A recent case from the Federal court that supervises the trial courts in New York, Connecticut, and Vermont, Stonington Water Street Associates v. National Fire Insurance Company of Hartford, is a caution to be mindful of the suretyship conditions contained in the AIA A-312 performance bond.
The case involved the construction of a $20 million condominium complex in Connecticut. Stonington, the owner, contracted with a local general contractor to build the complex. In return, the general contractor secured National Fire Insurance Company of Hartford to act as surety, and National Fire executed an AIA A-312 performance bond in favor of the general contractor. As is customary, the terms of the AIA A-312 performance bond provided that National Fire would assume the responsibilities of the general contractor for defective work and, if necessary, complete the project upon the occurrence of certain circumstances enumerated in the bond form.
The construction of the condominiums proved difficult. The project experienced three costly delays due to a fire, installation of defective materials, and a burst sprinkler hose. As a result, the financial condition of the general contractor deteriorated to the point that Stonington considered declaring the general contractor in default. Ultimately, the general contractor ceased working, and the owner hired replacement contractors to complete the project.
Two months after the general contractor stopped working, Stonington notified National Fire that it was terminating the general contractor and asserted that National Fire was responsible for fulfilling the contract’s obligations. National Fire denied coverage on the grounds that Stonington had failed to strictly comply with the terms of the performance bond. Stonington then filed suit in federal court.
The trial court agreed with National Fire. Construing the terms of the construction contract and the performance bond together, the trial court reasoned that the owner had to fulfill several conditions necessary to invoke the surety’s performance. First, under Section 3.2 of AIA A-312, the owner must declare a contractor default and formally terminate the general contractor, a process that requires written certification from the architect and seven days notice to the surety. Additionally, under Section 3.3 of AIA A-312, the owner must agree to pay the surety the balance of the contract price.
Stonington had not fulfilled either of these conditions, which prejudiced the ability of National Fire to protect its interests. Specifically, the unilateral hiring of replacement contractors deprived the surety of the opportunity to mitigate its damages. National Fire did not have the chance to participate in the selection of the replacement contractors, which may have been more expensive than the contractors National Fire would have selected. Moreover, because the owner had paid the replacement contractors the balance of the contract price, the surety had no further protection against the owner. In other words, because the owner depleted the contract balance, the surety was exposed in the event it had to complete construction. As a result, the trial court held that the terms of the performance bond were materially breached.
Upon review, the appeals court affirmed without requiring a showing of prejudice. The court agreed that the surety’s interests were compromised because the owner did not properly abide by the terms of the performance bond. They concluded that the require-ments to give notice and pay the contract balance to the surety were conditions precedent to the surety’s performance. Without satisfying the conditions precedent, the surety’s obligations did not come into existence. Additionally, they concluded that prejudice in fact was shown, even though that showing was not required.
While there is some split among courts applying the AIA form language, this decision, from an important commercial area of the country, stands for the proposition that an owner must be faithful in adhering to the exact terms of the performance bond if there is any likelihood that it will need to be invoked. Moreover, many courts hold the claimant to strict compliance with the notice requirements of the bond, whether or not the surety is prejudiced by the lack of compliance.