Terminating a Contractor:
Three Perspectives
Reprinted from January 2006 ohioconstructionlaw.com
Highlights. No one wants to do it, and on the best projects, it never happens. But there are times when terminating a contractor seems unavoidable—or at least, the lesser of two evils. What do you need to know about the process of terminating a contractor? That depends in part on your role in a construction project, so we sought advice from three sources of information, each tackling a specific perspective on the issue: the owner’s perspective, the contractor’s perspective, and the surety’s perspective. You will notice that they sometimes see things quite differently. Here is what they had to say.!
An Owner's Perspective
By Scott Davis
Construction contracts are often compared to a marriage between the construction
owner and the building contractor. For better or worse, contractor delay or schedule
acceleration (both worse), the construction owner and building contractor wade through
the murky waters of the construction industry. When the honeymoon ends, however, and the
parties can no longer co-exist peacefully, termination is the contract method by which either
party may seek a divorce. As with divorce, termination is a drastic measure in the life of a
construction project. Many issues must be considered before taking this ultimate step.
The savvy construction owner can take many steps before and after termination to limit its risk.
Grounds for Termination. Many construction contracts will include a list of reasons for which an owner may terminate a contractor. The standard American Institute of Architects (AIA) Document A201—1997 General Conditions gives the following grounds for termination:
Persistent or repeated refusal or failure to supply enough properly skilled workers or proper materials;
Failing to pay subcontractors;
Persistent disregard of laws, ordinances, or rules, regulations or orders of a public authority;
Otherwise being guilty of a substantial breach of a provision of the contract documents.
Similarly, the standard form General Conditions issued by the Ohio School Facilities Commission allows for termination in the event of the contractor's failure to prosecute the work in a timely manner or refusal to remedy any defective work.
The owner should be careful, however, not to jump the gun and prematurely call for termination. Those familiar with the construction process know that every project has its ups and downs. It is not uncommon to see occasional delays in the delivery or installation of materials. Furthermore, not all carpenters follow the “measure twice, cut once” rule, and so there may occasionally be minor instances of defective or non-conforming work on a project. These issues should be remedied during the punchlist phase of the project.
Along these lines, one federal court has held that “not every breach of a construction contract
constitutes a default sufficient to require the
surety to step in and remedy it.” L&A Contracting Co. v. Southern Concrete Services, 17 F.3d 106,
110 (5th Cir. 1994). Instead, what the
owner is looking for is a material breach of the items listed above. For example, a contractor’s persistent refusal to correct defective and non-conforming work after the required notice may be grounds for termination. Failure to meet the date for substantial completion is certainly grounds (assuming there have been no excusable delays to the contractor for which a timely request for a time extension has been made). Likewise, failure to pay subcontractors is another
ground for termination. Note that a contractor’s bankruptcy in and of itself is not grounds for a contractor’s termination.
Termination Procedures. Upon determining grounds for termination, the owner must follow the contract procedures for
termination if it wants to take possession of the Work and complete the Contract. Of these, none is more important than notice.
The AIA General Conditions call for a two-step notice process to the contractor: 1) certification by the architect that sufficient cause exists to
terminate, and 2) seven-day notice to both the contractor and surety.
An extreme example of such a scenario can be seen in United States use of Cortolano & Barone, Inc. v. Morano Construction Corp.,
724 F. Supp. 88 (S.D.N.Y 1989). There a subcontractor had fallen behind on the construction schedule and later pulled off the job.
The general contractor immediately terminated the subcontract without notice, and the subcontractor filed suit for wrongful termination.
Stating that the subcontractor was entitled to recover for its performance under the contract along with any lost profits, the court held that despite the
absence of any contractual protection, the subcontractor was still entitled to receive notice of its default and to be given an opportunity to cure.
Any notices to the contractor regarding termination should also be given to the surety. Notice of termination likely will trigger an investigation by
the surety. The surety's rights are governed by the Contract Documents and the terms of the surety bond. Depending on these rights, the surety will usually
elect one of four different options: 1) takeover and complete the project, 2) determine the amount of liability and pay the owner that amount, 3) tender a
replacement contractor to the owner along with the difference in contract amounts between the defaulted contractor and replacement contractor, or 4) deny
the claim and do nothing. For more information on the surety's probable reactions to contractor termination, see the final section of this article.
There often is a disagreement between the owner and the surety about what are these rights. In Ohio, on public works projects in
particular, we believe the surety’s rights are limited because the statutory form of bonds has materially different terms than do other forms of surety bonds.
Further, under Ohio case law, even if a different form of bond is used on public projects, the statutory form of bond is incorporated into the terms of the
bond that is used. This is what the Ohio Supreme Court did in Van Wert National Bank v. Roos (1938), 134 Ohio St. 359.
For the surety’s perspective, see the final section of this article
As a best practice, the termination notice should not be the first time the surety hears of problems on the jobsite. If the owner is seriously considering terminating a contractor, it has likely been dealing with issues from the contractor for some time. Project documents that memorialize these issues should be sent to the surety to keep it abreast of the situation.
Proper project documentation is a common theme in ohioconstructionlaw.com articles, and it
is best that owners document occurrences of the contractor's default in the form of videos, photos,
letters, job logs, meeting minutes, etc. These documents can be used to illustrate the
contractor's default and combat any surety defenses — and there are many — to payment on the claim.
Project documents also become vital in any litigation that ensues as a result of the termination.
A picture (as well as videos, job logs and meeting minutes) is worth a thousand words and often much more
in the form of decreased liability for wrongful termination.
Post-Termination Issues. The contract General Conditions will outline a number of post-termination issues that must be addressed by the owner, including payment, assignment of subcontracts, and seizure of materials.
Payment: The AIA General Conditions states that upon termination for cause, no further payment is due to the contractor. This would include payment for material and labor that has been completed but not yet paid for. If the balance of the contract amount exceeds the cost to complete the work, then the difference will be paid to the terminated contractor after the work is completed (be sure to seek the consent of the surety for this payment). If, as is often the case, the cost to complete the work exceeds the contract balance, then the contractor and its surety will be liable for the additional costs.
Assignment: The construction industry is becoming increasingly specialized with most work on a job being done by specialty subcontractors. The AIA General Conditions allow the owner to take an assignment of some or all of the subcontracts from the terminated contractor if it so chooses.
Seizure: The AIA General Conditions also allow the owner to take possession of the site and of all materials, equipment, tools, and construction equipment and machinery owned by the Contractor but left on the site.
Practical Considerations. Defective work or a schedule delay, if material, will be justification for termination. Whether the Owner decides to terminate will be based on several practical considerations. These practical considerations in making the decision to terminate include availability of replacement contactors, schedule, costs and surety involvement. In general, owners who are considering termination should follow the first rule of wing walking: never let go of what you have until you have hold of something else.
The first rule of wing walking is best illustrated when considering replacement contractors. Prior to making the decision to terminate, owners should investigate the marketplace for possible replacement contractors. A project that involves a terminated contractor may gain a negative reputation in the contracting community, thus limiting the number of contractors who will be interested in completing the project. The size and scope of defects encountered on the project may further narrow the field, as some contractors may not be willing or able to inherit the problems left behind by their colleagues. If there is a lack of qualified contractors in the marketplace to take on the project, an owner may elect to tough it out with the current contractor.
The termination process will also impact the construction budget. As can be expected, replacement contractors may come at a premium. This is to account for the many unknowns that they are inheriting, none larger than the quality of workmanship of the terminated contractor. Replacement contractors also lose the economies of scale benefit, as they are now quoting a smaller project with less opportunity for bulk quantity discounts. Depending on the stage of the project, mobilization and demobilization costs can be substantial. Additional costs will also come from the architect and construction manager for additional management fees, and there may be additional cost to put the replacement work out to bid.
Finally, with most terminations there is the threat, if not the reality, of litigation. So an owner can expect to incur legal fees in defending any suits from the contractor or prosecuting any claims against both the contractor and the surety.
An owner's construction schedule may be sacrificed when the decision to terminate is made. As described above, the termination process involves a number of procedural steps that the owner must follow. The surety will also need time to make its investigation and render a decision on the claim if it has not been kept advised about what is happening on the project. To the extent that the owner wishes to place the replacement work out to bid, this will take additional time. Finally, the replacement contractor, once selected, will be faced with a learning curve, as it gets up to speed and familiarizes itself with the project. Sometimes a tight timeframe—such as the opening of school or sale of the completed project—may inhibit the owner's ability to terminate the contractor.
Given the increased costs that result from a termination, and depending on the terms of the surety bond, the surety may have agreed to indemnify the Owner from all costs and expenses incurred as a result of the Contractor’s breach that led to termination. This does not mean, however, that the surety will respond. The surety bond is a financial obligation in which the surety binds itself to pay the owner should there be a material default of the contractor on the contract. Upon a material default, the surety is obligated to investigate any claim made by the owner. Sureties typically assert a number of defenses at their disposal, including lack of notice, improper or overpayment to the contractor, and unauthorized alteration of the bonded contract. Whether these defenses have any merit will depend upon the terms of the Contract Documents, the terms of the surety bond, and the facts. A surety may, therefore, deny responsibility. In doing so, the surety potentially exposes itself to a bad faith claim, particularly if it has not conducted a thorough investigation or has ignored indisputable facts. This is why proper documentation and early involvement of the surety is critical to overcome such defenses.
Other factors influencing the decision to terminate include whether the owner has funds available to it to finance any additional cost incurred as a result of the termination until such time as it can recover those costs from the Contractor and/or its surety. Termination may also cause some subcontractors to leave the project in search of other work during the transition period between the terminated contractor and the replacement contractor. (On a multi-prime project, there could be the same problem with other prime contactors.) The result? Possible delays to the project schedule.
Termination Alternatives. The contract General Conditions will typically outline a number of alternatives short of termination that an owner may use to motivate a contractor. Here are some common examples that can be found in both the AIA and OSFC General Conditions:
Withholding payment
Owner's right to prosecute work and backcharge contractor
Liquidated damages
Owner's right to require change of supervisory personnel
Stop work order
Involvement of the surety
Deduct change orders.
Just as with termination, owners should review the contract General Conditions and surety bond for notice requirements that may be involved with these tools.
Termination for Convenience. Up to this point, we have discussed termination for cause, meaning that the owner is ending the contract because of the contractor's failure to comply with the contract. If termination for cause is comparable to divorce, then termination for convenience is more akin to a dissolution. There is typically not the same amount of animosity and disdain between the parties. An owner may choose a termination for convenience for a variety of reasons, such as lack of funding or inability to obtain certain permits.
Termination for convenience usually requires the owner to pay the contractor for work executed and costs incurred by reason of such termination, along with reasonable overhead and profit on the work not executed.
General Conditions will sometimes allow an owner to terminate for cause and, in the alternative, terminate for convenience. This serves as an important safety net in case the termination for cause is deemed improper. One Ohio court, following federal law, held that even if the termination for convenience clause is not invoked at the time of termination for cause, it shall still be effective should a court determine that no cause existed. Of course, an owner is not entitled to performance from the surety if there is a termination for convenience.
Conclusion. Contract terminations can be a frustrating and daunting process. Adherence to the protocols outlined in the General Conditions and surety bond as well as proper documentation will ensure a smoother process. Take time to consider all of your options as well as all of the possible impacts to the project before making the decision to terminate a contractor.
A Contractor’s Perspective
By Rod Davisson
An Analogy. Contract, contract, contract. Read the contract. I know it sounds simple, but inevitably, contractors ignore the contract provisions. Imagine that you are playing a game of backyard football. How do you get started?
Well, the conversation goes something like this: End zones are the walnut tree and the edge of Mrs. Miller’s yard. The sidewalk and the fence are out of bounds. We’re playing tackle, and you have to count five Mississippi before you rush the quarterback. And if you go too far into Mrs. Miller’s yard, her dog will bite you.
If you do not like a certain rule - or if you have played with me before - you try to negotiate to play two-hand-touch instead of tackle. You may also negotiate for a wider field because you are fast and I am slow. The point is that you would not just agree to the rules if they were stacked against you. Likewise, when you get a contract for a job, do not just sign it—read it. If there are conditions that set you up to fail, negotiate to change them. (Of course, on public projects, the contracts are not negotiable, although you can complain about overly burdensome contract provisions prior to the bid to see if the owner will change them by addendum.)
Finally, we agree on a set of rules and begin play. If we could not agree on the rules, one of us would just take our ball and go home.
This is contracting in a nutshell. Rules are important because I will not count a touchdown if you step on the sidewalk on your way to the end zone. Why? Because we agreed that it was out of bounds. Similarly, the owner of a project will not approve a claim that you submitted on a bar napkin six months after it occurred. Why? Because we agreed in the contract that you would submit claims in a particular form within 14 days of the occurrence.
Avoiding Termination. How does this incessant rambling relate to default? The contract will tell you what events will trigger a default. The first rule of termination avoidance is this: Figure out what those events are and avoid them. There is no cosmic wisdom in doing the work the owner is paying you to do. The problem arises when you believe that you are following the contract but the owner or its representative believes you are not. How do you avoid that situation?
The answer is the Three C’s: Care, Communicate, Contract. Care about the pace and quality of your work. If you do not, stop reading
now and call a bankruptcy lawyer. Communicate with the owner or owner’s representative about the challenges on the job and the ways to resolve problems before they spiral out of control, leading to default. And ensure that you are following the contract. Are you giving timely notice of issues? Are you properly staffing the project? Are there obstacles to completing the schedule that the owner needs to know? Are you coordinating with other trades? You can find all of these responsibilities and answers in the contract.
Finally, reading the contract may be enough if you read contracts for a living and understand the law. If not, get help. If you think you
know all of the pitfalls, consider these questions:
May owners seize your materials and tools after you default?
May subcontracts be assigned to a new general contractor?
May a subcontractor cut a better deal with a replacement contractor?
May an owner terminate your contract simply because it wants to, or for its convenience?
How does a subcontractor get paid for past due amounts from the defaulting contractor?
If you are working on a job right now, you should know the answers to those questions. Want to guess where you will find the answers? You got it—the contract. Remember, care, communicate, and contract. Watch out for Mrs. Miller’s dog, and I will see you on the field.
A Surety's Perspective
By Lee M. Brewer, Alber Crafton PSC, Guest Author
What happens when a surety’s principal is terminated? Many times the termination triggers the surety’s investigation to determine what, if any, obligation it might have to act because it issued a bond on behalf of the principal. The surety’s obligations after termination are set out under the provisions of the performance bond.
Here in Ohio, on most public works projects, the surety has issued a Bid Guaranty & Contract Bond pursuant to Ohio Revised Code § 153.54. The surety’s obligation under the statutory bond is to indemnify the obligee. While the surety is not required to undertake performance of the bonded project, it may elect to do so pursuant to the terms of the bond, the contract, and/or common law.
Despite the requirement under R.C. § 153.54 that public owners utilize a bond form substantially similar to that set out in § 153.571, there are exceptions, and various other bond forms are used on public as well as private projects in Ohio. Examples of frequently used bond forms include the American Institute of Architects (AIA) Performance Bonds A-311 and A-312. The AIA A-312 Performance Bond sets out with specificity the steps the owner or obligee must take to pursue a claim against the bond.
The surety will undertake to determine whether the owner has breached the underlying contract and whether the owner has properly declared the principal to be in default of its contractual obligations. A material breach by the owner of the bonded contract or a failure by the owner to comply with the provisions of the bonded contract relating to termination is grounds for a surety to refuse to act under its bond.
Not every contractor breach is the basis for termination of the principal’s contract. The court in
L&A Contracting Co. v. Southern Concrete Services, 17 F.3d 106, 110 (5th Cir. 1994), which is cited above in the Owner’s Perspective,
held that “To constitute a legal default, there must be (1) material breach or a series of material breaches (2) of such magnitude that the obligee is
justified in terminating the contract.” Further, in Jacob & Youngs, Inc. v. George Edward Kent, 230 N.Y. 239 (1921), the court held that not
every deviation from the contract constitutes a breach. In Jacob & Youngs, the contractor inadvertently used the wrong type of pipe.
As noted in the Owner’s Perspective, the surety will determine whether the owner has complied with the owner’s obligations under the bonded contract and under Ohio law. Depending on among other factors the bond requirements and/or the extent to which the surety may have been prejudiced by the owner’s failure to comply with its obligations under contract or under Ohio law, the owner may be precluded from recovery of some or all of its claims against the surety.
The surety’s investigation is to determine whether it has an obligation to act due to the owner’s termination of the surety’s principal. The surety, therefore, will want to review all written documentation related to the bonded project and will want to speak with the owner’s representatives, including the construction manager and the architect/engineer.
Owners and contractors need to bear in mind that in the majority of performance bond claims, the surety’s first involvement with the project is shortly before its principal is terminated. Because the surety has not been involved in the day-to-day construction activities that have led up to the principal’s termination, the surety has to rely upon the documents and key personnel involved with the project to learn the project’s history before it can be expected to determine its obligation under the bond. Owners who want to speed up the investigation should cooperate fully and should consider involving the surety sooner rather than later.
Once a surety concludes its investigation and determines whether the owner properly terminated the surety’s principal, the surety will be in a position to respond to the owner’s demands.
