Last Resort: the General Contractor’s Dilemma Facing a Defaulting Subcontractor

US Federal Court Judge Gorton (Dist. of Mass.) recently held that a general contractor could not make claim on a defaulting subcontractor’s performance bond until the general contractor formally terminated the defaulting subcontractor. The general contractor argued that terminating the subcontractor “would be the equivalent of shooting [itself] in the face”. I would typically agree. However, unfortunately for the general contractor, that is precisely what the express language of Section 3.2 of the AIA A312-2010 Performance Bond requires.

Thus was the decision in Arch Ins. Co. v. The Graphic Builders LLC. The general contractor (The Graphic Builders LLC) subcontracted with RCM to provide modular building components. Graphic required RCM to provide a performance bond, which RCM did through Arch Insurance. After delivery, Graphic complained that RCM’s work was defective. However, rather than terminating RCM, Graphic took the path many savvy general contractors take when confronting a defaulting subcontractor–supplementing the work.

Supplementation generally offers many advantages over termination. A subcontractor facing supplementation may continue to put some of its forces and resources towards completing the project to avoid further allegation of abandonment. Additionally, a subcontractor facing supplementation generally cannot make a claim for lots profits for wrongful termination, because it has not been terminated. Finally, the fact of the supplementation is almost always indisputable. There is no disputing that someone other than the subcontractor completed part of the subcontractor’s work. The ultimate dispute between the general contractor and the subcontractor is almost always easier to resolve when the general supplements instead of terminates.

However, there is an exception to every rule and here Section 3.2 of the A312-2010 performance bond lays the groundwork. Section 3.2 requires that “…Surety’s obligation under this Bond shall arise after… the Owner [or general contractor in case of a subcontractor’s bond]… terminates the Construction Contract…”. Judge Gorton strictly applied this language and granted Arch Insurance summary judgment against Graphic dismissing Graphic’s nearly $3,000,000 bond claim because Graphic supplemented RCM’s work, instead of terminating RCM. Judge Gorton’s decision did not discuss the equities of this language, and the somewhat perverse incentives it creates, and Graphic has filed an appeal.

When facing a defaulting subcontractor, a general contractor should review payment bond terms and determine whether the subcontractor’s fate is so uncertain that the general contractor must take the drastic action of termination. A general contractor may also attempt to negotiate better bond forms in its standard form subcontracts and avoid this precondition. The Consensus Docs offer alternative forms that do not require termination as a condition precedent to surety’s performance, specifically the 2011 version of the 706 Subcontractor Performance Bond and the 260 prime contract performance bond. However, the ConsensusDocs did amend its standard form 706 Subcontractor Performance Bond in 2020 to add termination as a condition precedent.

And as always, consult counsel when making decisions regarding termination and subcontract requirements.

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