obligee's damages. The court again disagreed, recognizing
that "[t]he penal sum is always a limit on the surety's liability for its own
refusal to perform the contract."3
Performing Sureties Are Deemed To Have Waived Limited Liability
There are a number of courts which have found that a performing surety waives
its limited liability under the bond simply by taking over the principal's work.
They do so even though those same courts also recognize that the surety may
refuse to perform after the principal defaults and rest on its bond limit of
liability.4 The cases hold that a performing
surety waives its rights to rely on the terms of the bond, including the bond
penalty. Uniformly, these cases share the following factual pattern:
- The principal defaults.
- The bond is silent as to the surety's options upon the principal's default.
- The surety takes over.
- The surety performs the principal's obligation without limiting its
liability as a condition of performance, and without reserving its rights
to assert the bond limit of liability.
- The obligee seeks damages that exceed the bond amount.
Under the above factual pattern, the performing surety is deemed to have
waived its penal sum because the surety is deemed to have stepped into the shoes
of its principal and acted as a primary obligor instead of remaining a surety
under the bond. As primary obligor, the surety is deemed liable for the full
performance of its new, primary obligations.5
The case of Caron v Andrew, 133 Cal App 2d
402, 284 P2d 544 (1955), is representative. In Caron,
the surety guaranteed the performance of a leveling contract between its principal
and the owners. The surety bond contained a bond penalty. The principal defaulted,
abandoned the work, vacated the premises, and did not return." The surety agreed
to perform the work and did perform for several months. In the interim, however,
there were heavy rains and flooding. In addition, the owners allowed the removal
of a substantial amount of dirt from the property.
Eventually, the surety ceased work on the project, taking the position that
the contract was rendered impossible due to the flooding. Additionally, the
surety asserted that the owners' permitting the removal of dirt from the property
was a material alteration, and discharged the surety's further obligations.
The owners completed the leveling work for costs exceeding the bond penalty
and sued the surety.
After trial, the court found in favor of the owners, but limited the owners'
recovery to the bond penalty. On appeal, the owners successfully asserted that
the limitation on the surety's liability was no longer available. The appellate
court acknowledged that:
Upon breach by the principal, the surety is, unless otherwise specifically
provided in the contract, free to rest upon the contract of suretyship and
if it does it cannot be held beyond the limit of its bond and may invoke
any defense open to it as surety. Id. at 410.
However, the court found that the surety had waived its rights to rely on
the terms of the bond. In so ruling, the court reasoned:
[The surety] stepped into its principal's shoes and, as the court found,
undertook to complete its principal's contract without in any way seeking to protect itself
by exacting extensions of time or other conditions which would or might
make its undertaking less burdensome. Having done this and having
consumed several months of time, it, in turn, breached its obligations and
abandoned the work, leaving it to [the owners] to extricate themselves as
best they could from the difficulties thus cast upon them. Thereafter, [the
surety] could not shelter itself behind the limitation of its liability
expressed in its bond as it might have done had it rested upon its surety
contract. Id. at 412 [Emphasis added].
Thus, under Caron, the surety may be deemed
to have waived its bond penalty unless the surety seeks to "protect itself"
by conditioning its performance on maintaining its limited liability.
Of note, Caron relied on the terms of the
surety's bond, which did not describe the surety's options in remedying its
principal's default as the AIA bond forms do. Since the court ruled that the
surety proceeded "outside" the terms of the bond, the opposite result may have
been reached had the bond expressly included, as an option to the surety, taking
over and completing the project.6
While the cases discussed come from all over the country, the arguments examined
are California based. Readers should look for comparable case or statutory law
in their state that may form the basis of similar arguments against bond penalty
waiver.
Argument Against Waiver of the Bond Penalty
The Surety's Waiver of Its Bond Limit Must Be in Writing
To Satisfy the Statute of Frauds. California Civil Code § 2787 states
that, "A surety or guarantor is one who promises to answer for the debt, default,
or miscarriage of another...." Cal. As such, California's Statute of Frauds
expressly applies to suretyship. Code § 1624 provides:
- The following contracts are invalid, unless they, or some note or memorandum
thereof, are in writing and subscribed by the party to be charged or by
the party's agent:
* * *
- A special promise to answer for the debt, default, or miscarriage of
another, except in the cases provided for in Section 2794.
Even without the Statute of Frauds, California's Title 13, Suretyship, provides,
at section 2793:
Except as prescribed by the next section, a suretyship obligation must
be in writing, and signed by the surety; but the writing need not express
a consideration.
Material changes to a contract subject to the Statute of Frauds must also
be in writing.7 Thus, an argument can be
made that the surety's "waiver" of its bond limit when agreeing to take over
and complete performance must be in writing.
A Surety May Take Over and Complete a Construction
Project Without Acting as a Principal. In 1996 the California legislature
enacted Business & Professions Code section 7044.2, which is within the statutory
scheme regulating contractors through licensure, states:
This chapter [requiring a contractor's license] does not apply to an
admitted surety insurer whenever that surety insurer engages a contractor
to undertake the completion of a contract on which a performance or completion
bond was issued by the surety insurer, provided all actual construction
work is performed by duly licensed contractors.
In California, anyone who engages in construction activities, i.e., acts
as a contractor, must be licensed and, if not, cannot collect payment for work
performed.8 With the enactment of Business
& Professions Code section 7044.2, the legislature arguably recognized a surety's
rights, as surety, to perform under a performance
bond. As discussed above, as long as the surety is performing under its bond, an argument can be made
that its liability would be limited to the bond amount.
A Performance Bond Is A Statutory Bond Such That the
Statute Limits the Surety's Liability. In California, the Bonds and Undertaking
chapter of the Code of Civil Procedure governs a surety's liability on bonds
issued pursuant to statute. Specifically, section 995.020 provides:
- The provisions of this chapter [§§ 995.010–996.560 "Chapter 2. Bonds
and Undertakings] apply to a bond or undertaking executed, filed, posted,
furnished, or otherwise given as security pursuant to any statute of this
state, except to the extent the statute prescribes a different rule or is
inconsistent.
Progress Glass Co. v American Ins. Co., 100
Cal App 3d 720, 161 Cal Rptr 243 (1980), holds that a bond "permitted" by a
statute is a statutory bond. California Public Contracts Code sections 10221-10222,
10224, provide for public works performance bonds, which are clearly statutory
bonds. Additionally, California Civil Code section 3248(b) permits a subcontractor
performance bond on a public works project, and, therefore, may be considered
a statutory bond as well. Thus, there is an argument that all performance bonds
issued in connection with a public works project in California are statutory
bonds.
The significance of that conclusion is set forth in California Code of Civil
Procedure section 996.470, which provides:
- Notwithstanding any other statute ... the aggregate liability of a surety
to al persons for all breaches of the condition of a bond is limited to
the amount of the bond....
- If a bond is given in an amount greater than the amount required by
statute or by order of the court or officer pursuant to statute, the liability
of the surety on the bond is limited to the amount required by statute or
by order of the court or officer....
Thus, a surety's liability under such bonds may be limited to the amount
of the bond regardless of whether the surety takes over or not.
Conclusion
The prudent surety should, if at all possible, insist on an express limitation
of liability when it takes over. However, based on the authorities cited above,
creative arguments exist, at least in California, for the performing surety's
liability to be limited to its bond amount, unless the surety expressly waives
such limitation in writing.
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