Surety Liability under a Performance Bond for Post-Construction Guarantees

September 24, 2009

Are sureties obliged to respond to a long-term product guaranty given by a contractor pursuant to a construction contract if the contractor cannot respond? Such guaranties and warranties can span many years, often longer than a surety typically extends its bond liability. The answer may depend on the terms of the performance bond. But, what if the bond terms do not explicitly address the issue? Surety liability under these circumstances likely depends on the law of jurisdiction in which the project is located.

Until recently, there was no reported Wisconsin decision interpreting the terms of a construction performance bond, as they relate to a surety’s liability for post-completion guarantees and warranties of a contractor. In the majority of jurisdictions, where a contractor fails to perform its obligations under the construction contract, and where the bond is “conditioned upon the contractor’s faithful performance of all of its obligations under the contract,” a majority of courts have held the performance bond surety liable for latent defects in the contractor’s work. The Wisconsin Court of Appeals recently agreed with a majority rule.

In Milwaukee Board of School Directors v. Bitec, Inc., App. No. 2008AP003022 (recommended for publication), MBSD contracted with Specialty Associations, Inc. (SAI) to replace an elementary school roof. The bid documents required the bidder to obtain a performance bond, and required all work to be completed in a “perfect and undamaged condition, free of flaws or defects.”

The project was completed, and SAI gave a five-year limited roof warranty to MDSB as required by the bid requirements. MBSD noticed problems with the roof three years later, and filed suit against SAI and others within the warranty period. When MBSD learned that SAI was bankrupt, it added the surety, Atlantic Mutual, as a defendant in the lawsuit. The trial court granted the surety’s motion for summary judgment based on the surety’s argument that it was not a party to the five-year limited roof warranty.

The general rule in Wisconsin is that a surety’s obligation is derived from its principal, and the liability of the surety is measured by the liability of the principal. The terms of the surety bond were not unusual. It obligated Atlantic Mutual to indemnify MDSB if SAI failed to perform its duties under the contract. The surety argued that its obligations ended when the construction was completed. However, there were no durational limits in the bond’s language. MBSD argued that a sample copy of the performance bond was included in the bid package and, therefore, the surety knew the required bond terms prior to bonding the project. Thus, the surety could have set its premium accordingly. The court noted that the surety could have also negotiated for the inclusion of an express completion date in the performance bond, a specific provision limiting its financial exposure, or a clause stating that any warranty language in the contract was excluded by the terms of the bond. Atlantic Mutual made no effort to limit its exposure by these means.

On appeal, Atlantic Mutual argued that the five-year warranty was a separate contract, apart from the underlying contract, that was “issued and backed only by the warranting party.” The Wisconsin Court of Appeals was not persuaded. Such a result, said the court, would “have us disregard fundamental principles of suretyship law and the interpretation of those principles set forth in treatises and case law from other jurisdictions.” In the absence of bond terms relieving the surety of liability for SAI’s failure to make good on its guaranty, the court found Atlantic Mutual liable for the five-year warranty given by SAI.

The performance bond is usually a relatively simple document, typically one or two pages long. The underlying obligation secured by the bond, the construction contract, is usually incorporated by reference. Owners, contractors and sureties must examine the bond terms and the underlying contract to determine the risks assumed and benefits granted by these documents. Because risk allocation is heavily affected by the law in the project’s jurisdiction, each party must have a thorough knowledge of the law of the state that will be used to interpret the contract in order to understand the risk allocation associated with the contract and bond.

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For more information about "Surety Liability under a Performance Bond for Post-Construction Guarantees," contact Steven M. Streck at sstreck@axley.com or 608.283.6721.