by Jason M. Muncey, Associate

A recent decision by the First Circuit Court of Appeals in St. Paul Fire & Marine Ins. Co. v. VDE Corp., 603 F.3d 119 (1st Cir. May 5, 2010) affirmed a federal district court’s holding that the owner’s refusal to permit the surety to undertake the completion of the project using a contractor of the surety’s choosing (which happened to be the original, now-defaulted contractor, whom the owner opposed as completion contractor)  constituted a material breach of the performance bond, thereby discharging the surety from its obligations to perform under the bond.

Although it is understandable that an owner may get heartburn when a surety arranges forthe same contractor that the owner just declared in default to complete the construction project despite the owner’s objections, such a result is not as unreasonable as it seems given the several options the surety has in the event of contractor default under the standard form American Institute of Architects document A312 performance bond (AIA A312). Depending upon the performance option selected by the surety - and the corresponding nature of the obligation assumed by the surety - consent from the owner may or may not be required.

VDE Corp. involved the construction and financing of a residential real estate project in Gurabo, Puerto Rico. The owner, VDE, entered into a construction contract with F&R Contractors Corporation (F&R), with F&R serving as the prime contractor on the project. St. Paul, as surety, issued a performance bond for the benefit of VDE, as obligee, for the performance of the construction contract by F&R, the principal under the bond. The performance bond issued by St. Paul was one of the most widely used type of traditional common law performance bonds in private
construction - the AIA A312.

Paragraph 4 of the AIA A312 sets forth the following performance options for the surety in the event that the contractor defaults under the
construction contract:

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

4.4 Waive its right to perform and complete, arrange for completion, or obtain a new contractor and with reasonable promptness under the
circumstances:

.1 After investigation, determine the amount for which it may be liable to the Owner and, as soon as practicable after the amount is determined, tender payment therefor to the Owner; or

.2 Deny liability in whole or in part and notify the Owner citing reasons therefor.

(emphasis added).

Approximately two years into the project, the owner declared the contractor in default of its obligations under the construction contract and terminated the contractor’s right to continue work on the project. The owner stated that the contractor had, among other things, failed to work at a reasonable pace, abandoned work on the project, insisted on collecting payments not yet due, and failed to act in good faith.

Shortly thereafter, the owner notified the surety that it had declared the contractor in default. In addition to requesting that the surety perform its obligations under the bond, the owner informed the surety that it “oppose[d] that the project be completed with F&R as contractor, either directly or indirectly.”

In response to the owner’s request for the surety to perform its obligations under the bond, the surety requested information to support its investigation of the owner’s allegations of contractor default. After acknowledging the owner’s statement of opposition to the use of F&R as contractor, the surety informed the owner that should the surety choose to complete the performance of the contract under Paragraph 4.2 of the AIA A312, the terms of the performance bond did not permit the owner to oppose the contractor that the surety selected as its own completion
contractor.

Approximately three weeks later, the surety informed the owner that it had not received the requested documentation to support its investigation and requested that the owner provide the missing documentation as soon as possible. That same day, the owner responded, stating that the time for the surety to act had expired and declaring the surety in default on its obligations under the performance bond.

Following the owner’s declaration that the surety was in default, the surety filed a declaratory judgment action against the owner in federal district court. The surety requested a declaration that the owner breached the terms of the bond by not permitting the surety to take action under Paragraph 4.2 of the performance bond, and asked that the surety be released from its obligations under the bond. The district court granted summary judgment to the surety, reasoning that the owner materially breached the terms of the bond by insisting that the surety could not undertake to complete the project using F&R as completion contractor, contrary to the express terms of Paragraph 4 of the performance bond.

On appeal, the First Circuit Court of Appeals affirmed the district court’s decision. The owner made a number of unsuccessful arguments. The owner argued that Paragraph 4.2 was ambiguous as to whether it requires owner consent. The owner further argued that even if Paragraph 4.2 did not ordinarily require that the owner consent to the use of the original contractor as completion contractor, owner consent was required in the event the original contractor acted in bad faith.

The First Circuit Court of Appeals found none of the owner’s arguments persuasive. Rather, the court held that the language in Paragraph 4 at issue was unambiguous - Paragraphs 4.1. and 4.3 both contained an explicit consent requirement, while a consent requirement in Paragraph 4.2 was notably absent. Acknowledging well-accepted tenets of contract interpretation, the court noted that when the text of a bond agreement is clear, or when the true meaning of its clauses can be easily discerned, courts should adhere to the text as written.

The court, however, did not limit its analysis to a literal interpretation of the language in Paragraph 4. The court went on further to explain that the presence of the consent requirement in Paragraph 4.1 - and the corresponding absence of a consent requirement in Paragraph 4.2 - reflected the different type of obligation assumed by a surety under the AIA A312. In electing to proceed under Paragraph 4.1, a surety was merely electing to arrange for the original contractor to perform and complete the construction contract with the owner’s consent by financing the original contractor’s continued performance. Under Paragraph 4.1, a surety did not assume any responsibility for completing the contract and the owner continued to maintain a contractual relationship with the original contractor.

In contrast, by electing to proceed under Paragraph 4.2, a surety undertakes to perform and complete the contract itself. According to the court, when a surety assumes primary responsibility for performance and completion of a construction contract under Paragraph 4.2, that responsibility is accompanied by the surety’s freedom to assemble a project team of its choosing (i.e., owner’s consent is not required).

In reaching its decision in VDE Corp., the court relied heavily on the reasoning and holding in St. Paul Fire & Marine Ins. Co. v. Green River, 93 F.Supp.2d 1170 (D. Wyo. 2000), aff’d Fed.Appx. 828 (10th Cir. 2001), a case in which Watt Tieder Hoffar & Fitzgerald, L.L.P. represented the surety in successfully discharging the surety’s obligations under an identical provision of the AIA A312 after the owner refused to allow the surety to complete the project using personnel of the defaulted contractor. As aptly stated in Green River, and quoted in VDE Corp., “[w]hile it makes sense that the owner would have the right to object to...a ‘shotgun wedding’ to the contractor it just terminated [under Paragraph 4.1], it certainly does not follow that the [owner] would have this right when the surety assumes primary contractual responsibility [under Paragraph 4.2].”

VDE Corp. and Green River both demonstrate a consistent interpretation of the AIA A312’s provisions regarding a surety’s options for performance in the event of a contractor default, which has important implications for both owners and sureties alike.

The information or opinion provided in this article is the author's own and not necessarily that of Watt, Tieder, Hoffar & Fitzgerald, LLP. The author is solely responsible for the information and opinion that he or she has provided. The information contained herein does not replace seeking specific legal counsel to directly address individual client needs.