Surety Case Law Note: Discharge of the Surety
July 5, 2022
In this Surety Today blog post we will provide a Case Law Note to consider the issue of when a surety may be discharged from its obligations under a performance bond. This case presents a unique argument that the failure of the bonded subcontractor to provide a warranty for the windows installed should not be subject to the bond requirement of termination. The claimant also argued that because substantial completion occurred, it could not terminate the subcontractor. Read on to see what the First Circuit thought of such arguments.
ARCH INS. CO. V. GRAPHIC BUILDERS LLC,36 F.4th 12, 14–16 (1st Cir. 2022)
This case arises out of the conversion of an existing commercial building to loft-style apartments and the construction of a four-story apartment building using a modular method of construction. Graphic Builders was engaged as the general contractor and Graphic contracted with RCM Modular, Inc., to fabricate and assemble the modular structures. Among the obligations included in the subcontract was a “Special Manufacturers’ Warranty” for the modular units’ windows and doors.
Arch Insurance Company issued performance and payment bonds for RCM on the AIA A312 bond form. Section 3 of the bond specified the actions required by Graphic to trigger Arch’s obligation under the Bond, including declaring RCM in default and terminating the subcontract.
Shortly after RCM delivered the modular units to the project, Graphic complained that the units were defective. Graphic advised that, among other issues, the windows leaked and the exteriors of the modules were misaligned. Graphic reported that it received “no meaningful response from RCM.” It therefore “engaged in remedial efforts to correct the defectively delivered and installed modules.” Issues remained, however, and Graphic and RCM developed a remediation plan to correct the defective work, including producing the window manufacturer’s warranty. According to Graphic, RCM failed to complete the remediation plan, and the manufacturer refused to provide a warranty.
There followed a series of letters from Graphic to RCM and Arch, initially providing notice only of RCM’s potential default and later notifying RCM and Arch of RCM’s default. Indeed, a default was declared because, among other reasons, RCM allegedly failed to deliver a window warranty and had not undertaken necessary remedial steps to correct the defective work, which forced Graphic to do so at its own expense. However, in that letter Graphic stopped short of terminating RCM, but reserved the right to do so. Graphic followed up with another letter to Arch advising that it was not yet taking the next step of terminating the Subcontract and making demand on the Bond in the hope that RCM and/or Arch would arrange to quickly complete the unfinished work and “make a good faith move to reduce the large financial impacts Graphic has suffered.” In response Arch acknowledged receipt of Graphic’s communications and noted its understanding that Graphic was “not attempting to make a claim on the Arch Performance Bond.”
Subsequently, Graphic sent a detailed letter to Arch stating that it was providing notice of RCM’s default pursuant to the terms of the performance bond and demanding that Arch pay $3.175 million in remedial costs that Graphic had incurred as a result of RCM’s failure to perform. In response, Arch denied liability on the ground that Graphic had not complied with multiple prerequisites specified in the bond for triggering Arch’s surety obligations. Arch noted the undisputed fact that Graphic had “not terminated RCM before it undertook to complete RCM’s scope of work,” a failure that rendered the bond “null and void.”
A short while later, Arch filed suit seeking a declaratory judgment that Graphic had materially breached the performance bond, thereby discharging Arch from liability. Graphic counterclaimed, asserting that the preconditions for performance set forth in section 3 of the bond do not apply to Arch’s obligations to indemnify Graphic for its costs related to RCM’s defective work or the surety’s obligation to provide a window warranty in RCM’s stead. Arch subsequently moved for summary judgment. In its opposition, Graphic asserted, among other arguments, that it could not satisfy the bond’s termination requirement “because RCM had ‘substantially completed’ its work under the subcontract and thus could not be terminated.”
The District Court granted summary judgment for Arch. It found that Graphic had “indisputably failed to comply with a condition precedent” for Arch’s liability under the performance bond by unilaterally arranging for third-party subcontractors to remediate RCM’s work instead of terminating RCM. Accordingly, the court held that Graphic materially breached the bond and that Arch was “discharged from any and all liability” under it.
On appeal, Graphic reiterated its contention that it had no obligation to comply with section 3 of the bond and that termination was neither feasible nor legally permissible because RCM had substantially completed its work under the subcontract. In the appeal, Graphic abandoned its indemnification claim and the sole and only issue on appeal was enforcement of Arch’s alleged post-completion guarantee of its obligation to issue a window warranty.
The first question on appeal was “does the bond oblige Arch to provide the window warranty?” The Court began its analysis by noting that Graphic satisfied the requirements of section 3.1 of the performance bond, but failed to fulfill the requirements of sections 3.2 and 3.3 in that Graphic did not terminate RCM and it never agreed to pay Arch any portion of the contract price. Graphic argues that its demand for a window warranty does not require compliance with the section 3 conditions.
In its argument, Graphic attempted to distinguish between providing a warranty and the physical work required under the subcontract, contending that a “post-completion” warranty is not reasonably subject to section 3’s termination requirement because it does not come into play until after the work is completed. Graphic’s demand was atypical in that it was not seeking actual physical warranty work, instead it was seeking the promised warranty itself. This was somewhat of a smoke and mirror argument because Graphic just happened to value the warranty at $2 million.
The Court noted that together, sections 3 and 5 of the A312 bond protect the surety by clearly signaling when the surety must take over for a defaulting principal and by giving the surety the choice on how to remediate the default. See generally St. Paul Fire & Marine Ins. Co. v. City of Green River, 93 F. Supp. 2d 1170, 1178 (D. Wyo. 2000), aff’d, 6 Fed. App’x 828 (10th Cir. 2001) (noting the importance of preserving the surety’s “ability to protect itself pursuant to performance options granted under a performance bond”); Enter. Cap., Inc. v. San-Gra Corp., 284 F. Supp. 2d 166, 177 (D. Mass. 2003)(same).
In addressing Graphic’s claimed distinction, the Court observed “the obligation to provide a manufacturer’s window warranty is a distinct element of the Graphic-RCM subcontract. The mere fact that the warranty obligation does not involve hands-on construction does not reveal why it would be excluded from the conditions in the bond that apply to other performance elements of the subcontract. Nor does timing provide the explanation. While the benefits of a warranty ordinarily may be realized after a construction project is completed (or substantially completed), (citations omitted) procuring the warranty from the window manufacturer was an obligation that needed to be fulfilled before RCM’s performance under the contract would be complete.”
The Court continued “there was nothing in the language of the bond that would exclude RCM’s default in fulfilling the warranty obligation from section 3’s requirements and the performance options available to Arch under section 5 of the bond are no less suitable for the warranty obligation than for the physical work.” Importantly, the warranty “performance” that Graphic sought was inextricably linked to the window installation itself. The warranty was withheld based on the manufacturer’s assessment that the installation remained problematic even after RCM’s remedial efforts. The Court stated “[i]n effect, then, Graphic’s version of a warranty claim is an attempt to shift to Arch the risk Graphic assumed when, instead of terminating RCM and placing the burden of remediating the window installation in Arch’s hands, it persisted in demanding action from RCM.”
The Court noted “[w]ith respect to securing the warranty, Graphic’s decision to eschew termination and continue working with RCM despite Graphic’s ongoing dissatisfaction with RCM’s performance was no different, under the terms of the bond, from a unilateral decision to replace RCM with a third-party subcontractor. Both decisions sidestep the requirements of section 3 and extinguish the options available to the surety under section 5 of the performance bond.” Solai & Cameron, Inc. v. Plainfield Cmty. Consol. Sch. Dist. No. 202, 374 Ill. App.3d 825, 313 Ill. Dec. 217, 871 N.E.2d 944, 956 (2007); see also, e.g., Seaboard Sur. Co. v. Town of Greenfield, 370 F.3d 215, 220 (1st Cir. 2004) (noting that “[c]ourts have consistently held that an obligee’s action that deprives a surety of its ability to protect itself pursuant to performance options granted under a performance bond constitutes a material breach, which renders the bond null and void” (quoting St. Paul Fire & Marine, 93 F. Supp. 2d at 1178)); Dragon Constr., Inc. v. Parkway Bank & Tr., 287 Ill. App.3d 29, 222 Ill. Dec. 648, 678 N.E.2d 55, 58 (1997) (“Surely, would not have issued the surety bonds if it did not have the authority to protect itself through the selection of a successor contractor.”).
The Court stated “[w]e 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. . . . 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. Under those terms, it was Graphic’s burden to determine if, and when, RCM had defaulted and to terminate RCM if it sought recourse for the default from Arch.” The Court opined “[t]he surety is not a party to the subcontract, and it necessarily plays a different role in the relationship among the parties. That role is defined by the bond, which, for the specific warranty claim at issue here, requires Graphic to fulfill the prerequisites of section 3 before Arch’s obligation under th[e] Bond shall arise.” Elm Haven Constr. Ltd. P’ship v. Neri Constr. LLC, 376 F.3d 96, 100 (2d Cir. 2004) (noting that one of the “standard principles of contract interpretation” applicable to surety bonds “is that, before a surety’s obligations under a bond can mature, the obligee must comply with any conditions precedent” (quoting U.S. Fid. & Guar. Co. v. Braspetro Oil Servs. Co., 369 F.3d 34, 51 (2d Cir. 2004)).
Finally, the Court addressed the last argument made by Graphic that it could not terminate RCM because the work was substantially complete. Graphic’s contention rests on the proposition that a contractor may not lawfully be terminated once its work under a contract is “substantially complete.” The Court noted that the argument of substantial completion directly conflicted with Graphic’s representations to RCM and Arch throughout the nine months in which Graphic was demanding remediation of the work performed by RCM before ultimately declaring RCM in default. Early on Graphic took the position that the option to terminate remained when it advised RCM and Arch that it was not yet taking the next step of terminating the Subcontract and making demand on the Bond. Accordingly, the Court held “In sum, the performance bond required Graphic to terminate RCM to trigger Arch’s obligation to provide a window warranty, and the undisputed facts in the record show that Graphic had ample knowledge of RCM’s alleged failures at a time when termination remained a viable option under the relevant principles of law. The district court therefore properly granted summary judgment for Arch.”
Perhaps some “style points” should be given to the plaintiff for creativity, but in the end, the smoke and mirrors gave way to the cold hard reality that conditions precedent in the bond must be satisfied before the surety can have any obligation under bond.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (firstname.lastname@example.org) or any member of the Surety and Fidelity Practice Group.
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