Requiring a subcontractor to provide a performance bond on a construction project is a great way for GCs to ensure the project is protected in case the sub defaults. But, just like any other agreement or contract, there are certain steps and requirements that must be met to trigger such protection. This was a hard lesson learned for one general contractor in Massachusetts — when a US District Court held that the sub’s performance bond surety couldn’t be held liable unless that sub was terminated prior to making a demand against the surety.
Subcontractor performance bonds
Typically, it’s the general contractor who’s required by the property owner to post payment and performance bonds on a project. They act as guarantees for the property owner that the project will be completed. However, there are projects where the GC asks subcontractors to post a subcontractor performance bond as well.
- Deep dive: Construction Payment Bonds vs. Performance Bonds | What Contractors and Suppliers Must Know
If/when that subcontractor defaults, or otherwise fails to perform, the contractor can look to the surety to cover the costs of finishing the work under the subcontract.
But sureties won’t just hand out money anytime there’s a problem. Making a claim against the surety requires certain procedures to be followed known as “conditions precedent.” This means that their liability won’t kick in until some specified event occurs first.
Consequently, contractors should review the terms of the bond agreement carefully to ensure these conditions have been met before attempting to make a claim. This is exactly what caused problems for a Massachusetts general contractor who failed to terminate the sub before making a claim against the performance bond surety.
Surety off the hook because the sub wasn’t terminated pursuant to the performance bond
The case in question is Arch Insurance, Co. v. The Graphic Builders, LLC.
- Surety: Arch Insurance, Co. (Arch)
- General Contractor: The Graphic Builders, LLC (TGB)
- Subcontractor: R.C.M. Modular, Inc. (RCM)
In 2017, TGB was hired as a general contractor for the construction of an apartment building in Boston. Subsequently, RCM was hired as a subcontractor to fabricate and assemble modular components of the improvement. Pursuant to the subcontract requirements, RCM posted a performance bond issued by Arch under a standard AIA form A312-2010 Performance Bond Agreement.
The terms of which states that RCM & Arch agree to “jointly and severally, bind themselves… to [TGB] for the performance of the [subcontract],” which had been incorporated therein by reference. Furthermore, Section 3 of the bond agreement outlined when the surety’s obligation arises, the most relevant portion reads as follows;
“Section 3. If there is no Owner Default under the Construction Contract, the Surety’s obligation under this Bond shall arise after… (2) the Owner declares a Contractor Default, terminates the Construction Contract and notifies the Surety…”
GC decides not to terminate the sub for defective work
Shortly after RCM began installing the modular units on the project, TGB complained that they were defective, citing issues such as leaking windows and misaligned exteriors, among other things.
TGB then proceeded to send several letters to Arch and RCM notifying them that they were considering declaring RCM in default and requesting contractual warranty and indemnification payments. All three parties met at some point to discuss the non-performance issues, but were never able to resolve the dispute.
Where things begin to go south is when TGB decided not to terminate RCM. In their own words, doing so, “would be the equivalent of shooting [itself] in the face.”
Instead, TGB unilaterally arranged for various third-party subs to supplement RCM’s work under the subcontract, at the cost of close to $3M.
A few months later, TGB sent another letter declaring that RCM was in default but noted that they were “not yet terminating its subcontract with RCM.” Arch responded with a letter to confirm receipt of the notice, refusing the request for payments, and to acknowledge that RCM had not been terminated.
Court confirms surety’s non-liability due to GC’s failure to comply with condition precedent
After a few more communications between the parties, Arch filed a suit seeking a declaration that TGB materially breached the terms of the performance bond by failing to terminate RCM. The court reviewed the terms of the performance bond and agreed with Arch.
“…Section 3.2 which unambiguously sets forth the condition that TGB must, inter alia, terminate its subcontract with RCM to obligate the surety’s performance. It is undisputed that TGB never terminated that subcontract, but instead, unilaterally arranged for third-party subcontractors to remediate RCM’s work… Accordingly, TGB indisputably failed to comply with a condition precedent and, therefore, cannot enforce the obligation of Arch to indemnify which arises pursuant to the Performance Bond and/or the incorporated subcontract.”
Since the terms explicitly condition liability on the termination of the subcontract, Arch was relieved of any liability. In a last-ditch attempt, TGB argued that termination condition only applied in situations where the surety was requested to complete the work, and not when the GC was looking to recoup costs.
But the court wasn’t swayed by this argument. The bond agreement clearly states that any obligation by the surety was conditioned upon the termination of the sub. Period.
Accordingly, the court declared that the surety was under no obligation to pay TGB for any additional costs incurred in supplementing the work under the subcontract.
Review the bond terms before taking action
The main issue here was that TGB essentially imposed their own remedy for default, rather than following the proper steps and conditions precedent of the performance bond. By doing so, TGG rendered the bond “null and void and discharg[ed] Arch from liability thereunder.”
When faced with a non-performing subcontractor, GC’s should make a habit of reviewing the terms of the bond performance bond to determine if terminating the subcontract is the best option. As most standard construction documents such as AIA and ConsensusDoc forms will usually include termination as a condition precedent to liability.
TGB did file an appeal to the First Circuit, and we’ll post an update if the any significant developments arise.
Jonathan Burwood — member of the Levelset Community and counsel to Arch Insurance on this case — had this to say:
“[This] ruling is consistent with the overwhelming majority of courts across the country holding that the conditions precedent set forth in the A312 performance bond must be satisfied — strictly and sequentially — by an obligee before the surety has any obligation to perform.
Judge Gorton did not put any stock in the obligee’s attempt to draw a distinction between “work” and “payment” obligations arising under a performance bond. The surety either has an obligation to perform the bonded construction contract, or it does not. There is no middle ground from which an obligee can engage in self-help in the first instance, only to later pass the associated costs on to the surety.
Arch’s decision to immediately and proactively seek declaratory judgment paid off, in that the surety was able to control both the timing and scope of the litigation, with an efficient result.”