The Federal Court of Appeals Rules that a Surety was discharged from its obligations under the performance bond due to the Project Owner's insistence that the bonding company not use the defaulted contractor as the completion contractor

St. Paul Fire & Marine Ins. Co. v. VDE Corp., 603 F.2nd 119 (2nd Circ. 2010)

A prime contractor posted a performance bond in favor of the project owner. The performance bond issued by the surety was a standard AIA A312 (1984) form bond. During the project, the owner defaulted and terminated the contactor for, among other things, refusing to perform its contractual obligations, failing to work at a reasonable pace, abandonment of the work, and failing to act in good faith. The owner notified the surety of the default and termination, insisted that the surety satisfy its obligations under the bond, and objected to the surety using the defaulted contractor to complete the project.

Paragraph 4 of the bond provided in pertinent part:

When the Owner has satisfied the conditions of Paragraph 3 [for declaring the contractor to be in default], the Surety shall promptly and at the Surety’s expense take one of the following actions:

4.1 Arrange for the Contractor, with consent of the Owner, to perform and complete the Construction Contract; or

4.2 Undertake to perform and complete the Construction 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 Construction 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 Construction 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’s default; or….

Under these provisions, the owner’s consent is expressly required only for the options set out in 4.1 and 4.3.

After the owner declared the surety in default of its obligations under the bond, the surety filed a declaratory judgment action against the owner seeking a declaration that the owner had breached the bond by not permitting the surety to use the original contractor to complete the work and, asked to be released from the bond. The District Court granted summary judgment in favor of the surety, finding that the owner materially breached the bond by denying the surety the right to complete the project using the original contractor, pursuant to Paragraph 4.2 of the bond, which released the surety from its obligations under the bond.

On appeal, the owner argued that under Paragraph 4 of the bond, the surety may not complete the project with a contractor unless the owner consents. It also argued that even if consent is not ordinarily required, it is required on the facts before the court where there is an allegation that the contractor acted in bad faith. Principally relying on the rational and holding in St. Paul Fire & Marine Ins. Co. v. Green River, 93 F.Supp. 2nd, 1170, 1177 (D.Wyo. 2000), aff’d, 6 F.Ap’x 828 (10th Circ. 2001), the Second Circuit Court of Appeals found the owner’s arguments unfounded.

Specifically, the court found the text of Paragraph 4.2 to be unambiguous and did not require an owner’s consent to use the original defaulted contractor. Unlike Paragraph 4.1 of the bond, which expressly requires the owner’s consent for the surety to arrange for the contractor to perform and complete the construction contract and Paragraph 4.3 of the bond, which expressly requires the owner’s consent of contractors from which the surety would solicit bids to complete the work. Paragraph 4.2 contains no express requirements for owner consent. Apart from the absence of any express requirement for owner consent, the court noted that there is a functional difference between the various alternatives in that, in Paragraph 4.2, the surety is undertaking primary responsibility to complete the contract and enters into a take over agreement directly with the owner, which sets out the party’s future rights and obligations with the respect to the scope of the remaining work to be completed. By contrast, pursuant to Paragraph 4.1, the owner’s contract with the contractor remains intact, with the surety arranging for the contractor’s completion of the work by financing its continued performance. The court likewise rejected the owner’s argument that the contractor’s bad faith justifies its right to require its consent for the contractor to complete the project on grounds that there is no authority for such a proposition and that the test of Paragraph 4.2 places not restrictions on the surety’s selection of the completion contractor.

Accordingly, the court affirmed the decision of the District Court and ruled that the owner’s refusal to permit the surety to use the original contractor as the completion contractor for the project, permitted by Paragraph 4.2 of the bond, was a material breach of the bond, which consequently discharged the surety from its performance obligations.

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