12.3 Termination for Default

• Library: Virginia Construction Law Deskbook (Virginia CLE) (2019 Ed.)

12.3 TERMINATION FOR DEFAULT

12.301 In General. As previously observed, a firm principle of Virginia law is that a party has the right to rescind or terminate a contract based upon the material breach of that contract by the other party. ⁷⁸ Nevertheless, the choice to declare a contract terminated due to a material breach or default by the other party is a momentous and pivotal decision in construction practice. ⁷⁹

Contracts can be, and are, terminated for many reasons. Delays, performance issues, financial problems, unforeseen conditions, and a litany of other potential problems may drive one party to determine that the contract must end and that the cause of the termination lies with the other party.

An owner's wrong decision to terminate the contract may discharge both the contractor and its performance bond surety from all obligations. Put simply, a material breach could entirely discharge the aggrieved party's obligation to perform. Furthermore, material breach by the owner can expose the owner to liability to the contractor for lost profits and other damages due to wrongful breach. The owner may also be liable for extra-contractual damages where the termination decision is found not only to have been wrongful, but made in bad faith. The following materials will deal with some of the most common grounds for default terminations, defenses to those grounds, and an itemization of the damages available to the parties under those circumstances.

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12.302 Types of Contractor Defaults.

A. Failure to Prosecute the Work. A termination for default of a government contract based on a failure to make progress usually occurs where the contractor has fallen so far behind schedule that timely completion is nearly impossible. ⁸⁰ However, a default termination for lack of timely completion does not require absolute impossibility of performance or repudiation or abandonment by the contractor, but merely a showing by the government of a demonstrated lack of diligence. ⁸¹ "Lack of diligence" does not permit default termination merely on the ground that performance is less than absolutely certain. ⁸² Rather, courts typically require a reasonable belief on the part of the terminating party that there is no reasonable likelihood that the contractor could perform the entire contract effort within the time remaining for contract performance. ⁸³

It is imperative that a decision to terminate for default be based on a correct understanding of the remaining work and the time left for completion. A decision to terminate for default that is based upon "materially erroneous information as to the labor and time required to complete the work, cannot be said to be a reasonable exercise of discretion. To hold otherwise would be to reward ignorance and encourage deception." ⁸⁴ When a contractor's progress is not accurately and adequately evaluated but the contractor is defaulted for failure to progress in the work, wrongful termination is the obvious result. ⁸⁵

Virginia courts have upheld contract provisions that allow default for failure to prosecute work. In D.C. McClain, Inc. v. Arlington County, ⁸⁶ the Virginia Supreme Court found that, as a matter of law, an owner was justified in terminating a contract with its contractor for failure to construct a bridge in a diligent and timely manner as required by the contract.

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B. Failure of Contractor to Pay Subcontractors and Suppliers. The failure of a contractor to pay its subcontractors and suppliers is very problematic. First, if it relates to construction on non-public property, it can expose the owner to mechanics' liens. Secondly, it can be an indication that a contractor is having significant financial trouble that may prevent the contractor from adequately completing the project. Lastly, failure to pay subcontractors and suppliers can result in subcontractors walking off of a project or suppliers refusing to provide much-needed material, placing the project in serious jeopardy.

Many owner contracts expressly obligate a contractor to make payments to all subcontractors and suppliers in direct proportion to what the contractor receives from the owner. Failure of the contractor to pay its subcontractors can, with regard to such contracts, be grounds for termination for default. ⁸⁷

While termination may be a right, it is sometimes easier and better for the terminating party to work with the party in default to arrive at a resolution short of termination. Some possible solutions might be (i) creation of a joint check relationship to make sure that payments are going directly to those who need it most, and (ii) making payments directly to third parties, or, if possible, consulting with the defaulting party's payment bond surety to see if alternative arrangements or emergency financing can be put in place. As discussed above, the project will usually be better served if a termination can be avoided.

C. Failure to Correct Defective Work. According to the Virginia Supreme Court, a "building contractor defaults in the performance of his contract if he furnishes defective materials or workmanship." ⁸⁸ Stated in a different way, "a builder's breach in the performance of his contract, i.e., a defective performance, also would be a 'default' in that contract." ⁸⁹

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At common law, a contractor is obligated to perform its work in a good and workmanlike manner. ⁹⁰ By contract, parties typically specify the desired result and may incorporate the common law standard or apply a modification of it. Ultimately, a contractor or subcontractor is responsible to perform the work in accordance with the plans and specifications issued by the owner.

In many of the standard form documents issued by the AIA and the EJCDC, the contractor warrants that the work will be "free from defects" and "conform to the requirements of the Contract Documents." ⁹¹ However, termination for default based upon defective work is sometimes not as simple as it seems. The contractor may believe that it performed the work in accordance with the plans and specifications, yet the work may still be found defective. In such an instance, default is improper. A contractor who is bound to certain plans and specifications provided by the owner will not be responsible for defects in those plans and specifications. ⁹² The terminating party also usually has the burden of proving that the work claimed to be defective is of a nature material to the project. ⁹³

D. Violation of Laws. Construction contracts commonly allow the owner to terminate if the contractor defaults by violating laws that are applicable to the project or locale. Determining whether a violation of law is material or not can be difficult, as an isolated incident of violation may not give rise to a breach justifying default termination. However, termination is probably appropriate if the defaulting party "repeatedly disregards applicable laws, statutes, ordinances, codes, rules and regulations, or lawful orders of a public authority."

Examples of persistent violations that could trigger default include (i) persistent failure to follow OSHA safety requirements; ⁹⁴ (ii) failure to comply with federal regulations governing waste disposal in a wildlife refuge; ⁹⁵

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and (iii) failure to pay prevailing wage rates in accordance with federal law on federally funded projects. ⁹⁶

E. Insolvency or Bankruptcy.⁹⁷ Many form contracts, private contracts, and some Virginia state contracts specify that a party's bankruptcy constitutes cause for terminating the contract for default. ⁹⁸ These clauses are commonly referred to as ipso facto clauses. Section 365(e)(1) of the United States Bankruptcy Code ⁹⁹ invalidates ipso facto clauses and specifically provides that an executory contract may not be terminated or modified after the filing of a bankruptcy because of a provision concerning the financial condition of the debtor or the filing of a petition under the Bankruptcy Code. A "post-petition" termination might be recognized when the termination arises from a debtor's "pre-petition" breach followed by no post-bankruptcy efforts to assume or reject the contract or to cure the pre-petition defaults. However, a post-petition termination decision should follow only after a thorough, fact-specific legal analysis.

As for insolvency, courts have held that the "contractor assumes the risk of providing funds sufficient to perform the contract," meaning that "neither undercapitalization nor insolvency (actual or impending) will excuse a failure to perform." ¹⁰⁰ Thus, a "contractor's financial difficulties are not a legitimate excuse for its failure to make progress." ¹⁰¹ The loss of performance capability caused by a contractor's financial condition constitutes a constructive abandonment of performance or anticipatory breach entitling a party to terminate for default. ¹⁰² A court will uphold a default termination if the contractor (i) was inadequately financed when it signed the contracts, (ii) used

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its funds for purposes other than the performance of the contracts during the contract period, or (iii) overextended itself on other projects. ¹⁰³

A contracting party's status of insolvency or bankruptcy and its subsequent inability to perform under a contract constitutes a material and total breach. ¹⁰⁴ It is an implied condition in every contract that the promisor will not permit itself, through insolvency or acts of bankruptcy, to be unable to perform. ¹⁰⁵

12.303 Contractor Defenses to Default.

A. Substantial Performance. It is well settled in Virginia that if one party meets and performs in good faith the conditions of the contract in all material respects, although there may be deviations in trifling or inconsequential particulars, then that party has substantially performed and the other party is not justified in repudiating the contract. ¹⁰⁶ The other party may, nevertheless, recover damages for defects in performance, such as defective work or...