 |
 |
|
|
|
 |
|
| |
September 2001
Newsletter
Katz & Stone, L.L.P. Construction Newsletter
September/October 2001
Volume XI, Number V
PERFORMANCE BOND SURETY NEED
ONLY COMPLETE DEFAULTED CONTRACTOR'S WORK WITH "REASONABLE PROMPTNESS"
When a contractor defaults on a project, its performance
bond surety must step in to ensure completion of the contractor's
work. Generally, the surety has three options under the
performance bond: finance the contractor's completion of its own
work, tender another contractor to complete the work, or complete
the work itself. When the surety chooses the last of these
options, the U.S. Court of Appeals for the Tenth Circuit held
in St. Paul Fire and Marine Insurance Co. v. City of Green
River, Wyoming, 2001 U.S. App. LEXIS 6269 (Apr. 13, 2001),
it is not required to bear unlimited costs to complete the contractor's
work by the original completion date, but instead may elect to
complete the work with "reasonable promptness" and incur liquidated
damages.
In St. Paul, the contractor entered into a contract with
a public water board to build a water treatment plant, and the
surety issued a performance bond to guarantee the contractor's
performance. The contract provided for a December 1, 1998
completion date and a $2,500-per-day liquidated damages penalty
thereafter. When the contractor was terminated for default
in January, 1999, the surety exercised the option under its performance
bond to complete the contractor's work itself. The surety
informed the water board that it could achieve substantial completion
on September 24, 1999, and would pay the liquidated damages penalties
associated with such late completion. The water board rejected
this completion date, however, asserting that the surety was bound
by the December 1, 1998 completion date. The surety then
offered a completion date of May 14, 1999, on the condition that
the water board pay for certain of the costs of expediting completion.
The water board again refused and declared the surety in breach
of its obligations under the performance bond. The surety
then brought an action in federal court seeking a declaration
that the water board had in fact breached the terms of the bond.
The district court granted the surety's motion for summary judgment
and discharged it from any further performance obligations under
the bond.
On appeal, the Tenth Circuit Court of Appeals upheld the district
court's ruling. The court found that while a surety does
"step into the shoes" of its contractor upon the latter's default,
the surety here was required by the terms of its performance bond
only to proceed with "reasonable promptness," not to meet the
contractor's original completion date. Because the surety
was fully prepared to proceed to completion, and recognized its
obligation to pay liquidated damages, the court held that the
water board had breached the bond by refusing the completion dates
offered by the surety. The court found that to hold otherwise
would create unreasonable results, particularly where contractors
default close to the original completion date. Moreover,
noting that the water board had conceded that the surety's accelerated
completion date of May 14, 1999 would have been acceptable, the
court held that it was reasonable for the surety to seek compensation
for the cost of accelerating its performance beyond the "reasonable
promptness" standard.
If a contractor defaults on its work, its performance bond surety
must take action, in one form or another, to see that the work
is completed. When it does, however, as St. Paul
suggests, the surety will not be required to meet the original
contract completion date at any cost, but may instead opt to complete
the work with "reasonable promptness" and incur any liquidated
damages which may accrue.
SUBCONTRACTOR PAYS TWICE FOR
SAME EQUIPMENT: ONCE TO UNPAID SUPPLIER OF SUB-SUBCONTRACTOR AND
ONCE TO IRS
In the case of In re M&T Electrical Contractors, Inc.,
95-00060, 2001 Bankr. LEXIS 450 (Bankr. D.C. April 10, 2001),
an electrical subcontractor was forced to pay twice for equipment
provided, once to the unpaid supplier of its sub-subcontractor
and once to the IRS that had filed a tax lien against the property
rights of the sub-subcontractor.
In M&T, a prime contractor contracted with a first-tier
subcontractor for electrical work on the Dulles Airport expansion
project. The project included disadvantaged business enterprise
("DBE") participation requirements. Although the electrical
subcontractor had initially planned to order equipment directly
from its supplier, it ultimately elected to enter into a "pass-through"
agreement to help meet DBE participation requirements. Under
the agreement, the DBE second-tier subcontractor would order approximately
$1.4 million of equipment directly from the chosen supplier, taking
a 3% fee. In turn, the electrical subcontractor would satisfy
approximately $1.5 million of the DBE requirement.
After part of the order had been placed and filled, the electrical
subcontractor sent a progress payment payable to the sub-subcontractor
directly to the supplier. The sub-subcontractor refused
to endorse the check over to the supplier. Shortly thereafter,
the IRS sent a notice of levy in the amount of $726,907 to the
subcontractor and the supplier for the tax liabilities of the
sub-subcontractor. After the IRS levy had been received
by the electrical subcontractor and having received no payments
from the sub-subcontractor, the supplier made a demand upon the
electrical subcontractor and its payment bond surety for payment
in the amount of $1,378,836.
The electrical subcontractor ultimately paid the supplier in full
and forwarded the sub-subcontractor's 3% fee totaling $35,700
to the IRS. After the sub-subcontractor filed for Chapter
11 bankruptcy protection , the bankruptcy trustee filed claims
against the electrical subcontractor in bankruptcy court alleging
numerous causes of action attempting to recover the money paid
directly to the supplier.
After determining that the electrical subcontractor had a right
of setoff against the sub-subcontractor for all amounts paid to
the supplier, the bankruptcy court focused on the critical issue
of whether the electrical subcontractor's right of setoff took
priority over the IRS tax lien. Resolution of this issue
would determine whether the electrical subcontractor would be
liable to the IRS for payment of the federal tax lien. Unfortunately
for the electrical subcontractor, the bankruptcy court determined
that the federal tax lien arose first, had priority over the set-off
claim, and that the electrical subcontractor was liable to the
IRS for $726,907, despite its payment to the supplier.
The bankruptcy court proffered three potential protections the
electrical subcontractor could have employed to have avoided this
result. First, it could have inserted a contract clause
providing that nothing would be owed to the sub-subcontractor
if it was in default of paying its supplier. This would
have extinguished the sub-subcontractor's property right in the
receivables and prevented the tax lien's attachment. Second,
the subcontractor could have required a payment bond from the
sub-subcontractor which may have foreclosed the subcontractor's
need to pay the supplier directly. Finally, the contract
could have required, in writing, that the supplier would
be paid by joint-check passed through the sub-subcontractor in
"trust." This too would have the legal effect of extinguishing
the sub-subcontractor's property rights regarding the money earmarked
for the supplier, thereby preventing the tax lien from attaching.
The M&T Electrical Contractors case illustrates the
risk of utilizing financially unsound lower-tier subcontractors
to satisfy DBE participation requirements. To avoid the
unfortunate result in M&T, contractors would be well
advised to take special precautions in setting up payment procedures
on bonded projects to ensure they are not forced into paying twice
for the same work.
CONTRACTOR DENIED RECOVERY
FROM THE U.S. GOVERNMENT FOR LOST PROFITS RESULTING FROM DIMINISHED
BONDING CAPACITY DESPITE SIX YEAR DELAY
When a contractor is delayed in completing
a public construction project, its performance bond must remain
in place longer than anticipated. As a result, the contractor
may not have the bonding capacity to take on additional work it
would otherwise have the ability to perform. Unfortunately,
it is difficult, if not impossible for a contractor to recover
lost profits on work not undertaken despite substantial government
delay. In Appeal of Hughes-Groesch Construction Corporation,
2000 VA BCA Lexis 5 (April 20, 2000), the Department of Veterans
Affairs Board of Contract Appeals denied a contractor's attempt
to recover $1,597,246 from the government for lost profits on
other work the contractor claimed it could have secured
had the government not unreasonably delayed its contract.
In Hughes-Groesch, the contractor entered into a $305,927
contract with the government to perform certain construction work
at the Denver, Colorado VA Medical Center. The contract,
which was originally scheduled to take 324-days to complete, was
for the removal and replacement of three laundry chutes at the
Medical Center's west, south and north risers. In particular,
the contractor was to demolish the walls around the original laundry
chutes, build new fire-rated walls, and replace the old chutes
and chute doors. The contractor was required to post a performance
bond in the amount of the contract sum ($305,927).
The project was delayed almost immediately after the government
issued a notice to proceed in October 1990. The submittal
process, which was supposed to take 30 days, instead took six
months, largely due to the government's rejection of the contractor's
proposed asbestos-abatement subcontractor, who did not meet the
contract's 5-year experience requirement. Once that issue
was resolved, the contractor began work on the west chute in June
1991 and completed it in February 1992. Numerous problems,
however, plagued the west chute, including door handles and door
closures that repeatedly broke, and laundry that plugged the chute
as often as three times a week.
Because of the above problems, the government suspended work on
the remaining chutes while the parties investigated the issues
and debated possible solutions. Problems kept occurring,
however, and the government ultimately suspended the work three
times. 2,126 days (almost six years) after the 324-day contract
began, the project was finally completed.
The contractor filed suit against the government to recover $1,597,246
in lost profits from work it contended it otherwise would have
secured had the contract not been delayed. Specifically,
the contractor alleged that since it was required to maintain
its performance bond in effect during the entirety of the project,
its bonding capacity was diminished so that it could not bid on
similarly-sized contracts. The contractor estimated that
over the life of the project, its diminished bonding capacity
during the delay period precluded it from obtaining approximately
$16 million in contracts, on which it would have made $1,597,246
in profit.
The VA Board of Contract Appeals, however, denied the contractor's
claim in its entirety. The Board first made clear that the
contractor's claim was not for the anticipated profits
of the contract in question, but for the anticipated profits of
its entire business enterprise. Lost profits, though,
are only recoverable against the government if the profits claimed
are those that would have grown out of the contract itself as
a direct and immediate result of the contract's fulfillment.
The Board further noted that lost profits that might have been
realized from other independent and collateral undertakings
are too uncertain to be recoverable as breach of contract damages.
Lastly, and even if the contractor was able to satisfy the Board
that it had actually lost work due to diminished bonding capacity,
the Board noted that lost profits of this nature have never been
awarded against the government in any federal contracting case
and would not be in this instance.
Appeal of Hughes-Groesch illustrates the futility of
attempting to recover profits lost on other non-contract work
against the U.S. government. Given this result, contractors
bidding federal government work should carefully consider the
negative consequences a long term project delay could have on
their bonding capacity and overall workload prior to bidding any
project requiring a large bond.
MARYLAND COURT HOLDS THAT LABORERS'
LIEN RIGHTS COULD NOT BE RELEASED BY ITS EMPLOYER
Lower-tier contractors often question whether
a higher-tier contractor can quash their lien rights simply by
executing a waiver or release of liens. As illustrated by the
recent decision of the Maryland Court of Special Appeals in the
case of Judd Fire Protection, Inc. v. Larry Davidson, 2001
Md. App. Lexis 96 (Md. App. 2001), courts will ordinarily answer
this question "no."
In Judd, a subcontractor hired a sub-subcontractor to install
and test sprinkler heads in an apartment building for the price
of $17.00 per head. After much of the work had been performed,
the employees of the sub-subcontractor walked off the job because
their paychecks were being returned for insufficient funds. As
a result of the sub-subcontractor's labor problems, the subcontractor
and the sub-subcontractor entered into an agreement whereby the
subcontractor paid for work completed and the sub-subcontractor
signed a lien release purporting to release the subcontractor
and the project from both its claims and the claims of its employees.
The sub-subcontractor accepted payment under the agreement, falsely
representing to the subcontractor that its employees had likewise
been paid in full.
As the lien rights of those who improve real property in Maryland
are not affected by the fact that payment has been made to a higher-tier
contractor, the unpaid employees of the sub-subcontractor were
not barred from subsequently filing a lien suit against the property.
Upon commencement of the action, the subcontractor intervened
to defend the owner of the project. The trial court found in the
employees' favor, awarding damages for the unpaid value of each
employee's services based upon their hourly wages under the terms
of a collective bargaining agreement.
On appeal, the subcontractor argued that: (1) the employees had
released their lien rights by virtue of the sub-subcontractor's
lien release and (2) the trial court should have used the contract
price of $17 per head in calculating damages. The Maryland Court
of Special Appeals disagreed with the employee's first argument.
Citing decisions from several other jurisdictions, the court held
that a waiver or release of lien rights was not effective unless
it was individually and expressly adopted by language or clear
implication by the party against whom it operates. The court held
that the lien release, to which the employees were not a party,
did not satisfy these requirements. As to the damages issue, however,
the court agreed that the proper measure of the value of the employee's
services should be based on the contract price, not the hourly
rate contained in their collective bargaining agreement.
Judd serves as a reminder to contractors and owners that
when it comes to the waiver or release of the right to lien a
project, the party waiving or releasing rights will ordinarily
only have the ability to bind itself. As illustrated in Judd,
a potential lienholder's right to lien a project cannot be waived
or released by a third-party, even if that party is the lienholder's
employer. Without some individualized action on the part of the
lienholder evidencing an express and clear intent to waive or
release the right to file a lien, such right cannot be released
by a third-party. Contractors should also be aware however, that
in states such as Virginia which recognize a payment defense -
i.e., payment in full to the higher-tier contractor extinguishes
the lien rights of all below - a different outcome would have
resulted. In such states, the unpaid employees would not have
had a valid lien in the first place because the higher-tier subcontractor
had paid their employer in full.
|
|
|
 |
|
|
