Appeals Court Rules that Improper Termination Bars Breach of Contract Action Against Contractor and Bond

To reduce the potential damage that a haphazard termination can cause to owners and contractors, many contracts contain specific termination procedures that must be followed. For example, AIA Document A201-1997, General Conditions of the Contract for Construction, § 14.2.2, states that the owner may terminate the contractor “upon certification by the Architect that sufficient cause exists to justify such action […,] without prejudice to any other rights or remedies of the Owner[,] and after giving the Contractor’s surety, if any, seven days’ written notice….” Both versions require the owner to obtain independent certification justifying the reasons for termination of the contractor prior to issuing the notice.

Similarly, the surety who guarantees the contractor’s performance requires notice from the owner prior to termination in order to evaluate its takeover options and potentially mitigate damages. For example, AIA Document A312-1984, Performance Bond, § 3, provides that a surety’s obligations under the bond only arise after notice that the owner is considering defaulting the contractor, a conference request, a lapse of twenty days, a declaration of default and formal termination, including the owner’s tendering of the contract balance to the surety. The performance bond also incorporates the terms of the contract which, at least as to AIA Documents A201-1997 and A201-2007, requires seven days written notice to the surety prior to formal termination.

Despite the detailed termination procedure outlined in both the standard contract forms and bond forms, many owners neglect to follow one or more of these steps. What effect does the owner’s improper termination have upon the owner’s right to resort to other remedies under the contract or bond in court? In Town of Plainfield v. Paden Engineering Co., Inc., 943 N.E.2d 904 (Ind. Ct. App. 2011), the Indiana Court of Appeals considered this very question. In this case, the town hired a contractor to provide a steel package for a recreation center. The town and the contractor executed an AIA Document A101-1997 and A201-1997, and the contractor provided an AIA A312-1984 Performance Bond. As outlined above, both documents contained specific steps the owner was required to take in order to terminate the contractor and implicate the bond’s obligation to complete the project. When disputes arose between the town and the contractor over the contractor’s performance, the owner provided seven days written notice to the contractor; however, it never requested and the architect never issued a certificate to justify termination. In further disregard of the contract’s and performance bond’s notice requirements, the owner waited an additional eight days after the effective date of formal termination to provide the surety with its first notice of the termination. On that basis, the surety declined to perform under the bond.

When a subcontractor on the project filed suit against the contractor for lack of payment, the contractor brought the town into the litigation via a third-party complaint. The town then filed a counter-claim against the contractor for breach of contract and its own-third party complaint against the surety for breach of the performance bond. Both the contractor and the surety moved for summary judgment against the town on the grounds that the town’s failure to comply with the notice provisions of the contract and bond barred the town from now enforcing the contract and bond in litigation, which the trial court granted.

On appeal, the town raised several arguments for why its failure to strictly follow the termination provisions did not preclude it from enforcing the contract. First, the town argued that an e-mail sent from an architectural engineer on the project asking for a meeting to determine “is this the point where we agree to end this situation?” satisfied the requirement for the architect’s certification. However, even considering the e-mail in the light most favorable to the town, the court found that the architect’s certification in A201-1997 is a specific form requiring the signature of the project architect acting in that role. Alternatively, the town pointed to the “reservation of rights” language contained in § 14.2.2 stating that town’s utilization of the termination process did not waive its right to utilize common law remedies, such as a breach of contract action. The court likewise rejected this argument, finding that, when the contract provisions were harmonized, the town could in fact enforce the terms of the contract in a breach of contract action if it complied with the contract’s provisions. The town had the option to terminate the contractor or sue it for breach of contract, or both, but if it elected to terminate the contractor it was required to comply with the contract’s termination procedures. Otherwise, the improper default termination constituted a breach of contract by the town that barred its enforcement of the contract. Therefore, the court granted summary judgment in favor of the contractor .

Likewise, the town’s failure to comply with the bond’s notice provisions constituted a breach of its obligations under the performance bond. The town argued that, as an insurer, the surety had to show actual prejudice that resulted from the town’s late notice. The court declined to rule on whether a surety is considered an insurer under Indiana law, but held that under Indiana law, a late notice was presumptively prejudicial. Thus, the town bore the burden of proof to provide evidence that the surety was not prejudiced. Because the town had no evidence that the lack of notice was harmless to the surety, the court upheld summary judgment in favor of the surety.

The lesson to be learned from Town of Plainfield is that parties who fail to comply with the contract provisions, even the hyper-technical ones that involve procedures and timelines, risk losing the ability to enforce the contract. This is particularly true in terminations, as courts deem this to be a drastic remedy, and do not want to allow a forfeiture to take place unless the owner follows the precise contract requirements for effecting the termination. Though the amount of damages being sought by the Town was not disclosed, the Town here was clearly the ultimate loser. Despite having a contractor and $1.1 million completion bond in place, the Town had to bear all the expenses of completing the work, was unable to use the performance bond that it paid for, and spent substantial legal fees to pursue this case through an appeals process.