John Fatino Published About Paul Reed Construction & Supply Inc. v. Arcon, Inc.

American Bar Association Fidelity & Surety Law Committee News

John F. Fatino was published in the Fall edition of the American Bar Association Fidelity & Surety Law Committee News. Mr. Fatino's article concerned a matter of import to the industry, the legal questions surrounding performance bonds.

A Matter of Contract Interpretation: When is a Performance Bond a Payment Bond?

As readers of this article know, generally speaking, there are two distinct types of bonds which are common in the construction industry: performance bonds and payment bonds. Performance bonds guarantee a contractor will complete a project. In contrast, payment bonds guarantee a contractor will pay for all of the labor performed on and material supplied to a project. Often, project owners and contractors will require both performance and payment bonds to protect themselves from liability in the event issues arise in either context or to meet statutorily required obligations. However, the existence of two distinct types of bonds has created an interesting legal question for courts when parties only obtain a performance bond and someone has not been paid. The question becomes whether the performance bond covers liability for labor and material because, from the perspective of the project owner or unpaid subcontractor or supplier, in order to fully “perform”under a contract, the contractor must pay for all labor provided and materials supplied under its contract. Will a performance bond surety be called upon to pay when a contractor fails? As is often the case in the context of the law, the short answer is that it depends. The unique terms of the bond in question, as well as who brings the claim, may change how a court interprets the terms of the performance bond and whether the performance bond covers liability usually associated with a payment bond. 

In Paul Reed Construction & Supply Inc. v. Arcon, Inc., a contractor contracted with a subcontractor to perform a portion of the work on a large project.1 Within the subcontract, the parties agreed on two important terms: (1) the subcontractor would provide a performance bond, and (2) the subcontractor would perform all work required to complete the project and, in so doing, furnish all materials and labor. In  compliance with the contract, the subcontractor obtained a performance bond with a surety company. The performance bond guaranteed that the subcontractor would “promptly and faithfully perform”the initial contract. The subcontractor completed the physical work under the initial contract. However, two vendors hired by the subcontractor alleged that the subcontractor was never paid for their services and filed payment claims against the subcontractor and its surety. The surety company denied the vendors’ claims after concluding that payment claims were outside the scope of coverage provided by the performance bond.

The obligee contractor sued the surety company and the subcontractor based on several different legal claims, one of which was that the surety company failed to uphold the terms of the performance bond when it denied the vendors’ claims. The contractor argued that the terms of the performance bond  included that the subcontractor would perform under the contract. The terms of the subcontractor’s initial performance contract included a promise to furnish and pay for all materials and labor necessary for the subcontractor to perform its work. Therefore, the contractor argued that failing to pay was a breach of the promise that had been secured by the bond—the promise to perform the initial contract. The surety company moved for summary judgment in response. It argued that the contractor was attempting to distort its performance bond into a payment bond, arguing that the two instruments are distinct and the bond in question was a performance bond that only guaranteed completion of the project.

The issue presented to the court was one of contract interpretation: whether a performance bond that guaranteed a subcontractor’s completion of a project covered the subcontractor’s promise to pay for all material and labor necessary to complete the project; or did the bond only guarantee performance of the physical work necessary to complete the project. The court ultimately concluded the bond did not guarantee payment obligations and granted the surety’s motion for summary judgment based on two primary reasons. First, the court explained that the bond should be interpreted in light of prevailing norms in the construction industry that clearly establish that performance bonds and payment bonds are distinct instruments.2 Second, the court reasoned that, in light of these norms, even if the terms of this particular performance bond could also be interpreted to include payment obligations, then at most the bond would be ambiguous. And if ambiguous, then the surety provided ample evidence to suggest that all parties involved considered this bond to be a typical performance bond—not a payment bond.3

Paul Reed Construction & Supply, Inc. is an example consistent with how courts interpret the limitations of performance bonds when the issue is framed as a state law contract claim or a contractor trying to force payment from a subcontractor for materials and labor. Without an express term in the performance bond that requires a party to pay for all labor and materials, the performance bond cannot be used to indemnify the parties against such claims. Even when the contract provides the contractor will “furnish”all materials, courts generally will not read this term in a performance bond so broadly as to include any claims for  unpaid material or labor into the liability coverage provided by the bond.4 Many other cases support this interpretation of similar performance bonds.5 However, such claims may be successful in a very limited circumstances—if the terms of the performance bond clearly impose an obligation on the contractor to pay for all material or labor (incorporating the purpose of both a performance and payment bond).6

In contrast with claims brought under state common law, courts applying the Miller Act or state statutory equivalents to nonpayment claims under a performance bond may reach a different result. In these cases, the terms of the performance bond are interpreted more broadly and an agreement to perform all work and “furnish”all material includes an obligation to pay for all material.7 Therefore, when a claim is brought under the Miller Act or a state’s analog, performance bonds may indemnify the parties against claims for unpaid labor or material.

The textual differences of the Miller Act and its related jurisprudence from common law contract theories appear to be the critical distinction which compel this result. Another key distinction appears to be which party brings the claim.8 This fact may support courts’ more broadly interpreting the scope of the bonded obligation given that the parties to the suit were also parties to the contract itself.9 Other federal circuit courts have affirmed a broader interpretation of the bonded obligation, to include the obligation to pay for labor and materials, when claims involve the Miller Act or a state equivalent.10 As demonstrated by these cases, whether an obligee may recover for unpaid material or labor costs under a performance bond is a matter of contract interpretation that is informed by the terms of the contract, the identity of the parties themselves, the type of bond, and the applicable statute, if any. Performance bonds and payment bonds are distinct instruments in the construction industry. Moreover, indemnification of claims from unpaid material suppliers or laborers is certainly best provided by a payment bond. But there may be limited circumstances where a court will interpret the terms of the performance bond to indemnify parties against what could be considered a payment bond claim. With knowledge of this divergent legal landscape, practitioners may conduct themselves accordingly.

For more information

John F. Fatino, Member, Whitfield & Eddy, P.L.C., Des Moines, Iowa. 515-288-6041 or Shianne E. Thomas, J.D. Candidate, University of Iowa College of Law, assisted in the preparation of these materials.

The full article is published on the American Bar Association Fidelity & Surety Law Committee website located here.

1 Paul Reed Const. & Supply, Inc. v. Arcon, Inc., No. 8:12CV48, 2012 WL 6086915, at *1–8 (D. Neb. Dec. 5, 2012).
2 Id. at 8.
3 Id.
4 See also Babcock & Wilcox v. Am. Sur. Co. of New York, 236 F. 340, 342 (8th Cir. 1916) (rejecting a claim that unpaid material was indemnified by a performance bond, noting “it is argued for appellants that, as the contract required [the contractor] to furnish all the materials, this was equivalent to an agreement on [the contractor’s] part to pay for the same, and that the bond having been given to secure the faithful performance of the contract the surety company can be held liable for the amount due for materials . . . . It is unfortunate for the materialmen that the case stands as it does, but we may not by construction make other and different contracts than those made by the parties.”).
5 See, e.g., Greenfield Lumber & Ice Co. v. Parker, 159 Ind. 571, 65 N.E. 747, 747 (1902) (“[I]t is clear that, unless the sureties agreed to be bound for debts due persons for furnishing material, there is no legal reason why they should be held liable”); Johns-Manville Sales Corp. v. Reliance Ins. Co., 410 F.2d 277, 278–79 (9th Cir. 1969) (“In this case . . . the bond issued was a non-statutory performance bond, not conditioned on payment of materialmen . . . . Under these circumstances, the Arizona cases cited . . . do not permit materialmen to recover”); Crow & Crow, Inc. v. St. Paul-Mercury Indem. Co., 247 Minn. 426, 77 N.W.2d 429, 430–31 (1956) (“[T]he contract . . . would require us in effect to rewrite or add a provision in order to find that the contract . . . required a bond conditioned to pay laborers and materialmen”); Elec. Appliance Co. v. U.S. Fid. & Guar. Co., 110 Wis. 434, 85 N.W. 648, 650 (1901) (“[C]ases in this jurisdiction will [not] sustain the proposition that the third party can maintain an action against an alleged promisor
based on an implied promise to pay”); Puget Sound Brick, Tile & Terra Cotta Co. v. Sch. Dist. No. 73 of King Cnty., 12 Wash. 118, 40 P. 608, 608 (1895) (“It is true that it is therein provided that he shall furnish the materials, and it would be fair to presume that that meant that he should furnish them at his own expense, but it could not be inferred from the fact that he was required to do this that he thereby bound himself to pay the persons from whom the materials should be obtained.”).
6 See, e.g., Baker v. Bryan, 64 Iowa 561, 21 N.W. 83, 84 (1884) (“The bond in unmistakable language binds the defendants ‘to pay all claims for labor and material, etc., used in the construction of said building, and produce proper receipts therefor.’”); Algonite Stone Mfg. Co. v. Fid. & Deposit Co. of Maryland, 100 Kan. 28, 163 P. 1076, 1079 (1917) (“[I]t must be said that the laborers and materialmen are sufficiently designated as a class for whose benefit the condition requiring the contractor to pay for labor and material was inserted in the contract, and that therefore they may maintain this action upon the bond.”).
7 Am. Cas. Co. of Reading, Pa. v. Brezina Const. Co., 295 F.2d 603, 606 (8th Cir. 1961) (“[A] contract as in the instant case, which requires the contractor to provide material, under a reasonable construction, means that the contractor will pay for the material, and a bond which guarantees faithful performance of such a contract includes within its scope losses suffered because of the failure of the contractor to pay for the materials furnished.”).
8 See, e.g., Seaboard Sur. Co. v. Standard Accident Ins. Co., 277 N.Y. 429, 14 N.E.2d 778, 782 (1938).
9 See id. (“In the case at bar if a suit had been brought directly by or on behalf of the unpaid materialmen, it is doubtful whether the bond issued by the defendant would entitle the materialmen to recover. In fact, in the leading federal case the court was careful to point out that the suit was brought by materialmen, and that ‘the cases which give the word ‘furnish’the broad signification contended for were cases brought by the obligee of the bond.’”(quoting Babcock & Wilcox, 236 F. at 343).
10 See, e.g., U.S. for Use of W.E. Foley & Bro. v. U.S. Fid. & Guar. Co., 113 F.2d 888, 889 (2d Cir. 1940) (“Although there is no express provision in the contract . . . [to] pay for the material . . . such a promise is undoubtedly to be implied from [the] agreement to ‘furnish and supply all materials’”); Saint Paul Mercury Indem. Co. v. Wright Contracting Co., 250 F.2d 758, 761 (4th Cir. 1958) (applying the same analysis to a claim brought under a North Carolina statute that required parties to construction contracts to furnish specific bonds); Glens Falls Indem. Co. v. U.S. ex rel. & to Use of Westinghouse Elec. Supply Co., 229 F.2d 370 (9th Cir. 1955) (“The electrical work of the subcontract was completed but [the contractor] did not fully and promptly pay for the materials furnished . . . . This was just as much a breach of performance of the contract as if the electrical work specified in the contract had not been completed.”); Houston Fire & Cas. Ins. Co. v. E. E. Cloer Gen. Contractor, 217 F.2d 906, 909 (5th Cir. 1954) (“As we read the contract in the light of the circumstances under which it was executed, we conclude that it required not only that [the contractor] furnish the materials, but also that it furnish them free of any claims of materialmen”).



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