Many performance bonds (the popular AIA A312 is an example) state that the surety’s obligation is not triggered unless the principal’s contract has been terminated. This can put the obligee, whether an owner holding its general contractor’s performance bond or a general contractor holding its subcontractor’s performance bond, in a difficult spot. Wrongful termination will not only be a breach of contract giving the principal a claim for damages against the obligee, but it will forfeit the protection of the bond. Conversely, not terminating also forgoes the protection of the bond – if termination is an enforceable condition of the surety’s liability.
In Arch Insurance Co. v. Graphic Builders LLC, 36 F.4th 12 (1st Cir. 2022), a general contractor sought to enforce its subcontractor’s performance bond after the subcontractor failed to correct leaking windows and failed to furnish the contractually-required manufacturer’s warranty for the windows. But the contractor didn’t terminate the subcontractor – a condition of the surety’s liability under its standard A312 performance bond – because (a) substantial completion had already been achieved such that the subcontractor “thus could not be terminated,” id. at 15, and (b) no physical work was involved in providing the missing warranty. Affirming summary judgment for the surety, the Court of Appeals rejected both excuses, holding that termination was nevertheless required in order to trigger the surety’s liability:
“We acknowledge the difficulty contractors may face in navigating between the risk of premature termination of a subcontractor and the risk of failing to comply with the requirements of section 3 of the A312 performance bond. See 4A Bruner & O’Connor, supra, at § 12:38 (noting that “[a] wrong decision to terminate is a material breach of contract and results in the obligee’s completion of the contract without recourse against the contractor or surety” and that “[t]he wrong decision not to terminate may result in unsatisfactory completion ..., with recourse limited to the contractor and not the surety”. Yet that is the framework under which Graphic agreed to operate pursuant to the performance bond, and it was obliged to adhere to the bond’s terms to invoke the bond’s coverage.”
Id. at 20. It is significant that the court rejected the contractor’s argument that the subcontractor had substantially completed its work, noting the contractor’s earlier letters stating that the subcontractor had not done so – and particularly given the contractor’s valuation of the warranty obligation “at $2 million, a significant proportion of the subcontract’s total price tag of roughly $8.6 million,” id. at 18. It is likewise significant that defective work was in play; the reason that the manufacturer declined to issue a warranty was over concern about improper installation by the subcontractor. Id. at 19.
Was the contractor correct that it could not lawfully terminate a subcontractor whose work was substantially complete? Arch did not reach this question given the Court’s conclusion that the subcontractor’s work was in fact not substantially complete. But I think the answer to the question is yes. 4A Bruner & O’Connor on Construction Law § 12:45 (2021) (noting that an “obligee may not terminate for default a construction contract that has been substantially performed”). And if termination of the principal is always a condition precedent to the surety’s liability, then in practical effect substantial completion by the principal will absolve the surety of liability under the bond. Punch list completion and warranty obligations will not be bonded!
The one thing that gives me pause here is that bonds incorporate the terms of the bonded contract by reference, and often those bonded contracts will – as is true of the AIA A201 form – require consent of the surety for release of retainage after substantial completion (see § 9.8.5) and for final payment (see § 9.10.2). Why would that consent be necessary if the surety is exonerated by substantial completion? “In interpreting a multiple-document agreement, we seek to harmonize and give effect to the provisions of the various documents so that none will be rendered meaningless.” Motion Motors, Inc. v. Berwick, 150 N.H. 771, 777 (2004). And that principle of interpretation may well save the day for the obligee.
In Arch Insurance Co. v. Graphic Builders LLC, 36 F.4th 12 (1st Cir. 2022), a general contractor sought to enforce its subcontractor’s performance bond after the subcontractor failed to correct leaking windows and failed to furnish the contractually-required manufacturer’s warranty for the windows. But the contractor didn’t terminate the subcontractor – a condition of the surety’s liability under its standard A312 performance bond – because (a) substantial completion had already been achieved such that the subcontractor “thus could not be terminated,” id. at 15, and (b) no physical work was involved in providing the missing warranty. Affirming summary judgment for the surety, the Court of Appeals rejected both excuses, holding that termination was nevertheless required in order to trigger the surety’s liability:
“We acknowledge the difficulty contractors may face in navigating between the risk of premature termination of a subcontractor and the risk of failing to comply with the requirements of section 3 of the A312 performance bond. See 4A Bruner & O’Connor, supra, at § 12:38 (noting that “[a] wrong decision to terminate is a material breach of contract and results in the obligee’s completion of the contract without recourse against the contractor or surety” and that “[t]he wrong decision not to terminate may result in unsatisfactory completion ..., with recourse limited to the contractor and not the surety”. Yet that is the framework under which Graphic agreed to operate pursuant to the performance bond, and it was obliged to adhere to the bond’s terms to invoke the bond’s coverage.”
Id. at 20. It is significant that the court rejected the contractor’s argument that the subcontractor had substantially completed its work, noting the contractor’s earlier letters stating that the subcontractor had not done so – and particularly given the contractor’s valuation of the warranty obligation “at $2 million, a significant proportion of the subcontract’s total price tag of roughly $8.6 million,” id. at 18. It is likewise significant that defective work was in play; the reason that the manufacturer declined to issue a warranty was over concern about improper installation by the subcontractor. Id. at 19.
Was the contractor correct that it could not lawfully terminate a subcontractor whose work was substantially complete? Arch did not reach this question given the Court’s conclusion that the subcontractor’s work was in fact not substantially complete. But I think the answer to the question is yes. 4A Bruner & O’Connor on Construction Law § 12:45 (2021) (noting that an “obligee may not terminate for default a construction contract that has been substantially performed”). And if termination of the principal is always a condition precedent to the surety’s liability, then in practical effect substantial completion by the principal will absolve the surety of liability under the bond. Punch list completion and warranty obligations will not be bonded!
The one thing that gives me pause here is that bonds incorporate the terms of the bonded contract by reference, and often those bonded contracts will – as is true of the AIA A201 form – require consent of the surety for release of retainage after substantial completion (see § 9.8.5) and for final payment (see § 9.10.2). Why would that consent be necessary if the surety is exonerated by substantial completion? “In interpreting a multiple-document agreement, we seek to harmonize and give effect to the provisions of the various documents so that none will be rendered meaningless.” Motion Motors, Inc. v. Berwick, 150 N.H. 771, 777 (2004). And that principle of interpretation may well save the day for the obligee.
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