Killer Bond Forms and Contract Provisions (Part 2)
August 2007
As noted in Part 1, the June 2007 article, public and private obligees, including
property owners and general contractors, are rewriting bond forms and contract
provisions for contractors or subcontractors. The following article provides
more examples.
by Marilyn
Klinger*
Sedgwick,
Detert, Moran & Arnold LLP
Provisions by which the penal sum of the bond increases with change orders
are becoming more common.
Penal Sum Increases with Change Orders
One of the most common examples of such provisions is the following:
Any increase in the Contract amount shall automatically result in a corresponding
increase in the Bond's penal amount without notice to or consent from Surety,
such notice and consent being hereby waived. Decreases in the Contract amount
shall not, however, reduce the Bond's penal amount unless specifically provided
in said Change Order.
It is unclear why obligees are requiring these provisions. It is possible
they do not understand that the full coverage under a traditional performance
bond includes not just the amount of the bond but any remaining contract balance
that remains unpaid. In those situations, the cost of completing the work would
necessarily need to exceed both the remaining contract balance and the existing penal sum pegged at the
original contract price in order for the surety's liability to cap.
Consider this example:
| Original Contract Price |
$10,000,000 |
| Change Orders |
$1,500,000 |
| Revised Contract Price |
$11,500,000 |
| Paid to date, including 10% retention of $650,000
(56% of project complete) |
$6,500,000 |
| Paid to date, not including retention |
$5,850,000 |
| Remaining Contract Balance ($11,500,000 - $5,850,000) |
$5,650,000 |
| Penal Sum of Bond |
$10,000,000 |
| Total amount available to complete project |
$15,650,000 |
| Cost to complete (assume 10% over 44% completion
percentage) |
$5,566,000
Thus, there is a cushion of over $10 million before the surety's liability
caps. |
Further, obligees may not understand why sureties charge premium for change
orders but do not have their bond penalties increase correspondingly. The performance
bond covers the change order work, i.e., guarantees its completion, regardless
of the surety's limit of liability. Accordingly, they charge more premium—they
have guaranteed more work.
Presumably, there have been situations where a surety is not prepared to
complete a project, possibly where an obligee will not agree to cap the surety's
liability at the penal sum. At that stage, a surety may simply pay the penal
sum. Then, the obligee must complete the project itself and, presumably, that
cost could exceed the penal sum. It may be those situations, although extremely
rare, where obligees have decided they want to assure that the penal sum will
track the revised contract price.
It is also possible that obligees have decided to include these clauses to
provide an incentive for sureties to complete projects. Generally speaking,
unless the bond or the takeover agreement provides otherwise, a surety is deemed
to have waived its penal sum upon takeover. Accordingly, if the penal sum increases
with changes, the surety might be more inclined to take over rather than leave
completion to the obligee.
In addition to what is likely a misunderstanding on the part of obligees,
it is possible that with the increase in the types of damages recoverable against
a surety, the obligees want additional dollars available. For example, in California,
a surety may be liable for certain consequential damages arising out of the
bond principal's default.1 Those consequential damages,
such as actual delay damages (if there is no liquidated damages provision),
can be substantial and far exceed the original contract price. Overall, there
are relatively few instances where the penal sum cap comes into play.
There is another concern. Surety underwriters partially base the amount of
surety credit they provide for contractors on the amount of pending exposure.
Admittedly, they look primarily at backlog or work in progress, which does track
the value of the construction yet to be completed, including change orders.
Nonetheless, if the penal sum and, thus, the surety's exposure on already-issued
bonds can increase without notice to the surety, sureties will have no certainty.
It is unclear how the moving target of ever increasing penal sums will affect
surety underwriting into the future and how it will affect contractors' ability
to obtain new bonds for new projects.
Waiver of All Changes/Potential Result=Unlimited Penal Sum
At least one trial court in an unreported decision has read the following
provision with the one above to conclude that, regardless of the amount of the
change order, the surety is on the hook:
The Surety hereby waives notice of any change, including changes of time,
to the Construction Contract or to related subcontracts, purchase orders
and other obligations.
In other words, the court has combined the provision that says that the penal
sum of the bond increases with each change order with the provision that the
surety waives notice of any change. Thus, even if the change order is many times
larger than the original contract price, the surety arguably waived notice and
agreed that the penal sum would increase accordingly.
Waiver of All Changes
The portion of the following waiver that is of the most concern is the last
clause, "of any other act or acts by the Obligee or any of its authorized agents."
The Principal shall ensure that the Surety is familiar with all of the terms
and conditions of the Contract Documents, and shall obtain the Surety's
written acknowledgment that it waives the right of special notification
of any changes or modifications of the Contract, or of extensions of time,
or of decreased or increased work, or of cancellation of the Contract, or
of any other act or acts by the Obligee or any of its authorized agents.
It is possible that the obligee could argue that, by virtue of this clause,
the surety has waived all defenses, including wrongful termination, overpayment,
or failure to mitigate damages. In California, waiver is "an intentional relinquishment
of a known right after knowledge of the facts."2 Accordingly, there is a question of whether the provision would constitute a
waiver of something to occur in the future that is not defined with more particularity.
Nonetheless, it is a problematic clause that could cause a surety to refuse
to issue the bond.
Penal Sum Increases with Change Orders up to X%
As a compromise, the surety industry has been able to convince some obligees
that insist on having the penal sum increase with change orders to limit the
percentage increase without surety consent. The following provision is an example.
The Penal Sum of this Bond shall automatically increase as the Contract Amount
increases; provided, however, the initial Penal Sum shall not increase more
than ___% absent the Surety's written consent. Surety's refusal to consent
to such an increase in the Penal Sum shall not be a breach of this Bond.
The last sentence of the clause is quite essential. Otherwise, the percentage
limit would be meaningless. If the surety refused to have its penal sum increased
beyond the percentage limit and, because of that, the obligee declared the bond
principal in default for failing to have the required bond, the surety would
be facing a default. Thus, a percentage limitation without the last sentence
would be meaningless.
* Thanks should go to Pierre Le Compte
of The Hartford for identifying the subject matter for this series.
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