When a contractor is defaulted under a performance bond, can its surety hire the same defaulted contractor to complete the work? Stated differently, can the performance bond surety engage its defaulted bond-principal in taking over and completing the same work the contractor was defaulted under? The answer is “yes” if you are dealing with a standard form AIA A312 performance bond (and other bond forms that contain analogous language), as demonstrated by the recent decision in Seawatch at Marathon Condominium Association, Inc. v. The Guarantee Company of North America, 2019 WL 4850194 (Fla. 3d DCA 2019).

In this case, a condominium association hired a contractor in a multi-million dollar contract to renovate condominium buildings. The contractor provided the association, as the obligee, a performance bond written on an AIA A312 performance bond form. During construction, the association declared the contractor in default and terminated the contractor. In doing so, the association demanded that the performance bond surety make an election under paragraph 4 of the AIA A312 bond form that gave the surety the following options:

4.1 Arrange for the CONTRACTOR, with consent of the OWNER, to perform and complete the Contract; or

4.2 Undertake to perform and complete the Contract itself, through its agents or through independent contractors; or

4.3 Obtain bids or negotiated proposals from qualified contractors acceptable to the OWNER for a contract for performance and completion of the Contract, arrange for a contract to be prepared for execution by the OWNER and the contractor selected with the OWNER’S concurrence, to be secured with performance and payment bonds executed by a qualified surety equivalent to the Bonds Issued on the Contract, and pay to the OWNER the amount of damages as described in paragraph 6 in excess of the Balance of the Contract Price incurred by the OWNER resulting from the CONTRACTOR Default; or

4.4 Waive its right to perform and complete, arrange for completion, or obtain a new contractor and with reasonable promptness under the circumstances;

4.4.1 After investigation, determine the amount for which it may be liable to the OWNER and, as soon as practicable after the amount is determined, tender payment therefore to the OWNER; or

4.4.2 Deny liability in whole or in part and notify the OWNER citing reasons therefore.

Seawatch at Marathon Condo. Ass’n, 2019 WL at *1-2.

The surety elected the option under section 4.2, underlined and bolded above. The surety wanted to complete the construction contract and provided the association with a surety takeover agreement, i.e., an agreement where the surety takes over the completion of the defaulted / terminated contractor’s contract. The takeover agreement was predicated on the terminated contractor continuing to serve as the contractor to finish the contract.

The association rejected the takeover agreement largely because it was adamant that the terminated contractor cannot serve as the completion contractor under the takeover agreement. The association also argued that the surety could not properly elect section 4.2 because it was not a licensed contractor and needed to be a licensed contractor in order to undertake the completion of the defaulted contract. Because an agreement could not be reached, the association filed a lawsuit for declaratory relief on these issues seeking judicial intervention as to its rights under the performance bond.

A. The Performance Bond Surety Can Use the Defaulted Contractor to Complete the Work

The trial court, as affirmed on appeal, held that the surety was well within its rights under section 4.2 of the bond to complete the contract with the defaulted contractor (bond-principal). Section 4.2 places NO restrictions on the surety in using the defaulted contractor or any other contractor, for that matter. As noted by the appellate court:

Finally, “[i]t is common practice for a surety undertaking to complete the project itself to hire the original contractor, as [Guarantee] elected to do here.” “By completing the project itself, the surety obtains greater control than it would have had if it elected to require the obligee to complete, because the surety can select the completing contractor or consultants to finish the project as well as control the costs of completion.”

Seawatch at Marathon Condo. Ass’n, 2019 WL at *4 (internal quotations omitted).

B. The Performance Bond Surety Does Not Need to be a Licensed Contractor to Enter into Takeover Agreement

The appellate court summarily rejected the argument by the association that the surety needed to be a licensed contractor to enter into a takeover agreement and undertake the completion of the defaulted contract. Since the surety is not actually performing the completion, the court rejected this outright which would prohibit the surety from ever exercising rights under section 4.2 unless it was a licensed contractor.

One thing to consider after reading the outcome of the case is that there is nothing to prevent the obligee of a bond from modifying a standard form bond form, or my preference, creating its own manuscript performance bond form. Creating your own performance bond form gives you more flexibility regarding rights to trigger a surety’s obligations under the bond and the recourse under the bond.

Please contact David Adelstein at dadelstein@gmail.com or (954) 361-4720 if you have questions or would like more information regarding this article. You can follow David Adelstein on Twitter @DavidAdelstein1.

On federal government construction projects, the prime contractor provides the government with a performance bond (pursuant to the Miller Act) guarantying the prime contractor’s performance under the prime contract. Under normal course and in accordance with the Federal Acquisition Regulations (“FAR”), the performance bond is triggered when the government terminates the prime contractor for default and then looks to the performance bond surety to remedy the default by completing the defaulting prime contractor’s contractual obligations. (See FAR 49.402-3 regarding the government’s procedure to terminate the prime contractor for default and put the contractor and surety on notice.)

Subpart 49.4 of FAR deals with termination for defaults. Prime contractors as well as sureties should familiarze themselves with this subpart especially if they received notification from the contracting officer of the possibility of a terminatin for default or the notices seem to indicate that the terminatiion for default is imminent.

Let’s presume the contracting officer moves forward and terminates the prime contractor for default or the termination is imminent. Now what? Clearly, the contracting officer will be looking to the prime contractor’s performance bond surety to remedy the default. Below are considertaions that will be explored and are the reasons why prime contractors and sureties in this situation should absolutely ensure they are consulting with counsel.

A. Takeover Agreements

One common option under FAR 49.404 that can be implemented is a surety-takeover agreement with the government (see below). This is when the surety takes over the contractual obligations of the prime contract. Typically, the surety will enter into a takeover agreement with the government that outlines the obligations of the takeover and will enter into a separate contract with the completion contractor the surety engages to complete its defaulting prime contractor’s scope of work. While FAR ideally prefers a tripartite takeover agreement with the government, surety, and defaulted prime contractor, this generally does not happen with a prime contractor that challenges the termination for default and looks to convert the termination into one for convenience.

49.404 Surety-takeover agreements.

(a) The procedures in this section apply primarily, but not solely, to fixed-price construction contracts terminated for default.

(b) Since the surety is liable for damages resulting from the contractor’s default, the surety has certain rights and interests in the completion of the contract work and application of any undisbursed funds. Therefore, the contracting officer must consider carefully the surety’s proposals for completing the contract. The contracting officer must take action on the basis of the Government’s interest, including the possible effect upon the Government’s rights against the surety.

(c) The contracting officer should permit surety offers to complete the contract, unless the contracting officer believes that the persons or firms proposed by the surety to complete the work are not competent and qualified or the proposal is not in the best interest of the Government.

(d) There may be conflicting demands for the defaulting contractor’s assets, including unpaid prior earnings (retained percentages and unpaid progress estimates). Therefore, the surety may include a “takeover” agreement in its proposal, fixing the surety’s rights to payment from those funds. The contracting officer may (but not before the effective date of termination) enter into a written agreement with the surety. The contracting officer should consider using a tripartite agreement among the Government, the surety, and the defaulting contractor to resolve the defaulting contractor’s residual rights, including assertions to unpaid prior earnings.

(e) Any takeover agreement must require the surety to complete the contract and the Government to pay the surety’s costs and expenses up to the balance of the contract price unpaid at the time of default, subject to the following conditions:

(1) Any unpaid earnings of the defaulting contractor, including retained percentages and progress estimates for work accomplished before termination, must be subject to debts due the Government by the contractor, except to the extent that the unpaid earnings may be used to pay the completing surety its actual costs and expenses incurred in the completion of the work, but not including its payments and obligations under the payment bond given in connection with the contract.

(2) The surety is bound by contract terms governing liquidated damages for delays in completion of the work, unless the delays are excusable under the contract.

(3) If the contract proceeds have been assigned to a financing institution, the surety must not be paid from unpaid earnings, unless the assignee provides written consent.

(4) The contracting officer must not pay the surety more than the amount it expended completing the work and discharging its liabilities under the defaulting contractor’s payment bond. Payments to the surety to reimburse it for discharging its liabilities under the payment bond of the defaulting contractor must be only on authority of—

(i) Mutual agreement among the Government, the defaulting contractor, and the surety;

(ii) Determination of the Comptroller General as to payee and amount; or

(iii) Order of a court of competent jurisdiction.

B. Tender Agreements

Another option the surety can implement is by tendering a completion contractor to the government for the government to complete the work. Oftentimes the surety will obtain pricing to complete the defaulting prime contractor’s scope of work. The surety will then tender a completion contractor to the government so that the government can hire this contractor directly. The surety will also tender the difference between the balance of the defaulted prime contractor’s contract amount and the completion contractor’s contract amount to complete the work. (For example, if the balance of the defaulted prime contract is Twenty Million but it will cost a completion contractor Twenty Five Million to complete the defaulted prime contractor’s scope of work, the surety will tender the additional Five Million.) A tender agreement is generally entered into between the surety and the government and outlines the parameters of the tender including monetary responsibilities of the surety.

C. Government Completion (if surety does not takeover or tender)

FAR 49.405 gives the government authority to engage a completion contractor if the surety does not arrange for the completion of the defaulted prime contractor’s scope of work (see below). If the government moves forward with this option, it will certainly look to the surety for all costs it incurs associated with the prime contractor’s default and any delay associated with bringing a completion contractor on board.

49.405 Completion by another contractor.

If the surety does not arrange for completion of the contract, the contracting officer normally will arrange for completion of the work by awarding a new contract based on the same plans and specifications. The new contract may be the result of sealed bidding or any other appropriate contracting method or procedure. The contracting officer shall exercise reasonable diligence to obtain the lowest price available for completion.

D. Procedures Government Can Utilize Instead of Termination for Default

FAR 49.402-4 identifies certain procedures that the government can utilize instead of terminating the prime contractor for default, although these procedures are generally implemented after the prime contractor and surety are on notice of an impending termination for default (see below). The government is probably not going to move forward with these procedures unless its rights are reserved against the prime contractor and performance bond for any resultant damages (see FAR 49.406 below) associated with defaults asserted by the government against the prime contractor (e.g., liquidated damages for delays, correction of deficient work, etc.). If these procedures are considered and utilized, there is a good chance the procedure was suggested by the prime contractor and surety as a protocol to best mitigate potential damages asserted by the government. (By way of example, one option a surety can present is to agree to fund the prime contractor through completion in order to keep the project moving forward with the contractor most familiar with the scope of work.)

49.402-4 Procedure in lieu of termination for default.

The following courses of action, among others, are available to the contracting officer in lieu of termination for default when in the Government’s interest:

(a) Permit the contractor, the surety, or the guarantor, to continue performance of the contract under a revised delivery schedule.

(b) Permit the contractor to continue performance of the contract by means of a subcontract or other business arrangement with an acceptable third party, provided the rights of the Government are adequately preserved.

(c) If the requirement for the supplies and services in the contract no longer exists, and the contractor is not liable to the Government for damages as provided in 49.402-7, execute a no-cost termination settlement agreement using the formats in 49.603-6 and 49.603-7 as a guide.

49.406 Liquidation of liability.

(1) The contract provides that the contractor and the surety are liable to the Government for resultant damages. The contracting officer shall use all retained percentages of progress payments previously made to the contractor and any progress payments due for work completed before the termination to liquidate the contractor’s and the surety’s liability to the Government. If the retained and unpaid amounts are insufficient, the contracting officer shall take steps to recover the additional sum from the contractor and the surety.

E. Preservation of Surety’s Rights

When a surety takesover the completion of the work, tenders a completion contractor, or even funds the original prime contractor through completion, the surety will do so while preserving its rights. In other words, a surety will want to best preserve rights to pursue potential claims against the government while contemporaneously mitigating its exposure under the performance bond through the takeover, tender, or funding of the completion work. See, e.g., Transamerica, Ins. v. U.S., 31 Fed.Cl. 532 (1994) (finding surety can pursue equitable subrogation claim against government for funds held by government when surety tendered and paid completion contractor); see also In re Appeal of Fireman’s Fund Ins. Co., ASBCA No. 50657, 2000 WL 246620 (2000) (“When a terminated contractor assigns such [pre-takeover / tender] claims to the surety to which assignment the contracting officer consents, or incorporates such an assignment in novation or takeover [or tender] agreement executed by the contracting officer, the surety has standing to prosecute such claims before the Board.”); In re Hackney Group, ASBCA No. 51453, 2000 WL 655950 (2000) (surety’s argument that it has standing to assert defaulted prime contractor’s pre-takeover claims against government based on surety’s indemnity agreement with prime contractor failed since government was not a party to indemnity agreement and never consented to prime contractor’s assignment of pre-takeover claims to surety).

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PERFORMANCE BOND SURETY TAKEOVER – USING TERMINATED CONTRACTOR TO COMPLETE THE WORK