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Killer Bond Forms and Contract Provisions (Part 1) (June 2007)
Killer Bond Forms and Contract Provisions (Part 2) (August 2007)
Killer Bond Forms and Contract Provisions (Part 3) (August 2008)
Killer Bond Forms and Contract Provisions (Part 4) (August 2008)
Surety Underwriting, Sales & Service—A Delicate Balance (May 2006)
California Curtails Unlicensed Contractors' Recovery for Their Work (April 2006)
Construction Surety Bond Liability for Consequential Damages (March 2006)
Sales and Use Tax Bonds (April 2005)
"What Performance Did the Parties Bargain For?" (January 2005)
Unraveling Letters of Credit (November 2004)
ERISA Preemption and Claims for Employee Benefits (January 2004)
Are Letters of Credit Securing a Surety's Exposure Safe? (August 2003)
Enhancing Your Financials (July 2003)
Subdivision/Improvement Bonds (April 2003)
Can a Surety Enforce the Automatic Stay in the Principal's Bankruptcy? (February 2003)
Minimum Insurance Requirements (January 2003)
Corporate Execution of Surety Indemnity Agreements (November 2002)
Project Risk Assessment (October 2002)
Exoneration Based on Fraud in the Inducement as a Surety Defense (August 2002)
Protecting the Balance Sheet (July 2002)
Roles and Responsibilities: A Delicate Balance (April 2002)
California Workers Compensation Self-Insured Bonds and the Principal's Bankruptcy (February 2002)
Surety Credit Basics (January 2002)
Provisions in the Proposed Bankruptcy Reform Act of 2001 of Interest to Sureties (November 2001)
Bonding Tips and Tactics: Contractor Default Insurance (October 2001)
Surety Bond Penalty Waivers in Takeover Situations (July 2001)
All Guarantees Are Not Created Equal (July 2001)
Proactive Surety Claims Handling (April 2001)
To Risk or Not To Risk? (March 2001)
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Killer Bond Forms and Contract Provisions (Part 3)

August 2008

As noted in the first surety bond article in this series, public and private obligees, including property owners and general contractors, are rewriting bond forms and contract provisions for contractors or subcontractors.

by Marilyn Klinger*
Sedgwick, Detert, Moran & Arnold LLP

The following are more examples. This expert commentary is the third in the series.

Bond Coverage Limitation or Not

In no event, however, shall Surety be required to pay more than a sum equal to [1] the original contract price as amended from time to time together with [2] any additional sums accruing as the result of amendments to the original contract prior to default and [3] sums necessary to remedy any damage or depreciation suffered by the project, with the exception that in additional hereto, Surety shall be required to pay [4] all costs and attorney's fees the Obligee incurred in enforcing the Bond.

By using the words "in no event, however, shall Surety be required," this provision appears to be worded in a way to make it seem as if there is some limitation as to the surety's liability on the bond. However, the four categories of damages for which the surety is liable essentially encompass the entirety of what a surety could possibly be liable for under a performance bond. There essentially is no penal sum or limit of liability for the surety. It includes penal sum increases as a result of change orders by virtue of the second clause, i.e., any additional sums accruing as the results of amendments to the original contract. It includes consequential damages with the broad term "any damage…suffered by the project." And, it includes costs and attorney fees regardless of how much.

If Obligee Completes

Surety shall not have the right, if Obligee completes, to object on the grounds that Obligee's successor contractor is not the lowest and best bidder or that the successor contract price is excessive unless the objection is based on demonstrated amendments to the plans and specifications made after the declared default and constituting new work.
Surety shall be liable to Obligee for all consequential damages resulting from Surety's breach of this performance bond.

This approach on the part of obligees is one of the main reasons that sureties often opt to take over a project rather than allow the obligee to complete the project. Often, when an obligee completes, it will either have the work performed on a time and material or cost-plus basis, thereby running the risk of completion costs far in excess of the original contract price. Even if the obligee does not perform the project on a time and material basis, it might select a favored contractor or subcontractor to do the work and negotiate a contact price that is, again, significantly greater than the cost of a competitively bid project.

Even if a surety does not decide to take over a project, a surety typically has the argument that the obligee has included betterments or upgrades in its completion work for which the surety is not obligated to reimburse to the obligee. The above clause seemingly removes that argument. Admittedly, the argument is not a very effective one for a surety in the first place—it is typically an uphill battle. Essentially, the surety argues that the obligee has performed work that is outside the scope of the plans and specifications of the underlying bonded contract. However, there are subtleties in the quality of materials incorporated into a project and it is those upgrades that would be the subject of a surety's objection if the above clause were not included in the bond.

By the same token, upon reading the above provision in detail, in actuality, it is saying the same thing that sureties contend, i.e., that they are not liable for any work performed outside of the scope of the plans and specifications of the contract. Only if there are "amendments to the plans and specifications," that is, work performed outside the scope of the original plans and specifications, can the surety object to the obligee's expenditures in the sense of not being liable for same. Thus, although the language is unusual, the provision arguably is not significantly different from what a surety can and cannot object to when responding to an obligee's demand for reimbursement.

As to the amount of the bid or lump sum contract price for a completion contract, as long as the work being performed is within the scope of the plans and specifications and as long as there was no collusion between the obligee and the completion contract, a surety's argument that the obligee did not mitigate its damages by selecting the least expensive responsible or qualified prospective completion contractor is also an uphill battle. It is more than likely that the obligee will have sufficient grounds for selecting its completion contractor such that the surety will lose on its failure-to-mitigate argument.

Waiving All Defenses

If Principal breaches the Contract (as determined in Obligee's sole discretion), Surety will, within 7 days after written notice of breach, commence to complete the Contract. If, at its option, Obligee elects to complete, using contractors, subcontractors, or materials that Obligee, in its sole discretion, deems necessary, Surety will immediately pay Obligee's invoices without contest, waiving all defenses that either Surety or Principal may have under the Bond or the Contract.

By this provision, the surety must complete if the obligee requires it to complete but cannot insist upon completing if the obligee elects to complete—the worst of both possible scenarios from a surety's perspective. Further, if the obligee completes, the surety waives all defenses, including arguably that it is exonerated by virtue of the default of the obligee. The waiver language does not apply if the surety completes. Accordingly, the surety could arguably complete under a reservation of rights and then pursue its excess costs against the obligee if it determines that the obligee was in default.

Of course, it would be impossible for the surety to commence completion in 7 days of notice of the breach. This provision implies that the surety industry has a group of contractors in every possible type of construction standing by to mobilize within a week and commence completion. It just does not happen that way. It is likely that the surety will obtain an extension to that 7-day requirement. It is also likely that an obligee would be satisfied if within that 7 days or some other very short time frame, the surety advised the obligee that it would complete and explained what needed to be done to proceed forward in that fashion and a time estimate as to when completion would actually commence.

Subdivision Bonds

In the event of the failure of Developer to complete the work covered by the performance bond and Obligee completes construction of the improvements, Developer and Surety under the performance bond shall be jointly and severally liable to Obligee for such costs of completion, including but not limited to, management and administrative costs, and engineering, legal and other costs incurred relating to the completion. Obligee shall bill Developer and Surety for such costs, which bill shall be paid within thirty (30) days after its date. Interest shall accrue on any late payment at the legal rate then prevailing.

Arguably, each of the elements of damages described in the above provision would be included within a subdivision bond, i.e., costs of completion, and management, administrative, engineering, legal, and other costs incurred in completing the improvements. The payment for such costs in 30 days is unusual but arguably not onerous when compared to the 40 days in which a surety is to reject or deny a claim under California's Fair Claims Settlement Practices Regulations. Moreover, assuming the obligee has put the surety on notice of its intent to complete the improvements, the surety arguably had the opportunity to inspect what the obligee was doing so that it could pre-evaluate the obligee's costs before it received its bill for reimbursement. Of course, this provision is silent as to whether the surety has the option to complete instead of the obligee. Arguably, even though silent, the surety would have the right to complete, rendering the payment aspect of this clause inapplicable.

Attorney Fees in Excess of Bond Penalty

Principal and Surety agree that if Obligee is required to engage the services of an attorney in connection with enforcement of this Bond, each shall pay Obligee's costs and reasonable attorney's fees incurred, with or without suit, in addition to the above penal sum.

The law generally provides that a surety's liability is capped at the penal sum, including attorney's fees incurred in enforcing the bond. These provisions to the contrary, making a surety (and in this case, the bond principal) liable for attorney's fees in enforcing the bond in excess of the bond penalty is becoming quite prevalent. The theory is that the bond penalty corresponds with the contract price, which, in turn, theoretically corresponds to the cost to complete. If the attorney's fees that an obligee must expend to recover against a surety can eat away at the penal sum, there is less money available for the obligee to complete the project or reimburse itself for the costs of completion.

* Thanks should go to Pierre Le Compte of The Hartford for identifying the subject matter for this series.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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