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Howrey LLP
Two appellate court decisions demonstrate the importance of fully, clearly and timely complying with default notification provisions in order to preserve rights of recovery on performance and payment bonds.
In one case, the court discharged the surety from its bond obligations after the owner failed to expressly notify the surety of the surety's own default. Seaboard Surety Co. v. Greenfield Middle School Building Committee, 370 F.3d 215 (1st Cir. 2004).
The owner had previously terminated the contractor, and the owner and the surety had been negotiating an agreement for completion of the remaining work on the school project. After several months of investigation, discussion and complaints from the owner failed to induce the surety to act, the owner hired a third-party contractor to complete the work and notified the surety of its decision.
Shortly afterward, the surety moved in court to discharge its obligations under the bond. The appeals court affirmed, finding that the owner's complaint letters did not satisfy the express provisions of the bond regarding notice to the surety of its own default. Those provisions provided that if the surety did not proceed with the work with reasonable promptness, then the surety was in default "fifteen days after receipt of an additional written notice from the Owner to the Surety demanding that the Surety perform its obligations under this Bond."
The court, agreeing with the surety, found that the owner had not properly noticed the default before contracting with the third party, thereby denying the surety the opportunity to limit its financial exposure by obtaining bids for the completion work - an important right, in the court's view. Even when the owner's letters requested the surety's response by a certain deadline, the letters failed to clearly, directly and unequivocally alert the surety of the potential default, the court held. The letters also failed to assert a material breach for the surety's failure to perform with reasonable promptness, and they failed to warn of default within 15 days or to refer to the default provision in the bond.
Much had transpired before and at the time of the owner's letters to the surety, but this did not sway the court. After more than a year of construction, the owner had terminated the contractor. The surety initially responded to that termination by demanding time to investigate and additional documentation, followed by months of discussions and correspondence with the owner regarding certain emergency work and certain scheduling demands for the upcoming school year. The surety then insisted on using a construction manager for the remainder work with whom the owner had previously expressed dissatisfaction. At that point, the owner decided to complete the work through a third party. The surety responded with this lawsuit.
The dissent asserted that the court's decision added terms to the surety bond. The only express notification requirement was that the Town provide "additional written notice" "demanding that the Surety perform its obligations under this Bond." The dissent believed that a reasonable jury might find that this requirement was met.
In the second case, the failure to comply with bond notice requirements resulted in rejection of the general contractor's rights under a subcontractor's performance and payment bond. Elm Haven Construction L.P. v. Neri Construction LLC, 376 F.3d 96 (2nd Cir. 2004).
The subcontractor, Neri, had provided the general contractor with a performance bond and a payment bond as required by their subcontract agreement. After differences in opinion as to the scope of work under the subcontract, the contractor notified Neri and its surety of Neri's partial default under the subcontract terms, the contractor's intention to hire another subcontractor to perform that work but expressed its desire to otherwise keep the subcontract in force with the surety's assistance.
Seventeen days later, the contractor entered a contract with a third party subcontractor to complete all remaining work under Neri's subcontract. The contractor also paid the claims of two of Neri's sub-subcontractors without first seeking approval from Neri or the surety, which was required under the bond.
The contractor then made a claim on the performance bond for almost $1 million in losses and also made a claim on the payment bond. The surety denied both claims. The court ruled for the surety because the contractor did not notify the surety, as required by the performance bond, of Neri's total default until five weeks after the contractor had hired a replacement subcontractor for the remainder of Neri's work. This delay in notification prevented the surety from exercising its options under the bond. The previous notice of partial default was held insufficient to constitute notice for the subsequent complete replacement of Neri because the partial default notice had sought to keep the subcontract in force. The court held that the contractor was obligated to give notice of a total default in clear, unambiguous and precise terms and had failed to do so.
In addition, the contractor was held to have no rights under the performance bond for payments made to sub-subcontractors because it failed to seek approval from Neri or the surety, as required by the bond, before making payments to the sub-subcontractors. The contractor also failed to obtain an assignment of rights under the payment bond from the sub-subcontractors and therefore had no standing to proceed under that bond.
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For more information about the issues covered in this report, please contact Paul Berning in our San Francisco office at 415-848-4996 or at paulberning@howrey.com or contact your Howrey attorney. For more information about Howrey's Construction Practice Group, click here.
©2006 Howrey LLP
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