Performance Bond: Change Orders, Prepayment, and the Penal Sum Ceiling
Halden County awarded a $4,000,000 contract to Merrick Construction to build a salt storage facility. Merrick furnished a $4,000,000 performance bond and a $4,000,000 payment bond, both AIA A312-style. During construction the county approved $450,000 in change orders and, at Merrick's request, paid $600,000 of a $700,000 progress payment before the work was in place. The county's engineer knew Merrick was behind schedule and that a key supplier had filed a lien but did not notify the surety. When Merrick walked off the job in March, the county declared default and demanded the full $4,000,000. The cost to complete is $1,150,000. The county holds $250,000 in unpaid contract funds. The surety says it is discharged because of the change orders, the early payment, and the delayed notice.
1. Analyze whether the surety is discharged by the change orders, the early payment, and the delayed notice.
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No blanket discharge.
Change orders. A312-style bonds generally provide that the surety's obligation is not affected by changes to the work or contract sum, with the penal sum remaining the ceiling. Even under common-law suretyship, a compensated surety is discharged by a material modification only to the extent of actual prejudice. A $450,000 change on a $4,000,000 contract does not by itself discharge.
Early payment. This is the strongest defense. The county paid $600,000 for work not in place, depleting the contract funds the surety would otherwise use to complete and impairing the surety's subrogation rights. The surety is discharged to the extent of that prejudice, not necessarily in full.
Delayed notice. A312 requires prompt notice of default, but the surety must show prejudice. The surety investigated and can still act, so delay alone is not a discharge.
The county's demand for the full $4,000,000 is wrong. The bond measure is the cost to complete, capped at the penal sum, and the surety gets credit for contract funds.
2. Compute the surety's likely exposure and explain the credit you would assert.
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Base calculation:
- Cost to complete: $1,150,000
- Less remaining contract funds: $250,000
- Net exposure: $900,000
Then apply the prejudice credit. If the $600,000 was genuinely unearned, the county should have held $850,000 rather than $250,000. Net exposure would then be $1,150,000 - $850,000 = $300,000. The surety should not pay $900,000 without an accounting.
The credit is not automatic for the full $600,000. If the prepayment went to the steel supplier and reduced the cost to complete, there is no prejudice and the credit shrinks. If it went to the contractor's other debts or was diverted, prejudice is dollar-for-dollar. The surety's realistic exposure range is $300,000 to $900,000, plus any payment bond claims, all within the $4,000,000 penal sum.
The surety is also entitled to the $250,000 balance and any retainage. It should demand that the county not release those funds to Merrick.
3. What should the surety do now, and what are its options under the bond?
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The surety should respond in writing promptly, reserve all rights, and demand the county's payment records, engineer's certifications, and lien file.
Under an A312-style bond the surety chooses among: arranging for Merrick to perform, tendering a replacement contractor, financing Merrick, completing the work itself, or paying the penal sum. The obligee's demand for the full penal sum does not dictate the choice.
If the surety completes or tenders, it should:
- Take assignments of subcontracts, purchase orders, and equipment leases.
- Use existing subcontractors and suppliers where practical to reduce cost.
- Preserve subrogation against Merrick and its indemnitors.
- Evaluate payment bond exposure, including the supplier's lien and unpaid subcontractors, and consider a global resolution.
- Notify the indemnitors, review the indemnity agreement for collateral, and document the prejudice analysis.
The surety should avoid paying the penal sum as a first resort; doing so forfeits the chance to control completion cost and recover contract funds.