Court doesn't buy trust diversion claim: orders surety liable for damages for failure to perform under performance bond

In Mount Vernon City School District v. Nova Casualty Company, recently decided by the Appellate Division, Second Department, a school district hired an HVAC contractor to perform certain construction.  As part of the contract, the HVAC contractor obtained a performance bond from Nova Casualty.  Eventually the contractor failed to complete and the surety, Nova, also refused to perform under its performance bond.  The school district therefore completed the project on its own and then commenced an action against Nova for failure to perform under the performance bond. 

The decision is a little unclear on the facts but it appears that the HVAC contractor earned a $214,000 progress payment that, at the contractor's direction, was paid by the school district to the Department of Labor.  Nova argued that since those funds were used to pay other contractors on an unrelated project, they constituted diverted trust funds.  The court found that since Nova did not perform and never even attempted to take over the contractor's obligations and perform the contract, that it did not succeed to the rights of the owner or lien law trust fund beneficiaries.  The court also noted that since the $214,000 payment was undisputedly earned by the contractor, its payment was not a breach of the terms of the performance bond. Finally, the Court noted that while the General Obligations Law does allow a public entity to withhold such funds, it does not create a private right of action when the public entity does not retain the funds and, as such, Nova could not use that as a basis to claim that the $214,000 payment released it from its obligations under the performance bond.

This case provides a couple of good lessons for owners: 1) simply because you have a performance bond don't expect that your contract with be completed and you will be litigation free; and 2) if you do have a performance bond, and the surety won't perform, talk to an attorney fast and find out if you potentially have a claim against the surety. 

Vincent T. Pallaci is a partner at the New York law firm of Kushnick Pallaci, PLLC where his practice focuses primarily on the area of construction law.  He can be reached at (631) 752-7100 or vtp@kushnicklaw.com