Follow Terms of Contract and Bond Both

By John S. Mrowiec

Terminating a contract or subcontract for default is a serious matter. Do it incorrectly and the terminating party might find itself without the ability to use the remaining funds to complete.

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What constitutes a proper ground to terminate normally is addressed in the contract. But even if grounds are present, the termination must be procedurally correct. Sub procedural issues as content of notice, number of notices, timing of notices and right to cure usually are addressed in the contract.

If the unpaid balance in the terminated contract is insufficient to pay to complete the terminated work, the terminating party then will have to sue the terminated party to recover the excess completion costs. The terminated party might have insufficient assets to pay.

It is this possibility that parties anticipate when requiring performance bonds.

When a performance bond is present, another level of complexity is added to the termination scenario. Not only must the terminating party terminate in accordance with the contract, but also must abide by the terms of the bond if the terminating party expects to receive the bond’s benefit.

The terminating contractor learned that lesson in Solai & Cameron, Inc. v. Plainfield Community Consolidated School District No. 202, 2007 Ill. App. LEXIS 761 (3d Dist., July 10, 2007).

Four Schools Planned

Solai & Cameron, Inc. involved prime contracts for construction of four schools between the Plainfield School District and contractor Paul H. Schwendener Inc. On two of the four projects, a middle school and a high school, the contractor entered into subcontracts for electrical work with Solai & Cameron Inc. as subcontractor. The subcontracts gave the contractor the right to terminate for subcontractor’s default after three days written notice and gave the contractor the right to supplement subcontractor’s forces for inadequate progress.

The electrical subcontractor provided performance bonds for each of the two subcontracts for the benefit of the contractor from Hartford Fire Insurance Co., the surety. The bonds provided that the surety’s obligations arose only after, among other stipulations (paraphrased):

3.1 Prior notice to surety and subcontractor that contractor intended to declare subcontractor in default.

3.2 Declaration of subcontractor default which could not occur earlier than 20 days after receipt of the notice of 3.1.

3.3 Contractor agreement to pay the balance of the subcontract price to surety or to a replacement subcontractor tendered by surety.

Once the contractor satisfied those requirements, the surety had the right to hire a replacement subcontractor under paragraph 4 of the bond.

The contractor became dissatisfied with the subcontractor’s progress on both subcontracts. On March 20, 2002, the contractor wrote the subcontractor, with a copy to the surety, regarding the subcontractor’s inadequate performance on both subcontracts.

The letter contained the three-day notice to comply as required by the electrical subcontracts. The letter also stated, “Please note that a copy of this notice to comply has been sent to your bonding company as required in Section 3.1 of the Performance Bond and serves as their notification of default.”

Thereafter, over the next few weeks, the contractor, the subcontractor and the subcontractor’s surety were communicating about the contractor’s continued dissatisfaction over the pace of subcontractor’s work. Sometimes, though, the contractor wrote to the subcontractor without copying the surety.

New Subcontractor Hired

On April 12, 2002, the contractor retained a different electrical contractor to consult on the status of the subcontractor’s unfinished work. By May 9, the contractor had begun to supplement the subcontractor’s crews on the middle school project with the other electrical contractor’s.

By subcontract dated May 21, 2002, the contractor subcontracted with the other electrical contractor for the middle school project. After backcharging the original subcontractor on June 2, both subcontractors continued to work together until June 7 when the contractor terminated the original subcontractor from the middle school project.

On June 10, the contractor began supplementing the original subcontractor’s forces on the high school project. On June 15, the contractor terminated the high school electrical subcontract.

On June 21, the contractor entered into a new subcontract with the replacement subcontractor for the high school. On June 24, the contractor issued a deductive change order to the original subcontractor.

The contractor then demanded that the surety perform on the bonds for both projects. The contractor’s sworn statements to the owner on July 1 reflected electrical work was complete on each contract and moved the previously unbilled balance of the electrical item to a new line item entitled “electrical management” for which contractor requested payment.

By July 18, when the surety inspected both projects for the status of electrical work, the work was substantially complete. Eventually, the contractor demanded $500,000 in excess completion costs from the subcontractor’s surety.

The subcontractor filed suit for payment it claimed was due from the contractor. The contractor filed a third party complaint against the subcontractor’s surety.

The surety moved for summary judgment against contractor’s claim. The surety contended that the contractor had failed to satisfy paragraphs 3.2 and 3.3 of the bond, thereby preventing the surety’s right to hire a replacement subcontractor.

Court’s Assessment

The trial court agreed with surety that the contractor had not satisfied the bond’s requirements and entered summary judgment for the surety. The contractor’s hiring of the replacement subcontractor by written subcontract two weeks before formally terminating the middle school subcontract denied the surety its rights to investigate and to perform under that bond.

The contractor appealed. The appellate court first explained how the bonds worked:
“The structure of the performance bonds distinguished the act of termination [Paragraph 3] from the act of replacement [Paragraph 4]” Solai & Cameron, Inc., 2007 Ill. App. LEXIS 761, *22.

On the middle school project, the contractor “arranged, undertook to perform and negotiated with the replacement subcontractor”—a right only the surety had if the contractor wanted the protection of the bond, Solai & Cameron, Inc., 2007 Ill. App. LEXIS 761, *29. Beyond that, the contractor failed to agree to pay the surety the balance of the subcontract price. “This course of conduct violated the terms of the performance bond and nullified [surety’s] duty to perform” regarding the middle school bond, Solai & Cameron, Inc., 2007 Ill. App. LEXIS 761, *30. On the high school project, the contractor did not hire the replacement subcontractor in advance of terminating the original subcontractor. However, the contractor never agreed in advance to pay the surety the balance of the subcontract price. Therefore, although the facts of the high school project were different, the result was the same.

The contractor argued that the surety never objected to the contractor’s initial supplementation of the original subcontractor’s workforce with the entity who ultimately became the replacement subcontractor. The court reasoned that surety had no legal basis to object to supplementation so its failure to object was not waiver of surety’s rights to insist on contractor’s satisfaction of conditions to surety’s duty to perform. Likewise, the fact that the subcontract gave contractor the right to complete the defaulting subcontractor’s work did not mean that contractor could do so without giving the surety the first opportunity.

Solai & Cameron, Inc. involves a complex fact pattern with a contractor under pressure to complete its contracts. Even under that pressure, if one wants the benefit of a performance bond, following the rights and procedures of the subcontract might not be enough. The careful party reads and follows both the contract and the bond.


John S. Mrowiec is a partner with Chicago-based Conway & Mrowiec, a construction and public contracts law and litigation practice. He may be reached at (312) 658-1100. For information, go to the firm's Web site at www.cmcontractors.com.