Every owner and general contractor is familiar with the circumstances of a typical contractor default. A contractor falls behind schedule or fails to pay its subcontractors and suppliers. Attempts are made to rectify the situation, to no avail. Tempers flare and relationships deteriorate. Finally, with hard deadlines (and potentially liquidated damages) looming, there is no choice but to terminate the defaulting contractor, and its surety is called in.
The standard performance bonds provide the surety with several options at this point. It can take over the performance itself, tender a new completion contractor, arrange for completion by the defaulting contractor, or simply tender payment of the estimated completion cost. In some cases, the surety will exercise its “takeover” option but hire the defaulting contractor to perform the work. Does the owner or general contractor have the right to object to the hiring of the contractor that it terminated? A recent decision by the United States First Circuit Court of Appeals (which covers most of New England) held that the answer is “no” – and that if the owner or general contractor refuses to allow the terminated contractor to return to work, it forfeits its rights under the bond.
The case, St. Paul Fire & Marine Ins. Co. v. VDE Corp., arose out of a residential real estate construction project in Puerto Rico. VDE Corporation was the owner of the project, and F&R Contractors was VDE’s general contractor. St. Paul issued a standard A-312 performance bond guaranteeing F&R’s performance under the general contract. Two years into the project, VDE declared F&R to be in default for failing to perform work at a reasonable pace, not acting in good faith, and other alleged breaches. VDE notified St. Paul of the declaration of default, and advised St. Paul that it would oppose having the project completed by F&R.
St. Paul took the position that if St. Paul chose to complete the project work under Paragraph 4.2 of the bond, VDE had no right under the plain language of the bond to oppose the surety’s choice of contractor. Specifically, Paragraph 4.2 contains no language requiring owner consent. It simply provides that when an owner properly declares a default, the surety may “undertake to perform and complete the Construction Contract itself, through its agents or through independent contractors.”
St. Paul initiated a civil action seeking a declaration that VDE breached the bond by failing to allow St. Paul to take action under Paragraph 4 of the bond, and that St. Paul was therefore discharged from further bond obligations. VDE contended that even if the plain language of the bond did not require VDE’s consent of the completion contractor, VDE’s allegations that F&R acted in bad faith should trump the language of the bond and obligate St. Paul to obtain VDE’s consent. The court rejected VDE’s contentions and granted summary judgment in St. Paul’s favor, releasing St. Paul from its bond obligations. First, the Court noted: “[b]y its plain terms, Paragraph 4.2 places no restrictions on whom St. Paul can use to complete the project.” The Court contrasted Paragraph 4.2 with Paragraphs 4.1 and 4.3, which both expressly require the surety to obtain the owner’s consent as to the completion contractor.
The Court reconciled the differences between the three Paragraphs by observing that unlike Paragraphs 4.1 and 4.3, Paragraph 4.2 requires that the surety assume the primary responsibility for completing the contract. Under Paragraph 4.1, the original contractor, with the consent of the owner, remains primarily responsible for completing the contract, and under Paragraph 4.3, a replacement contractor – again selected with the consent of the owner – assumes responsibility for the contract. In contrast, under Paragraph 4.2 the surety “undertakes to perform” the contract. If the surety fails to meet its obligations to complete the contract, the owner has a remedy against the surety directly. The court held that with the greater risk and responsibility under Paragraph 4.2 comes “the freedom to assemble the project team of [the surety’s] choosing.”
The St. Paul decision not only further defines the rights of the parties under a commonly used bond form, it also serves as a warning to bond obligees that they may forfeit their bond rights if they impede the surety’s rights under Paragraph 4.2 to select its own principal as the completing contractor