While many of these sureties are often affiliated with insurance companies, an appellate court, in the recent case of JDS Development LLC v Parkside Construction Builders Corp. and Allied World Insurance Company, reminds us that there are fundamental differences between the insurance and surety bond products, and that a performance bond cannot be converted into an insurance policy after the fact.

Background

JDS Development is the developer of the supertall skyscraper at 111 West 57th Street in Manhattan, known as the Steinway Tower (which, as of the time of this writing, is the fourth tallest building in the United States, and the 29th tallest in the world). In 2015, JDS entered into a contract with Parkside Construction Builders for Parkside to undertake the construction of the superstructure of the building. This single subcontract was for the entire 85 floor superstructure, and the initial contract sum was $39.7 million. The subcontract also required Parkside to obtain a performance bond “on request,” with a penal sum equal to the subcontract price.

In 2016, JDS did request a performance bond, and Parkside attempted to obtain that bond from Allied World Insurance Company. However, Allied World balked because it could not write a bond with a penal sum in excess of $25 million. To get around that issue, JDS and Parkside executed a modified subcontract whereby Parkside would take the superstructure through the 36th floor for just under the $25-million cap. The new subcontract had a substantial completion date of Oct. 13, 2016. With the subcontract price reduced, Allied World wrote the bond on the form of an American Institute of Architects A312 bond. The A312 form of bond provides that the surety’s liability only arises after three conditions have been met, as follows: that the owner notifies the contractor and surety that the owner is considering declaring a default, and requests a pre-default meeting; that the owner declares a default and formally terminates the contract; and that the owner agrees to pay over the remaining contract balance to the surety for use in the completion of the project.

Shortly after the contract modification, JDS began to complain about Parkside’s work, particularly for lagging behind the project schedule. Parkside was over a year late, finishing the 36th floor in October of 2017.

JDS paid Parkside in full under the 36-floor subcontract (plus an additional $16 million via a price adjustment). Parkside continued the construction above the 36th floor under the original subcontract, and it worked through May of 2018, when its principals were indicted for wage theft and Worker’s Compensation fraud. Parkside’s work had only reached the 60th floor by this time. JDS retained a replacement contractor to complete the project.

In June of 2018—six months after the 36-floor subcontract had been completed—JDS sent Parkside and Allied World a letter advising that it was “considering declaring a contract default,” and requested a meeting. When JDS received no response to this letter, on Aug. 9, 2018, it declared Parkside “in default under the subcontract,” without specifying whether this was the 36-floor subcontract or the original 85-floor subcontract. A week later, JDS formally terminated Parkside from the project (again, without noting which contract was terminated). Two weeks after that, JDS placed a claim under Parkside’s bond, claiming that its damages totaled $89 million ($78 million of which were delay damages) and, accordingly, demanded that the surety tender the penal sum of the bond. Allied World responded by demanding documentation, alleging that what had been provided was not sufficient to establish liability under the bond. In response to Allied World’s demand, JDS commenced a lawsuit against it and Parkside (in which Parkside defaulted). After discovery, both parties moved for summary judgment, with JDS arguing that it had established Allied World’s liability under the bond—and Allied World arguing that JDS failed to comply with the conditions precedent to the surety’s liability for failing to properly send the letter advising that it was considering declaring a contract default, the notice of contractor default, and the notice of termination.

Decision

The motion court held in favor of Allied World, finding that JDS failed to properly comply with the conditions precedent of sending a letter advising the surety and the contractor that it was considering declaring a contract default, providing a notice of contractor default, and terminating the contract.

JDS appealed, arguing that the conditions precedent had been complied with as it sent the requisite correspondence. JDS also argued that while these conditions may be precedent to requiring the surety to complete the contract, they were not conditions precedent to a delay claim.

Allied World argued in opposition that the mere sending of this correspondence was insufficient as its liability would not arise until the conditions precedent were met and all of JDS’s claimed damages arose beforehand. Allied World also (correctly) noted that this correspondence was sent over six months after Parkside had reached the 36th floor (the limit of its bonded contract) and been paid in full for that work. Also, there was no default to declare. Given that Parkside walked off the job nearly 60 floors into the project could not be used to create a default prior to that time.

The appellate court affirmed, holding that the conditions in Section 3 of the A312 bond are well-settled conditions precedent that must be met before the surety’s liability will arise.

As to the correspondence that was sent to the surety by JDS, the appellate court held that the claim was barred because JDS “fail[ed] to have complied, at any time before the bonded work had been completed, with the condition precedent of the notice and termination procedures specified in paragraph 3 of the bond.” The appellate court noted the importance of this fact, holding that “a performance bond is not insurance against the cost of any breach by the principal, but, rather, a guarantee of the principal’s performance that is triggered only upon the termination of the principal from the project for a breach sufficiently egregious to constitute a default warranting termination.” Thus, the court held that the after-the-fact correspondence was insufficient to comply with the express conditions precedent.

Comment

As the appellate court reminds us in JDS Development, the function of a performance bond is not to insure against any breach of the contract by the principal, but to guarantee the completion of the project. While there are insurance products that will insure against a contractor or subcontractor default (with their own pros and cons), the appellate court properly declined to permit JDS to use its after-the-fact correspondence to transform the bond into such a policy. As was evident here, many factors go into the decision to terminate a contractor, not the least of which are the ultimate economics (as noted by JDS, the delays which would have resulted from changing contractors made it cheaper to drag Parkside across the finish line than to terminate its contract and bring a replacement contractor on board).

The decision to terminate the contractor is not analogous with the decision to advise the surety that it was considering such a termination and requesting a conference to discuss how to proceed. These conferences— termed “3.1 meetings” after the section of the bond which requires such a meeting— usually result in some sort of surety involvement to get the project back on track, or keep it on track, for a timely completion. This involvement can range from paying suppliers to release needed goods, to assisting the contractor in the completion of the contract. Had JDS sent this correspondence before Parkside had completed its contract, the parties could have explored ways to both complete the project earlier (thus mitigating JDS’s delay damages), and to provide JDS with some form of compensation for the damages it was incurring.

Two Bottom Lines

First, consultation with experienced construction counsel throughout the process can best protect the rights of all involved. Second, the performance bond is only a useful tool for an owner or contractor who understands how it works.

About the authors: Thomas H. Welby, an attorney and licensed professional engineer, is General Counsel to the Construction Industry Council of Westchester & Hudson Valley, Inc., and the Building Contractors Association, and is the Founder of and Senior Counsel to the law firm of Welby, Brady & Greenblatt, LLP. Gregory J. Spaun is General Counsel to the Queens and Bronx Building Association and an attorney and a partner with the firm, co-authors this series with Mr. Welby.