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By:  Robert J. MacPherson, Esq.

Surety bonds are contracts and the rights and obligations of the parties will be determined in accordance with basic principles of contract law.  The size of the claims and complexity of the project will not impact the result.  That is proven by a recent court decision of the New York Court of Appeals decision in Walter Concrete Constr. Corp. v. Lederle Laboratories, 2003 WL 367460, and by a decision of the U.S. District Court for the Southern District of New York decision in  United States Fidelity and Guaranty Company, et al. v. Braspetro Oil Services Company, et al., 219 F.Supp. 2d. 403 (2002).

Walter Concrete involved a claim by a general contractor (“GC “) against its subcontractor’s performance bond surety.  The GC had problems with its subcontractor’s performance, but never terminated the subcontract.  When the subcontractor abandoned the project, the GC did not ask the surety to complete the work.  Instead, it completed the subcontractor’s work.  The GC in turn demanded payment for those costs from the surety.  The surety denied the claim, contending that the GC had never notified the surety of its subcontractor’s default.  The Court of Appeals affirmed a decision granting summary judgment against the surety, finding that the performance bond contained no provision requiring a notice of default as a condition precedent to any legal action against the surety.  The only condition imposed on the GC in order to make a valid claim was that it commence its action within the bond’s time limits.

In contrast to Walter Concrete which involved a commercial building with claims of a little over a half-million dollars, the case in USF&G v. Braspetro involved claims by the owner against its contractor’s sureties on two related, but distinct projects.  One involved a $165 million design-build contract to convert an oil and natural gas platform into a semi-submersible oil and natural gas production platform and was reported to be the largest of its kind ever undertaken.  The second project was a $163 million design-build contract to convert an oil tanker into a floating production, storage and offloading vessel.

The bonds at issue in USF&G required that the sureties and the contractor be given a pre-default notice and that the sureties’ obligations under the bonds would not arise until after the contractor had been declared in default and its contract formally terminated.  The owner provided the pre-default notice and eventually formally terminated the contractor’s right to proceed with the work, but the sureties disclaimed any liability.  They contended that they were prejudiced by the owner’s delay in declaring a default.

The court rejected the sureties’ claims, finding that after the owner had sent the pre-default notice, the sureties actively discouraged the owner from formally declaring a default.  They did so by emphasizing that once a default was declared all work on the projects would stop while the sureties conducted an investigation to determine the propriety of the default.  The sureties also told the owner that such an investigation could not begin until a default was declared.  According to the Court, this did not stop the sureties from beginning the preparation of their defense to any claims under the bonds.  The Court found that when the default was formally declared the sureties made only a token effort to explore the possibility of taking over the contracts and did not conduct a good faith investigation.  Rather, they continued their efforts to prepare for litigation while characterizing these activities as an “investigation.”

While the Court held that the sureties had no legal obligation to take any specific action prior to a formal declaration of default, once a default was declared they had an obligation to make a good faith investigation into the claims.  The court found that the owner was entitled to recover damages of $90 million, plus attorneys’ fees on the tanker conversion project.  The damage award, plus attorneys’ fees, could not exceed the amount of the bond for each project, but the owner was also awarded pre-judgment interest, which is not limited by the amount of the bonds.  The sureties have appealed.

Author’s Note:  The decision to terminate a contractor and call upon its surety is always difficult.  It will invariably cause delay and disruption to the project and involve the expenditure of costs that may never be recovered.  Default declarations should never be made lightly and should only be made after exploring all avenues for having the contractor complete the project.  This may include a request to the surety that it actively take steps to prevent an impending default.  Sureties, however, have no legal obligation to take any affirmative action prior to a declaration of default and will not do so absent compelling reasons.  This does not mean that a party faced with a non-performing contractor should refrain from contacting the surety when warning signs appear.  The late submittal of a shop drawing is probably not such a sign, but claims by subcontractors that they have not been paid for work for which the general contractor has been paid most surely is.  A bond claimant who has provided complete and accurate information to a surety will be in a better position to insist that the surety act promptly once the default is declared.  Claimants must also comply strictly with the notice provisions and any time limitations contained in the bond.  Sureties, who under the guise of conducting an investigation into a claimed default, spend their time and resources building a defense, may find their delay in responding exposes them to a greater liability.

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About the Author:  Robert MacPherson is an attorney with the nationally recognized law firm of Postner & Rubin, with a practice emphasizing construction law.  The firm represents all parties who participate in the many phases of the construction process – from owners, contractors, construction managers, subcontractors and suppliers to architects, engineers, sureties and insurers.   He may be reached at 17 Battery Place, Suite 210 , New York , NY 10004 (21) 269-2510. E-mail: rmacpherson@postner.com.

ConstructionRisk.com Report, Vol. 5, No. 5 (Jun 2003)