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Surety 02

Killer Bond Forms and Contract Provisions (Part 2)

Marilyn Klinger | August 1, 2007

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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.

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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1 Cates Construction, Inc. v. Talbot Partners, 21 Cal. 4th 28 (1999).
2 See, e.g., Roesch v. De Mota, 24 Cal. 2d 563, 572 (1944).