By Nell M. Hurley of Ernstrom & Dreste LLP
The Massachusetts federal district court recently held that a contractor-obligee’s termination of its subcontractor was a condition precedent to the surety’s obligation to perform under an AIA[1] A312-2010 subcontract performance bond, and granted the surety’s summary judgment motion, declared its bond liability discharged, and dismissed all counterclaims of the contractor.[2]
The matter arose out of a new apartment building project in Boston commenced in 2017. Arch Insurance Co. (“Arch”) provided the A312 performance bond (“Bond”) for a modular construction subcontract between its principal, R.C.M. Modular, Inc. (“RCM”), and the general contractor, The Graphic Builders LLC (“TGB”). The subcontract, which was incorporated by reference into the bond, required RCM to: fabricate, deliver and assemble modular components of the apartment building, warrant that all work by RCM will be free from defects and indemnify TGB for any cost of damage arising from that work.
Soon after RCM began installing the modular units in May 2018, TGB discovered that the units were defective, with many windows leaking and exteriors misaligned. Rather than calling on the Bond at that time, TGB unilaterally arranged for other parties to remediate RCM’s work at a cost of over $2.8 million, but it did not terminate RCM’s subcontract. Beginning in October, 2018, TGB notified Arch that it was considering declaring RCM in default on the subcontract and sought contractual warranty and indemnification payments from Arch for the remediation work. TGB later declared RCM in default per Section 3.1 of the Bond,[3] and notified Arch, but emphasized that it was not terminating RCM. Arch acknowledged the notice but refused to make the demanded payments to TGB, denying liability because TGB had failed to terminate RCM, as required by Section 3.2 of the Bond.[4]
Arch filed suit seeking a declaration that TGB breached the bond by failing to terminate RCM, which is a condition precedent to Arch’s obligation to perform, and discharging Arch from liability thereunder. TGB counterclaimed that, independent from any condition precedent, Arch is obligated under Section 1 of the Bond to cure RCM’s defective work, indemnify TGB, and issue TGB warranty payments.[5] It also asserted state law claims against Arch for unfair and deceptive conduct.
Arch moved for summary judgment based on the conditions precedent contained in Section 3 of the Bond, and TGB’s failure to terminate RCM as required under Section 3.2. TGB countered with a novel argument that the Bond distinguishes between (1) claims that require the surety to complete work on the project, for which termination of the subcontract is a condition precedent, and (2) claims that simply require the surety to reimburse TGB for damages caused by RCM’s breach of the subcontract, for which there is no condition precedent. TGB asserted that the distinction is based upon the fact that the subcontract authorizes TGB to correct deficiencies and seek indemnification from RCM without termination, the subcontract’s express incorporation into the Bond, and Bond Section 1’s “joint and several liability” of RCM and Arch for the subcontract work.
Without directly addressing this argument, the court found that the Bond unambiguously imposed conditions precedent to any Bond obligation of Arch. The court held that Section 3.2 of the Bond required that RCM be terminated. Since it was undisputed that this never happened, said the court, TGB failed to comply with that condition precedent. The court ruled that Arch was thus discharged from all obligations under the Bond, and dismissed TGB’s counterclaims based on subcontract warranty and indemnity, as well as TGB’s “last ditch” claim that RCM could not be terminated because it had substantially completed the work.[6]
The court here cited to uncontroversial case law that holds the provisions of Section 3 of the Bond are conditions precedent to surety performance obligations. But the decision stops short of an express ruling on the contractor’s argument that a surety could possibly be obligated, independent of Section 3, for indemnity or warranty under Section 1, where its principal’s work proves defective. Of course, where remedial work is performed without the surety’s knowledge, it certainly belies a fundamental tenet of surety law and practice: the right of the surety to investigate. But since TGB filed its appeal immediately following this decision, we could see the argument again, in its effort to fashion “subguard” coverage from a performance bond.
[1] American Institute of Architects
[2] Arch Ins. Co. v. Graphic Builders LLC, 2021 U.S. Dist. LEXIS 27017* (D. Mass. Feb 12, 2021), appeal filed, No. 21-1126 (1st Cir. Feb 16, 2021).
[3] AIA A312-2010 Section 3.1 sets forth required notice provisions, which were not at issue in the case.
[4] AIA A312-2010 Section 3.2 provides that the obligations of Arch under the Bond “shall arise after [TGB] declares a Contractor Default, terminates the [subcontract] and notifies [Arch].
[5] AIA A312-2010 Section 1 provides that [RCM] and [Arch] agree to “jointly and severally bind themselves to [TGB] for the performance of the [subcontract]” which is incorporated by reference into the Bond.
[6] While many states follow the so-called “substantial performance” rule regarding termination, the court relied upon the subcontract, which permitted termination until the work was fully completed, and TGB’s failure to show that termination was impossible or impracticable.
Nell M. Hurley is Of Counsel to Ernstrom & Dreste, LLP, a surety and construction law practice in Rochester, N.Y. Hurley is an experienced advisor, litigator, and negotiator in all types of surety and construction disputes and risk management situations. Hurley also writes articles on cases, topics, and trends of significance to surety and construction professionals and businesses. She can be reached at nhurley@ed-llp.com or 585-473-3100.