Calling a Performance Bond After a Default

A performance bond is not a general guarantee that a project will go well. It answers for the principal's failure to perform the contract, and it becomes operative only when the obligee declares the principal in default and terminates. Everything that follows, including what the surety must do and what it may refuse to do, depends on whether that declaration was properly made.

What triggers the obligation

Delay does not trigger it. Financial difficulty does not trigger it. Disputes over change orders, deficient work and slow progress do not trigger it, however serious they become. What triggers it is a declared default followed by termination of the contractor's right to proceed, made in accordance with the underlying contract's own provisions and any additional conditions the bond imposes.

On federal construction the operative mechanism is the default clause, under which the government may terminate the contractor's right to proceed where the contractor refuses or fails to prosecute the work with the diligence needed to ensure completion within the time specified, or fails to complete within that time. The clause requires written notice and, in specified circumstances, an opportunity to cure. A termination that does not follow those steps is vulnerable to being converted into a termination for convenience, which removes the foundation for the bond claim entirely.

Private bond forms often add their own conditions. Common ones require the obligee to notify the surety that it is considering declaring default, to confer with the surety and the contractor before doing so, to declare the default formally in writing, and to agree to pay the balance of the contract price to the surety or to a completion contractor. Courts differ on how strictly these conditions are enforced, but an obligee that ignores them entirely gives the surety a defense that costs nothing to plead.

The options open to the surety

Once default is declared the surety investigates and elects. It may take over the contract itself and complete the work through a contractor it engages. It may tender a completion contractor to the obligee, who then contracts directly with that firm. It may allow the obligee to complete and pay the excess cost up to the penal sum. It may negotiate a payment of the estimated completion cost in exchange for a release. Or it may deny liability, on the ground that no default occurred, that the declaration was defective, or that the principal has defenses to the underlying claim.

The choice is a commercial one shaped by the size of the remaining work, the availability of a competent replacement, the amount of contract balance left and the strength of any defense. Federal practice recognizes the takeover route expressly, directing the contracting officer to consider the surety's proposals carefully because the surety is liable for damages resulting from the default and has rights and interests in completing the work and in the application of any undisbursed funds.

Timing constrains the election in practice. The obligee has a project standing idle, subcontractors demobilizing and a schedule that continues to run, so it will press for a decision within days. The surety needs to investigate before committing, since a takeover converts a capped guarantee into an operational obligation. That tension explains why sureties often fund an interim arrangement, allowing existing subcontractors to continue under a reservation of rights while the investigation proceeds.

What the takeover agreement contains

A takeover agreement is a tripartite arrangement recording that the surety will complete the work and the terms on which it will be paid. It fixes the contract balance available, the schedule for disbursement, the treatment of retainage, the status of pending change orders and claims, and the extent to which the surety assumes or reserves the principal's rights against the obligee. Federal guidance directs that the agreement provide for the surety's completion and address the application of undisbursed funds, and that the contracting officer take action to enable completion consistent with the surety's interests.

The most negotiated point is usually the treatment of claims that existed before the default. A surety completing the work generally wants to preserve the principal's claims against the obligee for extras and delay, while the obligee prefers a clean slate. Whether those claims are assigned, reserved or released materially changes the economics of the takeover and should be settled in the document rather than left to argument later.

A separate question is whether the completed work will exceed the penal sum. Where it plainly will, a surety that takes over the contract may be held to have assumed the completion obligation without the benefit of the cap, on the reasoning that the takeover is a new undertaking rather than performance of the bond. Sureties address this by reciting expressly in the agreement that the penal sum continues to limit their liability, and obligees resist that recital for the same reason.

What follows for the other parties

A default has consequences well beyond the two principals to the bond. Subcontractors and suppliers usually stop being paid before the default is declared, so payment bond claims follow quickly and are governed by a separate limit and separate conditions, including those in the notice a remote claimant must give. Sureties commonly resolve the completion and the payment streams together, but a claimant should treat them as distinct and satisfy every condition in defenses the surety will raise.

For the contractor, a default is the beginning of a second proceeding. Whatever the surety pays on either bond becomes a debt owed back to it under the arrangements described in the surety's indemnity against the contractor, secured by collateral demands and personal guarantees signed long before the project began.