Deconstructing subdivision bonds.

• Author: Kash, David W.

This article originally appeared in the November 2011 Fidelity and Surety Committee Newsletter.

As many of you know, the West is leading the country in housing failures and foreclosures. While Nevada is leading, California and Arizona are running second and third. There are scores of undeveloped subdivisions and subdivisions in default. Many, if not all, of the developers were responsible to provide financial responsibility to local public bodies for completion of the subdivisions. The financial responsibility required was predominately in the form of letters of credit or surety bonds. The bonds were issued to include infrastructure work, road work, water work, and even landscaping. Some projects have several bonds associated with them. While there are developmental similarities between each subdivision project, there is one commonplace dissimilarity: the bond form.

The problem with having several defaulted subdivision cases is that not a single bond form is the same. This leads to problems in more than one respect. The first is locating a resource that explains the bond language. The ordinances or rules creating them bear short shrift to explaining how the bonds are to work and what key words or phrases mean. For example, some of the bonds have a "call" provision with no explanation as to what the word "call" means, what the obligee's duties are in "calling" the bond, and what the surety's obligations are when, and if, the bond is "called." While some of the bonds are entitled "performance bonds," the bond forms do not define what "performance" means. Some of the bond language is more akin to an indemnity bond or a penalty bond than a performance bond. The type of bond form, along with the

surety's liability, is discussed by the Supreme Court of Virginia in Board of Supervisors Fairfax County v. Ecology One. (1) Here, the county sued a residential housing developer and the surety to recover a judgment as a result of the developer's breach of its development agreement to construct streets and drainage facilities. That agreement was entered into pursuant to a county ordinance and state statute concerning subdivisions and approval of plats. The bond form provided: "Both Principal and Surety desire to guarantee to the Obligee, performance of the agreement [between developer and the county]." (2) The developer abandoned the project. It defaulted on its construction loans, and the lender conducted a foreclosure sale, taking over the property.

At that time, eight lots were improved in various stage of construction, nine were unimproved, four houses had been completed but the streets were surfaced only with gravel, and the drainage facilities were practically nonexistent. The county assigned to the lender any money it received in its action against the principal and the surety not to exceed the amount actually spent by the lender to complete the work in accordance with the development agreement. The primary defense of the surety was that the assignment to the lender was invalid. Citing case law from New Jersey and Illinois, the court held that the assignment was valid because the assignment secured work covered by the bond, and the lender performed the work that was guaranteed by the bond. The county, however, claimed that the bond was an indemnity or penalty bond because it referenced a "penal" sum and wanted the balance of the bond paid as liquidated damages. This argument was rejected relying on the state enabling statute, the county ordinance, and the bond itself which called for a sufficient bond conditioned upon the construction of the public improvements. The surety's liability was limited to the cost of completion up to the penal sum.

It is not unusual for the obligee to be a public body. Some of the bonds naming contractors as principals have coobligees, adding a lender and/or the developer. Co-obligees often disagree over treatment: pay or complete? It is not uncommon for the obligee to not exactly know what it is supposed to do to make a claim and what to expect from the surety. When the surety investigates the project and finds that the developer/principal has failed to build even the initial infrastructure of the project and has abandoned the development, you may have what was litigated in Westchester Fire Insurance Co. v. City of Brooksville. (3) There, the principal filed bankruptcy shortly after beginning construction of phase 2 of the subdivision. While it removed trees and cleared land, it neither began neither constructing improvements nor building any homes. Once the public body made a demand for performance, the surety filed a declaratory judgment action to determine the rights and obligations of the parties. The city, as obligee, neither attempted to construct the improvements nor solicit bids to establish the expected...