The Surety’s Takeover Option – “To The Penal Limit and Beyond?”
May 24, 2022
In this Surety Today blog post we will discuss the surety’s Takeover performance option, including the advantages and risks. We will also focus on the biggest potential risk – liability beyond the penal sum and what to do to avoid or minimize such risk. But, before we get into the substance of today’s post, I wanted to share a humorous personal story. [Note: They say that blog posts should have some personal flavor.] I am a big movie goer, always have been. Of course, the pandemic shut down movie theaters for a long time. With restrictions lifted and vaccinations prevalent, I have started going back to the theater. Recently, I went to see a movie, but the experience was a little off, like a lot of things post-COVID. The first thing was the ticket kiosk didn’t print my ticket. Ten minutes later at customer service, I got a ticket and I was in line at the concession stand. The couple in front of me was grocery shopping – two of these, two of those, no, one of those instead, etc. When it was finally my turn, I was advised that they had no fountain sodas or bottled soda. I was dumb founded. A good soda and popcorn is a big part of the theater experience. Water it was. Then they told me the bathrooms, all of the bathrooms, were out of order. This is a large theater venue. How can you stay open without bathrooms? Fueled by my pandemic deprivation, I pushed on. The theater was huge and there were only four people in attendance. Of course, my preselected seat was just a few seats away from one of the other four. And, of course, he was talking loudly on his cell phone. I thought, surely he would stop when the previews started. Nope. Surely when the movie started. Nope. So, I got up to move, spilling my bag of M&M’s in the dark theater all over the floor. Once relocated, I discovered that – you guessed it, I had to go to the bathroom. I was able to confirm that even if the bathrooms are technically out of order, they can still serve their purpose.
Alright, enough about my tribulations, at its essence a takeover is relatively straight forward. The surety determines the remaining scope of work, remaining contract balance and time to complete and obtains a completion contractor to perform the work. However, as they say “the devil is in the details.” Takeover and completion of defaulted projects by the surety is common. The “right” to takeover can be found in the language of the bond, in the FAR provisions and such right has been recognized at common law. In the right circumstances takeover can be the most expeditious, practical, and cost effective of the surety’s options, and the one most preferred by, and generally most familiar to, the obligee.
There are a number of typical “advantages” associated with a Takeover, some of which include control over the completion process, ability to monitor costs and progress and make sure that the surety is only paying for what was originally required in the bonded contract, ability to reduce costs by using the principal’s employees, ability to utilize the resources of the indemnitors through various provisions of the Indemnity Agreement, protection through the requirement of bonds from the completing contractor, ratification of existing subcontractors and suppliers and use of the principal’s equipment, tools, and materials on site.
There are also a number of potential risks and disadvantages associated with a Takeover, some of which include additional fees and supervision costs and requirements that may not count toward reducing the penal sum, the possibility that the obligee may assert change orders or that the project schedule may get dragged out, latent defects and warranty work of the principal and/or of the completion contractor, delay damages, LD’s, and actions by the obligee, owner or other contractors that cause damage and increased costs to the surety’s performance, leading to claims and disputes.
Perhaps one of the biggest risks for the surety in the takeover performance option is the possibility of exposure beyond the penal sum of the bond. Some courts have taken the position that the penal sum of the bond does not operate to limit the surety’s liability when the surety elects to takeover and complete. The case of Int’l Fid. Ins. Co. v. County of Rockland, 98 F. Supp. 2d 400 (S.D.N.Y. 2000), illustrates the risk of exposure beyond the penal sum of the bond. In Rockland, the surety took over under a 1984 AIA A312 performance bond for a defaulted principal to complete a nursing facility in New York. The Takeover Agreement provided that nothing in it affected any of the rights and obligations of the surety or the other parties under the terms of the Construction Contract, or under the performance bond issued thereunder. The surety engaged a completion contractor and obtained bonds from the contractor. The completion contractor subsequently filed bankruptcy. The surety completed the work with another contractor, but there were significant delays. Eventually, the owner submitted a delay claim totaling over $4 million dollars, which exceeded the penal sum of the bond. The surety filed suit and the owner filed a counterclaim.
In analyzing the delay claims, the Rockland Court stated that the penal limit of the bond did not apply. The Court pointed to three different alleged justifications for its conclusion. First, the 1984 A312 bond form did not specifically limit the surety’s liability to the penal sum when the delay damages are caused by the surety. The Court observed that the provision limiting the Surety’s obligation “to the limit of the amount of this Bond” only addressed completion costs and principal-caused delay damages. Of course, one of the modifications that would later be made in the 2010 version of the A312 was to exclude the takeover option from the protection of the penal limit of the bond. As always, the surety must RTFB.
Second, the Rockland Court pointed to an alleged “long-established case law” holding that a surety’s takeover of its principal’s contract pursuant to a performance bond “always subjects the surety to liability beyond the penal limit of the bond.” The Court made reference to a handful of cases to support its statement, some of which amount to nothing more than passing statements in dicta. In fact, there is no long established case law on the issue and courts do not always subject the surety to liability beyond the penal sum in takeovers. Indeed, the opposite is true, courts typically limit the surety’s liability to the penal sum and that has historically been the case.
The Rockland Court stated “In short, there is a distinction in liability between, on the one hand, those cases in which the surety takes over completion of the contract by stepping into the shoes of the contractor—in which case the surety’s liability is equal to what the contractor’s liability would be—and, on the other hand, those cases in which the surety chooses simply to ‘pay off’ its obligation to the obligee (or deny liability), in which case its liability is generally limited to the penal sum of the bond.” What the Court overlooks is the fact that a takeover is nothing more than a method of performance under the bond and, as such, it must be limited to the penal limit of the bond, in the absence of language in the bond to the contrary. Of course, under a takeover the surety may be responsible for damages caused during the process, but that damage should be capped at the penal sum, similar to a damage waiver or limitation provision in a typical contract. Allowing exposure above the penal sum of the bond unfairly and unjustly equates a surety’s legitimate performance under the bond with bad faith failure to perform.
The final basis for the Court’s position was purportedly found in New York statutory law. Under then existing New York General Obligations Law §7–301 the statute specifically limited a surety’s liability to the penal sum of the bond if it chooses to pay, but the statute was silent in the event that a surety chooses to perform rather than pay. Without citation to authority, the Court construed that as intent of the legislature not to apply the penal limit to a takeover surety.
In apparent good news, the Rockland Court seemed to acknowledge that a surety could protect itself from exposure beyond the penal sum of the bond by including a clause in the takeover agreement with the obligee that limits the surety’s liability in the course of performance to the original bond penalty. In Rockland, the surety did include a provision in its Takeover Agreement with the owner seeking to limit its liability to the penal sum. However, the Rockland Court narrowly construed the provision stating that the dispute was not about funds advanced by the Surety to complete the contract; it was about loss of income to the owner caused by IFIC’s breach, and the extent to which IFIC must reimburse them for that loss. The court noted that the provision “did not include an absolute limitation on liability to the penal sum of the bond. Nor was there any limitation regarding liability for delay damages caused by the surety’s delayed performance of the Takeover Agreement.” The takeover agreement’s reservation of rights provision was also not specific enough for the Court. Thus, the penal sum was not the limit of the surety’s liability in that case.
In another case, Deluxe Bldg. Sys., Inc. v. Constructamax, Inc., No. 2:06-CV-02996 KM MAH, 2013 WL 4781017, at *3–6 (D.N.J. Sept. 5, 2013), the court stated that the penal sum was not the limit of the surety’s liability in a takeover, but recognized that the surety could limit its exposure by inserting a provision in the takeover agreement. The takeover agreement contained a clause stating:
Nothing contained in this Takeover Agreement is intended, or shall be construed, to waive, or to increase the liability of Surety beyond, the limit of Surety’s liability under the Bond or any other defenses to liability set forth in the Bond. Owner shall not make any claim against Surety, or demand damages or performance from Surety, after Surety has expended or obligated itself to expend the remaining penal sum of the Bond.
In Constructamax, the surety moved for summary judgment on the issue of limiting the surety’s liability to the penal sum of the bond. Despite what appears to be clear language to me, the Court would not grant summary judgment because claims of liquidated damages and delay damages were asserted. The Constructamax Court pointed to an alleged distinction between claims against the surety under the bond and claims for the surety’s breach of the takeover agreement. The Court also looked to indemnity provisions of the underlying construction contract and alleged inconsistencies with other provisions in the takeover agreement to find a dispute of fact.
Of course, there are many cases that hold the penal sum to be the limit of the takeover surety’s liability. For example, Allegheny Cas. Co. v. Archer-Western/Demaria Joint Venture III, No. 8:13-CV-128-SCB-TGW, 2014 WL 4162787, at *14 (M.D. Fla. Aug. 21, 2014). The takeaway here is that the takeover surety must be extremely sensitive to the exposure above the penal sum issue and make sure that it includes a broad limitation of liability provision that encompasses potential exposure under the bond and takeover agreement. The limitation provision must include all damages that cover more than just completion costs and specifically must mention delay damages and liquidated damages. In states where incorporation by reference obligates the surety to indemnity provisions in the underlying contract, the limitation provision should address such terms that may be incorporated by reference. The surety should also endeavor to minimize any conflicting provisions in the takeover agreement. For example, if there is a provision stating that the surety may be liable for liquidated damages for delays in performance of the takeover, a provision should be added referring to the penal sum limitation provision for any such damages. For a far more detailed and thorough discussion of the Surety’s Takeover Performance Option, I recommend the ABA/FSLC publication the Bond Default Manual 4th Edition, Chapter 5 authored by Patricia Wager and Chris Ward. You should also download our Surety Today podcast from November 8, 2021 on Takeover.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321/mstover@wcslaw.com) or any member of the WCS Surety and Fidelity Practice Group.