This was a great article by Colin McCarthy at Lanak & Hanna, P.C. that I wanted to share. The specific question addressed in this paper is what are the COVID-19 implications for the performance bond
Colin McCarthy, LEED A.P. is a principal attorney and shareholder at Lanak & Hanna, P.C. He has been representing general contractors, trade contractors and bonding companies for twenty years, with an emphasis in complex construction projects.
COVID-19 is a global Pandemic that is impacting every sector of the global economy. The construction industry is already being severely affected. While much analysis has been written on the Pandemic and the legal ramifications associated therewith, most of that analysis has been geared towards a “Force Majeure” inquiry.
The specific question addressed in this paper is what are the COVID-19 implications for the performance bond surety? Specifically, what is the interplay between COVID-19, Force Majeure and the surety receiving a claim from either the owner or general contractor under a construction performance bond? Is the performance bond surety entitled to assert this defense and what procedural safeguards should be put in place to perfect this defense?
FORCE MAJEURE FRAMEWORK
We begin with the underlying assumption that COVID-19 meets the traditional criteria for a Force Majeure event. Force Majeure, literally meaning “superior force” in French, is a long-recognized legal precept that holds that in the construction arena, a contractor will be excused from performance of the underlying construction obligation if an unforeseeable, significant event occurs which renders its performance impossible or impracticable.
California does not have a specific Force Majeure statute. However, the law does codify British common law by excusing a contracting party’s performance for events such as “an irresistible, superhuman cause, or by the act of public enemies of this state or of the United States.…”[1] The typical conditions-precedent to establishing a Force Majeure claim include timely notice to the other contracting party and efforts to immediately and meaningfully mitigate damages.[2]
While many construction contracts contain Force Majeure clauses (which must be followed), the absence of a specific contract clause will not render the defense unavailable. On federal public works, Force Majeure is codified within the Federal Acquisition Regulations.[3] Much has been written lately confirming that COVID-19 meets the legal definition of a Force Majeure event and we join in that conclusion.
CALIFORNIA’S RESPONSE TO THE COVID-19 PANDEMIC
On March 19, 2020, California Governor Gavin Newsom issued Executive Order N-33-20, which mandates “Shelter in Place” for all Californians. This Order prohibits Californians from returning to work and has resulted in the Statewide shutdown of most California businesses. Specifically exempted from the Governor’s Order are 16 critical infrastructure sectors identified by the United States Government as being critical to the health, safety, security and economic prosperity of our country.[4]
Subsequent to issuing Executive Order N-33-20, Governor Newsom amended the Order to provide additional exemptions for “critical government services, schools, childcare, and construction, including housing construction.”[5] The Amended Order has since been revised again to specifically identify contractors as critical infrastructure members, exempted from all Shelter in Place Orders.[6]
Put plainly, the Governor’s amended Orders have opened the doors to the resumption of construction work. Many project owners and general contractors are now ordering their contractors to return to work and commence construction operations.
COVID-19’s IMPACT ON THE PERFORMANCE BOND SURETY
In response to the amended Orders, some contractors have refused to return to work, citing continued health exposure issues and potential liability claims should they return to a project and a worker become ill with COVID-19.[7] Likewise, some contractors are unable to continue performance of the project work due to the mounting cost impacts associated with COVID-19, as well as loss of critical skilled labor due to financial, health and familial obligations.
The logical implication of this situation is that the performance bond surety may see an increase in claims being asserted under its bonds as general contractors and subcontractors fail to return to work. For example, some larger general contractors have begun issuing 48-hour Cure Notices to their subcontractors demanding they immediately return to work.
Therefore, the question becomes what is the performance bond surety’s obligation in this situation, and more specifically, can the surety avail itself of the Force Majeure defense should the COVID-19 Pandemic continue to disrupt the construction economy?
A surety’s obligations under its performance bond begins with an evaluation of the terms of the bond itself. A performance bond is interpreted just as any normal contract is and traditional rules of contract construction apply.[8] Therefore, the first step in the process is to carefully evaluate the specific terms of the applicable performance bond.
Generally speaking, the performance bond simply guarantees the full and faithful performance of the underlying contract in the event of principal default. Should the bond principal fail to complete the terms of the underlying contract, the surety can be called upon to complete the contractual obligations subject to the bond obligee satisfying the conditions-precedent to demand performance under the bond.[9]
It is universally recognized that the performance bond surety is entitled to assert all rights and defenses of its bond principal.[10] Those rights would include the assertion of a Force Majeure defense should the surety find itself in a situation in which continued performance of the defaulted bond principal’s obligations are impracticable or impossible due to COVID-19. Therefore, the surety could condition its response to the performance bond claim on resolution of the underlying Force Majeure defense, or seek affirmative relief that its obligations to perform under the bond are excused due to the Force Majeure event.
If the bonded contract that the principal agreed to perform becomes impossible, or impracticable to perform, this may constitute a defense available to the surety, depending upon the specific circumstances.[11] However, at least one California Court has refused to apply the impossibility defense to a surety for an alleged unforeseeable condition. In Caron v. Andrew, the surety attempted to argue that significant project flooding made continued project performance impossible, and therefore its obligations under the performance bond should be excused. The Court of Appeals disagreed, finding that the flooding which occurred was common knowledge to the original contracting parties and thus not a true unforeseeable event.[12]
In order to perfect an impossibility defense, the surety would have to establish the existence of a true Force Majeure defense and prove that the underlying conditions precedent to Force Majeure (timely notice, mitigation of damages, etc.) have occurred.
Whether a Pandemic such as COVID-19 is a true Force Majeure event significant enough to completely absolve the surety of its obligations under the performance bond remains unseen; especially in light of the Governor’s amended Orders. However, without establishment of the true impossibility of continued performance of the underlying contractual obligations, that was completely unforeseeable to the parties, many courts may reject this defense as it completely exonerates the surety under its bond and may be construed as a complete forfeiture of the obligee’s rights under bond.
COVID-19 AND THE TAKEOVER/COMPLETING SURETY
What about a Takeover/Completion arrangement? A more specific question which arises in this situation is whether the takeover surety may assert a Force Majeure defense in response to a performance bond claim. The immediate reaction is yes. Of course, a takeover surety may raise the Force Majeure defense as the surety may assert all of the defenses of its bond principal and most standard Takeover Agreements expressly incorporate the underlying contract.
However, upon further analysis, that question is not so easily answered, especially in the dynamic world of COVID-19, where new impacts are likely to occur in the future. Recall, in order to assert a true Force Majeure defense, the contracting party must establish certain conditions-precedent, including the existence of an unforeseeable event at the time of contracting. While COVID-19 may have been unforeseeable at the time of the original bid and underlying contract, it is not an unforeseeable event at the time the performance bond surety negotiates and executes the Takeover Agreement with the bond obligee.
By the time the Takeover Agreement is being negotiated, the Force Majeure event (such as COVID-19) is real. But any future Force Majeure is an unforeseeable event. Because the Takeover Agreement is a new and separate contract between the surety and obligee (as opposed to the original contract between the contractor and obligee) it is not a given that the Force Majeure defense for any possible future events, based on the originally worded, bonded contract, would automatically apply.
Therefore, to truly perfect a performance bond surety’s rights to assert defenses to future Force Majeure events is not simply a matter of asserting the bond principal’s defense through incorporation of the underlying contract in the Takeover Agreement. Best practices would dictate that should the performance bond surety intend to pursue a Force Majeure defense to proceeding under the Takeover Agreement, or at least reserve its rights to do so, the surety amend the standard Takeover Agreement to expressly include reference to future Force Majeure events and specifically reserve rights related to said defense not in the Takeover Agreement.
While the obligee may protest this addition, it is an important nuance to the Takeover Agreement, which would ensure that the surety has truly reserved its rights to the Force Majeure defense going forward and brought much-needed contractual clarity to this complex area of law.
Further, by expressly addressing the Force Majeure issue in the Takeover Agreement it would preclude the obligee from later seeking dismiss this defense as express notice of the Force Majeure event is being raised in the Takeover Agreement itself and acknowledgment of the conditions-precedent to the Force Majeure defense (notice, mitigation of damages, etc.) is handled within the new contract.
Once the Takeover Agreement is finalized, it is also important to address the Force Majeure issue in any Completion Contract the surety enters into. Like the Takeover Agreement, crystal clear language should be added to the Completion Contract to ensure both the surety and the completing contractor are on the exact same page when it comes to completion issues related to COVID-19 and respective obligations therewith.
How will time/cost impacts associated with the Pandemic be apportioned? Is the completing contractor taking on any risk associated with further delays/work stoppages associated with COVID-19, or is the surety assuming those risks? Has the appropriate risk been transferred to the completing contractor’s surety through its own performance bond?
The Completion Contract landscape should largely mirror that of the Takeover Agreement to ensure a seamless completion process and in order to mitigate further damages. Like the Takeover Agreement, simply using a standard form Completion Contract will not work if the surety wishes to reserve its rights to raise defenses associated with COVID-19.
CONCLUSION
COVID-19 is an unprecedent and dynamic situation whose long-term ramifications on bonded construction projects remains unknown. What is clear is that sureties cannot simply rely on standard contracts and pro forma responses to address the myriad of complex issues involved in handling a performance bond claim. Care must be taken to artfully draft responsive documents to ensure all appropriate rights and defenses are being preserved to avoid significant legal exposure down the road.
Lanak and Hanna is presently helping sureties and contractors navigate the complex world of COVID-19. If you would like additional information or resources related to this Pandemic and its impact on the construction/surety industry, please contact Frank J. Lanak ([email protected]) or Colin K. McCarthy ([email protected]).
The information contained herein is not advice and should not be treated as such. You must not rely on the information as an alternative to legal advice from an appropriately qualified attorney.
[1] Cal. Civil Code §1511 (1965).
[2] Stockton East Water Dist. v. United States, 109 Fed.Cl.760 (2013).
[3] 48 C.F.R. § 52.249-14 (2007).
[4] Executive Order N-33-20, March 19, 2020, https://covid19.ca.gov/img/Executive-Order-N-33-20.pdf
[5] https://covid19.ca.gov/stay-home-except-for-essential-needs/
[6] https://covid19.ca.gov/img/EssentialCriticalInfrastructureWorkers.pdf
[7] The legal and economic ramifications for a contractor are severe should a worker return to work and be exposed to COVID-19.
[8] Cates Construction, Inc. v. Talbot Partners, 21 Cal.4th 28, 40 (1999).
[9] See Generally, AIA A312 Performance Bond (2010).
[10] Anderson v. Shaffer, 98 Cal.App.457 (1929).
[11] The Law of Performance Bonds, 3d ed., pg. 530, American Bar Association (2018) (citing The Restatement of Contracts §266.
[12] Caron v. Andrew, 133 Cal.App.2d 402 (1955).