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Declaration of Default Not Required to Trigger Surety’s Liability on Performance Bond, Court Holds
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November 16, 2009
By Laura Thomson
In performing its contract to build a Wal-Mart store in Vancouver, Washington, Colorado Structures, Inc. subcontracted with Action Excavating and Paving, Inc. to build the store’s sewer system. Action fell behind schedule. Colorado Structures faced “enormous financial penalties” if the project was not completed on time for the store’s grand opening. To avoid the delays that would result if Action’s subcontract were terminated and a replacement subcontractor brought in, Colorado Structures chose to supplement Action’s work crews with additional manpower and equipment. Even with the additional manpower and equipment, the sewer system was not completed on time, and portions of the work were later rejected by city inspectors.
Colorado Structures had required Action to post a performance bond guaranteeing Action’s performance. It was written on an American Institute of Architects A311 bond form in the amount of the subcontract, $472,290, by Insurance Company of the West, Inc.
Colorado Structures first wrote to West several weeks before Action’s completion date that it was “a little concerned with Action completing” on time. In Colorado Structure’s second letter to West, it set out “breaches and the remedy to be employed,” including supplementing manpower and equipment. West refused multiple requests to visit the jobsite, to attend meetings, or to discuss Action’s non-performance or Colorado Structure’s proposed remedy. When Colorado Structures sent notice to West of the city’s rejection of portions of the sewer line, Colorado Structures told West it would seek reimbursement of its costs.
But, when Colorado Structures sought to reimbursement of its additional costs from the surety, West refused to pay on grounds that Colorado Structures had not formally declared Action in default.
Structures sued West, Action and Action’s owners. Action and its owners defaulted. The case proceeded against West. The Clark County Superior Court ruled, as a matter of law, that Colorado Structures was not required to formally declare Action in default before West was liable on the performance bond and that Colorado Structures had given adequate notice to West of Action’s performance problems. The trial court awarded damages and attorney fees up to the amount of the performance bond.
The Court of Appeals affirmed in part and reversed in part. Affirming recovery on the bond, the Court of Appeals held that under the plain language of the bond, West’s liability was not conditioned on Colorado Structures formally declaring Action to be in default.
The Washington Supreme Court affirmed, explicitly adopting the Court of Appeals’ opinion. Colorado Structures, Inc. v. Insurance Co. of the West, 161 Wash.2d 577, 167 P. 3d 1125 (2007).
In so ruling, the Supreme Court examined the express language of the bond. The bond provided that Action and West “are held and firmly bound” to Colorado Structures for $472,290. It continued:
THEREFORE, THE CONDITION OF THIS OBLIGATION IS SUCH THAT, if Principal shall promptly and faithfully perform said subcontract, then this obligation shall be null and void; otherwise, it shall remain in full force and effect….
The bond continued:
Whenever Principal shall be, and declared by Obligee to be in default under the subcontract, the Obligee having performed Obligee's obligations thereunder:
| (1) | Surety may promptly remedy the default, subject to the provisions of paragraph 3 herein, or;
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| (2) | Obligee after reasonable notice to Surety may, or Surety upon demand of Obligee may arrange for the performance of Principal's obligation under the subcontract subject to the provisions of paragraph 3 herein;
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| (3) | The balance of the subcontract price, as defined below, shall be credited against the reasonable cost of completing performance of the subcontract. If completed by the Obligee, and the reasonable cost exceeds the balance of the subcontract price, the Surety shall pay to the Obligee such excess, but in no event shall the aggregate liability of the Surety exceed the amount of this bond. If the Surety arranges completion or remedies the default, that portion of the balance of the subcontract price as may be required to complete the subcontract or remedy the default and to reimburse the Surety for its outlays shall be paid to the Surety at the times and in the manner as said sums would have been payable to Principal had there been no default under the subcontract.
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The Supreme Court rejected the argument. It held that a declaration of default was necessary only to access the three remedies listed after the bond’s default provision.
If no default is declared, the court held, the surety still remains liable on the bond and subject to common law remedies and measures of damages for breach of the subcontract, which was incorporated into the bond. West was excused from that liability only if Action “faithfully perform[ed]” the subcontract.
The Supreme Court held that the remedies listed in the bond were available only when: 1) the principal is in default under the subcontract; 2) the obligee declares the principal to be in default under the subcontract: and 3) the obligee has performed its own obligations under the subcontract.
The Supreme Court held that if the contractual remedies set out in the bond are not available, the surety, as guarantor, still is responsible for breach of the subcontract and subject to common law remedies. The court found there was only one express condition to imposing such common law liability on West: “the condition of this obligation is such that if Principal shall promptly and faithfully perform said subcontract, then this obligation shall be null and void; otherwise it shall remain in full force and effect.” The use of “otherwise,” the court held, “expressly eliminates all other conditions.” Accordingly, Colorado Structures was not required to declare the subcontractor in default as a precondition to the surety’s liability under the bond. Rather, West was liable if Action failed to “promptly and faithfully perform.”
As there was no question that Action materially breached the subcontract, the court analyzed whether Colorado Structures had declared Action to be in default. The court distinguished between “breach” of contract and “default” under a contract, noting that not every contract breach will constitute a default. The court held that a principal is in default only when it materially breaches a contract, thereby permitting (but not requiring) the obligee (here, Colorado Structure) to terminate or cancel the contract.
The court held that “an obligee ‘declares’ a principal to be in default when, having elected to treat the breach as ‘material,’ the obligee announces his or her intent to terminate the contract.” Under this analysis, the court found that Colorado Structures did not declare Action to be in default. Rather, Colorado Structure chose to allow Action to continue performing and sought only damages for Action’s performance failures under the contract.
Because Colorado Structures merely had the option to declare a default but was not obligated to do so, the Supreme Court held that Colorado Structure did not fail to fulfill any obligation or condition under the bond necessary to impose liability on the surety. The conditions precedent in the bond merely applied to remedies specified in the bond but did not apply to liability under the bond. The court made a similar analysis under the common law and the subcontract and concluded that Colorado Structures did not fail to fulfill any obligations imposed by law or the subcontract.
The Washington Supreme Court expressly declined to follow L&A Contracting Co. v. Southern Concrete Services, Inc., 17 F.3d 1006 (5th Cir. 1994), a case heavily relied upon by West. L&A Contracting held that a declaration of default must be “in terms sufficiently clear, direct, and unequivocal to inform the surety that the principal has defaulted on its obligations and the surety must immediately commence performing under the terms of its bond.” Finding that such a declaration was not made by the obligee general contractor, the L&A Contracting court ruled for the surety.
The Washington Supreme Court criticized L&A Construction, writing that the 5th Circuit “failed to analyze” the actual language of the bond’ and that its conclusion about the surety’s liability “plainly violates the language of the bond.”
Ultimately, the Supreme Court concluded, as did the trial court and Court of Appeals, that Colorado Structures gave adequate notice to West. However, the Supreme Court expressly wrote that notice had no bearing on its analysis of the language of the bond.
On the issue of attorney fees, also part of the appeal, the Supreme Court agreed with the Court of Appeals that Colorado Structures was entitled attorney fees under a Washington common law doctrine allowing attorney fees to an insured that is compelled to take legal action to obtain the benefit of its insurance contract. See, Olympic Steamship Co. v. Centennial Insurance Co., 117 Wash.2d 37, 811 P.2d (1991).
Emphasizing the unequal bargaining positions of the surety and the obligee in the construction bond context, the court extended Olympic Steamship to cover sureties that wrongfully refuse to pay on performance bonds. The court observed, “[T]he crucial fact is that sureties, like insurance companies, face minimal incentive to perform on their contracts if the maximum loss they may incur is the amount of the bond, especially since the transaction costs of litigation are likely to dissuade contractors who would otherwise assert their right to full payment.”
The court held that because Colorado Structures was entitled to attorney fees under the Olympic Steamship common law doctrine, its recovery of fees was not limited by the penal sum of the bond.
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