Construction Surety Bonds: Buyers Beware

Reprinted from the Spring 2013 BrickerConstructionLaw.com Newsletter
Download the complete Spring 2013 BCL issue

If you’re in the market for construction surety bonds, let this article serve as a cautionary tale. Not all surety bonds are the same. Some types of surety bonds offer only limited protection, while others may impose strict limitations on when and how an owner may file a claim against the bond. In the end, construction owners should heed a simple message: buyers beware.

Generally, a surety bond is an obligation by which one party (the surety) agrees to guarantee performance by another (the principal or, in our case, the contractor) of a specified obligation for the benefit of a third person (the obligee or owner). There are three general types of surety bonds and their names are indicative of their functions: (1) bid bonds, (2) payment bonds and (3) performance bonds. Bid bonds guarantee that a contractor will honor its bid, commonly up to a certain percentage of the bid or the difference between the bid and the next highest bidder, whichever is less. Payment bonds guarantee the contractor’s payment of its obligations to subcontractors, laborers and suppliers. Lastly, performance bonds provide financial assurance that the contractor will perform its obligations to the owner under the construction contract.

While these descriptions may sound a lot like insurance, surety bonds are not insurance. Insurance policies are based on a concept of fortuity, or truly accidental property damage or personal injury. Surety bonds, on the other hand, cover breaches of contract. Also, when there is a claim under an insurance policy, the insured is typically only required to pay a premium and the insurer will pay the claim, subject to policy limitations. When there is a claim under a surety bond, however, the contractor for whom the bond is provided (the principal) is required to repay the surety, dollar for dollar, for all expenses, including the underlying claim amount that the surety pays to the claimant. These reimbursement obligations between the principal and the surety are commonly memorialized in strictly worded indemnity agreements and are secured by personal assets of the principal. For these reasons, sureties should, in theory, never lose money.

For public owners in Ohio, choosing a surety bond is easy — there is no choice. Section 153.54 of the Ohio Revised Code mandates the form of bond that must be used on public works projects that exceed a certain dollar amount. For private construction owners, however, there are many different forms of bonds (and even a few insurance products as we will discuss below) that are available for use. When evaluating the type of surety bond to be used on your next project, construction owners should always evaluate three key provisions of the surety bond: (1) notice of claims, (2) time limit on claims and (3) surety takeover obligations.

The obligation of a surety to investigate a claim typically kicks in upon the default of the contractor. See L&A Contracting Co. v. Southern Concrete Services, Inc., 17 F.3d 106 (5th Cir. 1994). It only makes sense that an owner would have to tell the surety if the contractor is in default. Some forms of surety bonds, however, impose strict notice requirements on how the surety is to be notified of contractor defaults. For example, one commonly used surety bond requires the owner to first send a letter to the contractor and surety informing the contractor that the owner is considering declaring the contractor in default and then arrange a meeting between the owner and contractor within a certain number of days of the letter being sent. Next, the owner must formally declare the contractor in default in writing and terminate the contractor’s right to complete the project. Lastly, the owner must agree to pay the balance of the contract price to the surety. Only then will the surety investigate and possibly pay on the claim.

Although such a procedure may seem draconian, courts will strictly enforce these notice requirements. In Safety Signs, LLC v. Niles-Wiese Construction Company, a contractor working on the construction of an airport runway had a payment bond that required its surety to pay its subcontractors if the contractor did not. One subcontractor sent a notice of payment bond claim to the contractor’s primary business address rather than the address listed on the payment bond, as required by the applicable statute. Even though the surety agreed that the subcontractor had completed its work and had not been paid in full, the subcontractor could not recover payment from the surety because it did not strictly comply with the notice requirement in the statute and this defect could not be waived. Safety Signs, LLC v. Niles-Wiese Constr. Co., 820 N.W.2d 854 (Minn. Ct. App. 2012).

Another key issue to consider is the time period during which claims can be made on the surety bond. The AIA Document A312-2010 Performance Bond, for example, requires that legal proceedings under the bond be instituted no later than two years after the contractor stopped working on the project. The A312-2010 Payment Bond requires that legal proceedings occur no later than one year after the contractor finishes work on the project. This is as compared to the form of bond created and mandated by Section 153.54 of the Ohio Revised Code (often referred to in Ohio as the statutory form of bond) that runs for the life of the contract, which, in Ohio, is eight years under the Ohio statute of limitations. When a contractor is found to be in default by the surety, the surety typically has three different options under the terms of most performance bonds: (1) pay the owner for its damages in an amount up to the penal sum of the bond, (2) tender a completion contractor to the owner or (3) finance the defaulting contractor to complete the project.

If an owner has gone through the process of declaring the contractor to be in default and terminating its contract, the third option (i.e., letting the defaulting contractor finish the job) may not be that appealing to an owner. Depending on the language of the bond, however, an owner may be stuck with such an outcome. In St. Paul Fire & Marine Ins. Co. v. VDE Corp., the owner of a construction project declared the principal contractor in default after the contractor refused to complete its obligations in the contract, did not work at a reasonable pace, abandoned work on the project and insisted on collecting payments that were not yet due. The owner then requested that the contractor’s surety perform its obligations under the bond by completing the work. The owner also informed the surety that it was opposed to having the defaulting contractor complete the job. The surety argued that the owner was therefore in breach of the bond terms and the surety would no longer have any obligations under the bond. The court agreed, holding that the owner’s refusal to allow the defaulting contractor to complete the work was a material breach of the bond because the language of the bond placed no restrictions on which contractor the surety could use to complete the project. See St. Paul Fire & Marine Ins. Co. v. VDE Corp., 603 F.3d 119 (1st Cir. P.R. 2010).

Construction owners may avoid this result not only by selecting a form of bond that does not contain limiting language, but also with properly worded construction contracts. This is because performance bonds will commonly incorporate the language of the underlying construction agreement between the owner and contractor. Construction owners are thus advised to specify duties of the surety in their contractor agreements, including time frames for investigation of a claim and limitations, if any, that the owner may want to impose on possible takeover contractors tendered by the surety.

Approximately 17 years ago, insurance companies began creating insurance products to simulate the function of a bond. Subcontractor default insurance is a policy that a contractor can purchase to protect itself from subcontractor default. Just like insurance, subcontractor default insurance will provide coverage up to certain policy limits. Also, like insurance, subcontractor default insurance may require the prime contractor (i.e., the construction contractor who is in direct contract with the owner) to pay a deductible; however, there is no requirement that the contractor reimburse the insurer its costs and expenses in satisfying a claim.

While subcontractor default insurance presents a viable alternative to surety bonds, there are several key considerations that must be taken into account from an owner’s point of view. First, it is the contractor and not the owner that is the insured party under subcontractor default insurance. This means that if there is a default on the project, it is the contractor, and not the owner, who may bring a claim against the policy. There are riders available that allow owners to be additional insureds under subcontractor default insurance policies; however, in many cases, these riders still require the principal contractor to be declared insolvent before a claim may be made by the owner directly against the policy.

Another issue to consider is that subcontractor default insurance covers just that: defaults by the subcontractor. As a result, defaults by the prime contractor (e.g., defaults by the prime contractor on self-performed work) are not covered under subcontractor default insurance policies. To the extent that the prime contractor is self-performing a significant amount of work, or to the extent that the prime contractor’s self-performed work will greatly impact other subcontractors on the project, not having surety bond coverage for this work may expose the owner to significant risks. These risks should be balanced against cost savings and other advantages that are gained through the use of subcontractor default insurance. Lastly, note that subcontractor default insurance cannot be used as a substitute for the statutory form of bond required on public works projects in Ohio under Section 153.54 of the Ohio Revised Code.

For private construction owners, there are many different options available for bonding. Owners are warned to closely read the language of the bond before agreeing to use a certain type of bond for their construction project. Carefully crafted contract provisions will also allow owners to shift the risk of loss to the surety.