Construction and the Law in Texas

As general contractors on highway, road, and infrastructure projects, the potential for high-dollar scopes of work for some subcontractors exist on many projects. The potential also exists to award a scope of work to subcontractors with whom you have little experience. These situations can lead to greater risk assumption by a general contractor with respect to time and quality of performance. To help defer the high-end risks associated with potential subcontractor default, performance and payment bonds procured by the subcontractor for your benefit and protection can be a smart business decision.

Because the surety’s obligations on the performance bond are predicated upon a subcontractor default, protecting your interests in the project begins with a carefully worded and clearly defined provision governing default in your subcontract agreement. The default provision should be specific as to events of default and the process for declaring a default against an offending subcontractor.

Also, for purposes of securing surety performance, rather than preservation of remedies against a defaulting subcontractor, a clear termination provision should be included in the subcontract. In the event of subcontractor default, clearly stating the relevant facts that establish default, in writing, is essential for both entitlement to available remedies and preservation of claims against the offending subcontractor and its surety, should that become necessary. Also, if securing surety performance is a goal, it will likely be necessary to terminate the subcontractor to trigger a surety’s obligations to perform under the bond. If merely having the financial security of a surety obligation post-project, termination may not be necessary. In that case, recovery against the surety in a lawsuit after completion to recover damages resulting from the subcontractor’s failure to perform would be available.

When evaluating the likelihood of surety performance, one must keep in mind that the surety might have defenses to performance available to it. First, it is likely that the subcontractor will challenge a declaration of default as improper. The surety may adopt this defense and refuse to perform because, as it claims, the subcontractor did not actually default on its performance obligations. This defense illustrates the importance of specifically listing and citing the events of default that are the basis of the declaration of default and termination.

Also be aware that a possible breach by your company or the owner may provide an additional defense to the performance bond obligations and release surety of its obligations. In situations where a subcontractor claims delay, disruption, or interference as a defense to default, the surety may assert the defenses based on those claims. For example, in those situations, the surety may cite one of the following defenses as a reason for nonperformance: a) failure to provide adequate plans and specifications, b) design defects, c) unforeseen conditions, d) impossibility of performance, e) concurrent delay, f) or interference by your company, the owner, or other subcontractors. An assertion of these defenses will almost always result in the surety’s refusal to perform any remaining contractor obligations on the project.

Separately, sureties also have defenses available specifically to them. These defenses can be asserted in addition to the shared subcontractor/surety defenses and can discharge the surety’s obligation under the bond regardless of the subcontractor’s default. The surety may claim that the scope of the project materially changed during the project. Since the bond was written to guarantee performance of the original contract, a material change in scope provides a defense to the surety because it only underwrote a guarantee of performance as originally anticipated. Another defense might arise if the general contractor or owner has materially deviated from the contractual payment provisions. If there has been a significant underpayment or overpayment, the surety’s rights may have been prejudiced. Such prejudicial conduct might reduce or alleviate the surety’s performance obligations.

Bear in mind that when a subcontractor has been terminated and demand has been made to the surety for performance, the surety will first seek the opportunity to investigate the claims made, the status of the Project, and the relevant documents in the project file. All this and the need for the surety to evaluate its potential liability and obligations under the bond take time. If time is not available, then reserving your rights against the surety while hiring a replacement contractor must be done.

Finally, as the beneficiary of the performance bond obtained by a subcontractor, your company will have direct contractual rights against a surety that chooses not to perform when a default has occurred. As such, you have the right to the relief provided by your subcontract agreement. Virtually all surety bonds incorporate the terms of the underlying contract into the bond. Therefore, the remedies and dispute resolution procedures you put into your subcontract will determine your rights against the defaulting subcontractor and will also impact your rights against the surety. Carefully review and revise the subcontract for any additions or deletions that may be necessary for those projects that require bonding. Your rights to correct or complete a defaulting subcontractor’s work begin and end in that subcontract. Your rights against the surety also start with that subcontract. Awareness of these facts will assist your company in protecting its interests and managing its risks on your projects.

– As seen in the May 2012 Issue of Texas Contractor.