Suretyship is a risky business and the risks sureties face are heightened in this era of bailouts, failing economies, and government shutdowns.  Despite the diligence of their underwriting teams and their principals’ best intentions, when projects go wrong, sureties are often called upon to step up and ensure the completion of projects and satisfy the unpaid invoices of subcontractors and materialmen.  Meeting these obligations can carry a hefty price tag.  A sacred protection exists in the industry to protect the surety against loss in the event of a principal’s default – the bond’s penal sum limit.  As the United States District Court for the District of New Jersey recently addressed in Deluxe Building Systems, Inc. v. Constuctamax, Inc., Civ. No. 2:06-cv-02996 (KM), 2013 WL 4781017 (D.N.J. Sept. 5, 2013), however, this protection may be undermined by the very party that seeks its refuge – the surety. As such, certain precautions should taken.  The Deluxe case raises a number of concerns and provides lessons to the performing surety that will be discussed below.

Case Background

The Deluxe case concerned the construction of a 330-unit rental housing development in Jersey City, New Jersey, known as Whitlock Mills (the “Project”).  In 2004, the Owner of the Project entered into a construction contract (“Construction Contract”) with Constructamax, Inc. (“Cmax”) for it to perform as general contractor. Cmax obtained from its surety, Arch Insurance Company and Arch Reinsurance Company (collectively “Arch”), a payment and performance bond (the “Bond”) with a penal sum of $34,581,371 for the Project.

On November 3, 2004, Cmax entered into a subcontract (“Subcontract”) with Deluxe Building Systems, Inc. (“Deluxe”), pursuant to which Deluxe agreed to manufacture certain pre-fabricated modular buildings (“I-Buildings”) and deliver them to the Project site.  Under the Construction Contract, Cmax was obligated to perform the site work, including laying concrete foundations for the I-Buildings manufactured by Deluxe.

In 2006, the Project began to unravel.  By the spring of 2006, Cmax had failed to pay Deluxe $928,720.66 owed under the Subcontract.  Thereafter, Cmax abandoned work on the Project causing the Owner to make a demand on the Bond.  In response, Arch determined to step in to complete the Project and, after negotiations with the Owner, entered into a Takeover Agreement on February 13, 2007.

The Takeover Agreement required Arch to complete the work required under the Construction Contract within nine months, i.e., by October 13, 2007.  Nonetheless, 34 months after executing the Takeover Agreement, Arch still had not completed the Project.  Significantly, on December 11, 2009, Arch informed the Owner that it was terminating the Takeover Agreement and walking off the job.

The Litigation

In earlier opinions, the District Court concluded that Cmax had materially breached both the Construction Contract and the Subcontract and was liable to both the Owner and Deluxe for damages.  In addition, the court granted summary judgment in the Owner’s favor finding that: (a) Arch was liable on the Bond; and (b) that Arch had breached the Takeover Agreement for failing to perform pursuant to its terms.  Thus, liability was established by the court against the general contractor and surety, leaving only the issue of the amount of damages owed to be decided.  The primary issue raised in the Deluxe case was whether Arch was liable for damages in excess of the penal sum of the Bond.  In its analysis of that issue, the court considered: (i) Arch’s role as a performing surety; and (ii) the express terms of the Takeover Agreement.

Performing Sureties May Waive Bond’s Penal Sum Limitation

The first issue the District Court considered in its analysis whether the penal sum of the Bond limited Arch’s liability was whether a surety has liability for damages independent of its role as surety under the Bond.  In the court’s opinion, the answer to that inquiry in this particular case hinged upon the respective obligations of Arch as bond surety and Arch as performing surety under the Takeover Agreement.  In connection with its analysis, the Court found that that the default rule holds that a surety loses the protection of the bond’s penal limit when it takes over a project.

In coming to that finding,  the Deluxe court adopted the rationale of the United States District Court for the Southern District of New York in International Fidelity Insurance v. County of Rockland, 98 F. Supp.   2d 400, 429 (S.D.N.Y. 2000).  In Rockland, the court held that it was fair to strip a completing surety of the protection otherwise provided by the penal bond limit because, in taking over a project, the performing surety takes control of the completion costs away from the obligee and is in the best position to avoid costs.  The Deluxe court agreed with this rationale and held that in fairness to the obligee, the penal bond limit should be removed or there would be no incentive for the surety to keep costs low, or even to complete the project on time.  Ultimately, both the Deluxe court and the Rockland court before it concluded that the burden of liability is best placed on the performing surety, who takes control over the work, associated expenditures and the pace of construction.

Based upon this analysis and rationale, the Deluxe court held that when Arch stepped in to complete the Project, it no longer stood on its Bond and, as such, was no longer protected by the Bond’s penal limit.  Instead, as performing surety (and without some other agreement in place), Arch was liable for damages stemming from its breaches under the Takeover Agreement, even if these damages exceeded the Bond’s penal sum.

Takeover Agreement’s “Preservation Of Penal Sum Limitation On Surety’s Liability” Provision Did Not Protect Surety

The Deluxe court recognized the well-settled rule that a surety is free to negotiate certain protections when entering into a Takeover Agreement to complete a Project.  As such, the next step in the court’s analysis was to analyze the express terms of the Takeover Agreement.  In that regard, Arch argued that the Takeover Agreement unambiguously limited its total potential exposure to the amount of the Bond’s penal sum.  In support of its argument, Arch pointed to the following provision in the Takeover Agreement:

10.  Preservation of Penal Sum Limitation on Surety’s Liability.  All payments by Surety (a) toward completion of the Work and (b) for labor performed or materials, provisions, provender, or other supplies or teams, fuels, oils, implements, or machinery furnished in connection with the Contract in excess of the amount of payments actually made by Owner to Surety pursuant to this Takeover Agreement shall be deemed payments under the Bond, and the penal sum of the Bond, which constitutes the limit of Surety’s liability thereunder, shall be deemed to have been reduced by the amount of any such payments made by Surety … 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.

(Emphasis added.)  It was no doubt Arch’s intent that the above-quoted provision preserve the Bond’s penal sum limit and serve to cap Arch’s potential liability associated with completing the Project.  Despite its efforts, Arch failed to achieve the protection it sought, and the court concluded that Arch’s exposure was not limited by the Bond’s penal sum limit.  The court’s analysis provides, at least, three salient lessons in this regard:

1. The Takeover Agreement’s Terms Must Be Precisely Drawn

The Deluxe court read Arch’s Takeover Agreement’s “Preservation of Penal Sum Limitation” provision as pertaining only to Arch’s liability “under the Bond.”  By using that terminology, Arch opened the door to a plausible interpretation that the penal sum limitation language in the Takeover Agreement applied only to its liability as a “surety” as opposed to a completion contractor/surety. The court inferred from the language used that the provision did not contemplate a limitation of Arch’s liability for its own breaches of the contractual performance obligations it separately assumed by taking over the Project under the Takeover Agreement.

2. Attention Should Be Given To A Takeover Agreement’s Other Provisions

In connection with its analysis, the Deluxe court refused to read the “Preservation of Penal Sum Limitation” provision in isolation, but considered other provisions in the Takeover Agreement to shed light on its meaning.  In that regard, the court noted that the Takeover Agreement provided for the imposition of substantial liquidated damages (“LDs”) – $7,775 per day – for the surety’s failure to complete the Project by a date certain.  The Owner argued, and the court agreed, that LDs would not constitute “payments under the Bond” because they would not further the completion of the work.  The court found that the unlimited nature of the liquidated damages provision in the Takeover Agreement was inconsistent with the notion that damages for Arch’s breach of the Takeover Agreement were limited by the Bond.

3. A Completing Surety’s Liability May Be Determined By The Term Of  The Construction Contract

The court also considered the interplay between the damages provisions in the Takeover Agreement and those contained in the Construction Contract.  As often occurs, the Takeover Agreement in the Deluxecase incorporated the terms of the Construction Contract.  Of particular importance to the court was a provision of the Takeover Agreement that provided that the Owner’s rights against Arch under the Takeover Agreement were the same as the rights it had against Cmax  under the Construction Contract, unless the Takeover Agreement expressly stated otherwise.  The court also noted that, other than providing for liquidated damages for delay, the Takeover Agreement did not provide the Owner any remedy for the surety’s breach.  Due to this void in the Takeover Agreement, the court concluded that the remedy provisions in the Construction Contract controlled, which permitted the Owner to recover for any loss, damages or detriment without limitation.  As such, read in conjunction with the Construction Contract, the court concluded that the Takeover Agreement’s “Preservation of Penal Sum Limitation” provision did not limit the surety’s liability for its inadequate performance

Conclusion

The Deluxe case highlights the surety’s increased risk and potentially increased liability attendant to completing a project upon its principal’s default.  As demonstrated by the case, sureties must seriously weigh the pros and cons of stepping into the shoes of the contractor.  In connection with that assessment, sureties should appreciate that some courts have enforced a default rule that the penal sum protection is lost when the surety steps in to complete a Project.  Accordingly, it would be prudent for a surety contemplating completing a bonded project after a default to seek legal counsel to ensure that appropriate protections are set out in the Takeover Agreement.