Most contractors deal with performance bonds on public jobs when they furnish a bond for the benefit of an owner. However, many contractors will require subcontractors with significant scopes of work to furnish their own performance and payment bonds on significant projects. As such, this article will provide an understanding of sureties and how a surety is likely to analyze a performance bond claim.
BASICS ABOUT SURETIES
One must understand that a surety is not an insurer. Unlike insurance companies that fully expect a certain percentage of their policies will be triggered and benefits will be paid, sureties do not write bonds expecting to pay claims. Insurance is written with the actual certainty that losses will occur. Surety bonds are written with the expectation that no losses will occur. Insurance is expensive. Bonds are not. Insurance is expensive because insurance companies charge premiums of sufficient size to cover expected losses. Bonds are cheap because sureties charge premiums without the expectation that losses will occur.
The price difference also represents the market difference in underwriting polices. When sureties write performance bonds, they obtain a general indemnity agreement from the contractor and its principals to cover any losses that might incur as a result of a default. The narrow profit margins on bonds play a role in sureties’ decision making in bond default situation. The people sureties employ and the consultants they use often influence their decisions. If the claims representatives are employed by the surety, their perspective on claims can differ from representatives who are hired as outside consultants. Because the economics behind bonds influences surety performance, the claims consultants’ understanding of those economics can influence the recommendations made to the surety.
Also, most surety claims representatives are educated professionals and many of them are lawyers. Thus, they think like lawyers and evaluate risk according to their training and background. Some are employed directly by the surety and some are outside counsel. Many surety claims consultants are experienced in construction management or construction law. The lawyers understand that sureties enjoy many defenses to paying claims and will evaluate the situations they get called into with these defenses in mind. Because sureties are not in the business of paying claims, an available defense is a valuable tool for a surety.
Typically, a surety will share all defenses available to the principal on the bond. Sureties also have defenses available specifically to them. These defenses can be asserted in addition to the shared contractor/surety defenses and can discharge the surety’s obligation under the bond regardless of the contractor’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 obligee has materially deviated from the contractual payment provisions. If the obligee has underpaid or overpaid the bonded contractor, the surety’s rights may have been prejudiced. Such prejudicial conduct might reduce or alleviate the surety’s performance obligations.
DEFAULT! WHAT’S NEXT?
Performance bonds do not have the same notice requirements as payment bonds. However, if an obligee hopes to secure a surety’s cooperation and performance, then immediate notice of default should be provided to the surety. Keep in mind that the surety will not have been monitoring the project in most cases.
Typically, after notice of default, a meeting with the surety representative should occur to discuss the default. At the meeting, the obligee will be looking for the surety to say, “I’ve got this one covered.” However, most sureties will not be in a position to say that in the initial meeting. It is reasonable to assume the surety will want an opportunity to evaluate the job and determine what, if any, default has occurred. Most performance bonds are silent as to time limitations for surety performance. If quick action is required, the obligee can hire a replacement contractor to correct the work and seek recovery of any extra-contractual expenditure after completion.
While completing the project with a replacement contractor can sound attractive, this option can often lead to significant problems between the obligee and the surety. Without adequate opportunity to inspect the job and the project records prior to completion with another contractor, the surety might argue its position was prejudiced by the obligee’s unreasonable actions in refusing to wait for the investigation. Further, the surety may challenge the reasonableness of the completion costs.
Regardless of when and where a meeting occurs, the obligee should provide the surety access to the project records and all documentation that supports the declaration of default. Access to the project also should be freely given to any consultants or representatives of the surety.
Remember, the surety can breach its obligations under the bond. A performance bond is a contract. An unreasonable grasp onto a defense to avoid performance is an example of that breach. If the surety breaches its obligations and refuses to perform, the obligee should move forward with completion and seek reimbursement from the defaulted contractor and the surety for costs to complete.
– As seen in the February 2013 Issue of Legal Solutions.