Bond Form Makes a Difference in Ability of Owner to Obtain Benefits of Bond

The recent case of St. Paul Fire & Marine Ins. Co. v. VDE Corporation, 603 F.3d 119 (1st Cir. 2010) points to the importance of selecting an appropriate bond form and adhering to the terms of the bond.

VDE Corporation was the developer of a housing project in Puerto Rico and hired F&R Contractors Corporation to perform the work. St. Paul Fire & Marine, as surety, issued a performance bond with VDE as the obligee covering performance by F&R as the principal. The bond form selected was the AIAA312. After some problems on the project, VDE declared F&R in default and demanded that the surety perform its obligations under the bond.

In its declaration of default letter, VDE informed St. Paul that it would object to any further involvement of F&R, “either directly or indirectly,” as the contractor as the project moved forward. The terms of the bond, specifically Paragraph 4.2, provided that one of the options available to the surety once the default was declared was “undertake to perform and complete the Construction Contract itself, through its agents or through independent contractors.” Under the terms of the bond, two of the other options available to the surety required the consent of the owner/obligee in the selection of a contractor to perform the work but this one option had no such provision.

The surety conducted an investigation and notified VDE that it had decided to respond to the default by performance under Paragraph 4.2 and was prepared to complete the work using F&R as its performing subcontractor. VDE once again objected to this arrangement and confirmed that it would not allow F&R to continue work on the project in any capacity.

The surety filed a declaratory judgment action claiming that VDE had violated the terms of the bond, specifically Paragraph 4.2, by not allowing the surety to utilize F&R as its subcontractor to complete the work. The trial court granted the surety’s summary judgment motion holding that the actions of VDE insisting that the surety not use F&R amounted to a material breach of the bond, and VDE appealed.

The First Circuit affirmed the trial court’s dismissal of the case against the surety. The appellate court reasoned that a surety bond is a contract subject to the same rules of interpretation as any other contract. Since the language contained in Paragraph 4.2 of the AIAA312 bond was quite specific and did not require approval of the owner when the surety undertook completion of the work, VDE’s refusal to accept this arrangement constituted a material breach of the bond. The court observed that the language contained in Paragraph 4.2 was unambiguous and consistent with the common practices in the construction industry. The court held that under this option the surety was primarily obligated to perform the remaining work under the bonded contract.

The court reviewed the other options that were available to the surety and discussed how they were substantially different from the option selected. Under the provisions of Paragraph 4.1 the surety merely “arranges” with the bonded contractor to complete the work and usually makes the necessary funds available to handle the work and any claims. And these actions are taken with the consent of the owner/obligee. Under Paragraph 4.3, the surety obtains bids or accepts negotiated proposals from contractors to complete the work and makes the funds over and above the balance of the contract price available as needed to complete the work. But again, this option requires the consent of the owner/obligee in the selection of the take-over contractor.

The court rejected the various arguments advanced by VDE that amounted to a tortured interpretation of the clear language of Paragraph 4.2 in the AIAA312 bond form. The final result was that VDE was found to have materially breached the terms of the bond by insisting that the surety could not employ F&R as a completion contractor. This material breach discharged the surety from its obligation to perform under the terms of the bond. 

The lesson to be learned is that the selection of the bond form and compliance with its terms forms an integral and important role in the efforts of an obligee to obtain the benefits of a performance bond from its surety.

For more information on this and other surety bond issues contact Dave Olson, a member of the Construction Law Group at Frost Brown Todd LLC at Dolson@fbtlaw.com.

Posted by: David C. Olson

Categories: Current Developments / Legislation, Mechanics’ Liens, Risk Management / Insurance