Surety Bond Penalty Waivers in Takeover Situations

Performing Sureties Are Deemed to Have Waived Limited Liability

There are a number of courts which have found that a performing surety waives its limited liability under the bond simply by taking over the principal's work. They do so even though those same courts also recognize that the surety may refuse to perform after the principal defaults and rest on its bond limit of liability. ³ The cases hold that a performing surety waives its rights to rely on the terms of the bond, including the bond penalty. Uniformly, these cases share the following factual pattern:

1. The principal defaults.
2. The bond is silent as to the surety's options upon the principal's default.
3. The surety takes over.
4. The surety performs the principal's obligation without limiting its liability as a condition of performance, and without reserving its rights to assert the bond limit of liability.
5. The obligee seeks damages that exceed the bond amount.

Under the above factual pattern, the performing surety is deemed to have waived its penal sum because the surety is deemed to have stepped into the shoes of its principal and acted as a primary obligor instead of remaining a surety under the bond. As primary obligor, the surety is deemed liable for the full performance of its new, primary obligations. ⁴

The case of Caron v Andrew, 133 Cal App 2d 402, 284 P2d 544 (1955), is representative. In Caron, the surety guaranteed the performance of a leveling contract between its principal and the owners. The surety bond contained a bond penalty. The principal defaulted, abandoned the work, vacated the premises, and did not return." The surety agreed to perform the work and did perform for several months. In the interim, however, there were heavy rains and flooding. In addition, the owners allowed the removal of a substantial amount of dirt from the property.

Eventually, the surety ceased work on the project, taking the position that the contract was rendered impossible due to the flooding. Additionally, the surety asserted that the owners' permitting the removal of dirt from the property was a material alteration, and discharged the surety's further obligations. The owners completed the leveling work for costs exceeding the bond penalty and sued the surety.

After trial, the court found in favor of the owners, but limited the owners' recovery to the bond penalty. On appeal, the owners successfully asserted that the limitation on the surety's liability was no longer available. The appellate court acknowledged that:

Upon breach by the principal, the surety is, unless otherwise specifically provided in the contract, free to rest upon the contract of suretyship and if it does it cannot be held beyond the limit of its bond and may invoke any defense open to it as surety. Id. at 410.

However, the court found that the surety had waived its rights to rely on the terms of the bond. In so ruling, the court reasoned:

[The surety] stepped into its principal's shoes and, as the court found, undertook to complete its principal's contract without in any way seeking to protect itself by exacting extensions of time or other conditions which would or might make its undertaking less burdensome. Having done this and having consumed several months of time, it, in turn, breached its obligations and abandoned the work, leaving it to [the owners] to extricate themselves as best they could from the difficulties thus cast upon them. Thereafter, [the surety] could not shelter itself behind the limitation of its liability expressed in its bond as it might have done had it rested upon its surety contract. Id. at 412 [Emphasis added].

Thus, under Caron, the surety may be deemed to have waived its bond penalty unless the surety seeks to "protect itself" by conditioning its performance on maintaining its limited liability.

Of note, Caron relied on the terms of the surety's bond, which did not describe the surety's options in remedying its principal's default as the AIA bond forms do. Since the court ruled that the surety proceeded "outside" the terms of the bond, the opposite result may have been reached had the bond expressly included, as an option to the surety, taking over and completing the project. ⁵

While the cases discussed come from all over the country, the arguments examined are California based. Readers should look for comparable case or statutory law in their state that may form the basis of similar arguments against bond penalty waiver.

Argument Against Waiver of the Bond Penalty

The Surety's Waiver of Its Bond Limit Must Be in Writing To Satisfy the Statute of Frauds. California Civil Code § 2787 states that, "A surety or guarantor is one who promises to answer for the debt, default, or miscarriage of another...." Cal. As such, California's Statute of Frauds expressly applies to suretyship. Code § 1624 provides:

1. The following contracts are invalid, unless they, or some note or memorandum thereof, are in writing and subscribed by the party to be charged or by the party's agent: * * *
2. A special promise to answer for the debt, default, or miscarriage of another, except in the cases provided for in Section 2794.

Even without the Statute of Frauds, California's Title 13, Suretyship, provides, at section 2793:

Except as prescribed by the next section, a suretyship obligation must be in writing, and signed by the surety; but the writing need not express a consideration.

Material changes to a contract subject to the Statute of Frauds must also be in writing. ⁶ Thus, an argument can be made that the surety's "waiver" of its bond limit when agreeing to take over and complete performance must be in writing.

A Surety May Take Over and Complete a Construction Project Without Acting as a Principal. In 1996 the California legislature enacted Business & Professions Code section 7044.2, which is within the statutory scheme regulating contractors through licensure, states:

This chapter [requiring a contractor's license] does not apply to an admitted surety insurer whenever that surety insurer engages a contractor to undertake the completion of a contract on which a performance or completion bond was issued by the surety insurer, provided all actual construction work is performed by duly licensed contractors.

In California, anyone who engages in construction activities, i.e., acts as a contractor, must be licensed and, if not, cannot collect payment for work performed. ⁷ With the enactment of Business & Professions Code section 7044.2, the legislature arguably recognized a surety's rights, as surety, to perform under a performance bond. As discussed above, as long as the surety is performing under its bond, an argument can be made that its liability would be limited to the bond amount.

A Performance Bond Is A Statutory Bond Such That the Statute Limits the Surety's Liability. In California, the Bonds and Undertaking chapter of the Code of Civil Procedure governs a surety's liability on bonds issued pursuant to statute. Specifically, section 995.020 provides:

1. The provisions of this chapter [§§ 995.010-996.560 "Chapter 2. Bonds and Undertakings] apply to a bond or undertaking executed, filed, posted, furnished, or otherwise given as security pursuant to any statute of this state, except to the extent the statute prescribes a different rule or is inconsistent.

Progress Glass Co. v American Ins. Co., 100 Cal App 3d 720, 161 Cal Rptr 243 (1980), holds that a bond "permitted" by a statute is a statutory bond. California Public Contracts Code sections 10221-10222, 10224, provide for public works performance bonds, which are clearly statutory bonds. Additionally, California Civil Code section 3248(b) permits a subcontractor performance bond on a public works project, and, therefore, may be considered a statutory bond as well. Thus, there is an argument that all performance bonds issued in connection with a public works project in California are statutory bonds.

The significance of that conclusion is set forth in California Code of Civil Procedure section 996.470, which provides:

1. Notwithstanding any other statute ... the aggregate liability of a surety to al persons for all breaches of the condition of a bond is limited to the amount of the bond....
2. If a bond is given in an amount greater than the amount required by statute or by order of the court or officer pursuant to statute, the liability of the surety on the bond is limited to the amount required by statute or by order of the court or officer....

Thus, a surety's liability under such bonds may be limited to the amount of the bond regardless of whether the surety takes over or not.

Conclusion

The prudent surety should, if at all possible, insist on an express limitation of liability when it takes over. However, based on the authorities cited above, creative arguments exist, at least in California, for the performing surety's liability to be limited to its bond amount, unless the surety expressly waives such limitation in writing.