Discharge of a Surety: Does the Surety Have the Right to Choose its Course of

Action Upon a Principal’s Default?

by Elizabeth O’Gara, Associate*

Under general surety principles, the termination of a bonded contractor can trigger a

surety’s obligation under a performance bond. Construing the options and rights of a

surety can be difficult, however, especially when the owner and surety have different

ideas as to how the project should be completed. Oftentimes, the owner has suffered

through delays and defective work on account of the defaulted contractor, prompting the

owner to want complete control over the surety’s actions. At the same time, a surety has

legal rights and options set forth in its performance bond that must be acknowledged. In

fact, in a recent case, St. Paul Fire & Marine Insurance Company v. City of Green River,

Wyoming, 93 F. Supp.2d 1170 (D. Wyo. 2000); aff’d, 2001 WL 369831 (10th Cir. 2001),

the United States District Court for the District of Wyoming concluded that a surety was

discharged from its obligations under its performance bond when the bond obligee (the

project owner) deprived the surety of its right to complete the project as provided for

under the bond.

The contractor in Green River entered into a contract with the City of Green River and

the Wyoming Joint Powers Water Board to construct a multi-million dollar wastewater

treatment plant. Under the terms of the contract, the contractor had to achieve substantial

completion of the project by December 1, 1998. The contract also provided that time was

of the essence and that the Board would be entitled to liquidated damages for delays

beyond the completion deadline. Prior to construction, St. Paul, as surety, provided a

performance bond to the Board for the contractor’s performance under the construction

contract. The performance bond defined St. Paul’s options in the event of a contractor

default:

[T]he 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

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 therefore to the

Owner; or

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

reasons thereof. (Italics added).

As the project moved forward, it became evident that the contractor would not meet the

substantial completion deadline. After a number of disputed delays, the Wyoming Joint

Powers Water Board terminated the contract for breach, triggering St. Paul’s surety

obligations. St. Paul chose to proceed under the second option in the bond, advising the

Joint Powers Water Board that it would take over and complete the project itself, using a

construction manager and the defaulted contractor as completion contractor. St. Paul also

advised the Board that it could not meet the original contract completion date and

proposed a new completion date.

After hearing St. Paul’s proposed plan of performance, the Board refused to allow St.

Paul to perform. The Board claimed that St. Paul’s conduct of unilaterally extending the

project completion date and its use of the defaulted principal constituted an anticipatory

breach of its performance bond obligation. St. Paul immediately filed a declaratory

judgment action against the Board claiming that the Board’s actions violated St. Paul’s

performance bond rights. The federal District Court agreed with St. Paul and relieved St.

Paul of any liability under the bond.

In determining that St. Paul was discharged from its bond obligations, the Court first

examined whether St. Paul had an absolute duty to finish the project by the date set forth

in the construction contract. The Court recognized St. Paul’s coextensive liability with

that of its principal, but held that it was commercially unreasonable to bind St. Paul to the

original completion date. The Court relied on the “reasonable promptness” language in

paragraph 4.4 of the bond, stating that the bond contemplated a delayed performance by

St. Paul. Furthermore, the Court recognized that sureties are frequently called on to

perform only when projects are already late or well behind schedule. As a result, while

the Court found that St. Paul could have been liable for liquidated damages, the fact that

the project completion would be delayed did not constitute a material breach of St. Paul’s

obligations under the bond.

Second, under the plain language of the bond, the Court determined that St. Paul had the

right to use the defaulted principal to complete the project. The court recognized that

once St. Paul agreed to take over the project itself, St. Paul and not the defaulted

contractor became contractually responsible for the adequacy of the performance. As a

result, St. Paul was within its rights to tender its principal as the completion contractor.

Because St. Paul did not breach its obligations under the bond, the Court found that the

Joint Powers Water Board’s termination of St. Paul divested St. Paul of its ability to

minimize its liability by selecting the lowest cost option, directing the construction or

participating in the contractor selection process. As a result, the Court held that the

Board materially breached its obligations under the bond and discharged St. Paul from

any liability. On appeal, the U.S. Court of Appeals for the Tenth Circuit affirmed the

ruling.

This Federal District Court decision falls in line with previous cases holding that an

obligee’s action depriving a surety of the ability to protect itself pursuant to performance

options renders the bond null and void. In sum, bond obligees, such as project owners,

must be cognizant of a surety’s rights under its bond and not demand more of the surety

than the bond allows, or face the prospect of losing the benefits of that bond.

* Watt, Tieder, Hoffar & Fitzgerald, L.L.P.

8405 Greensboro Drive, Suite 100

McLean Virginia 22102

703-749-1000