The Basics of Bonding: Part 2

In the June issue of Construction Business Owner magazine, we featured The Basics of Bonding: Part 1, by Marilyn Klinger. Part 1 discussed an explanation of the difference between insurance and bonding, the three Cs of surety underwriting and more. The following article is a continuation of Part 1. Learn more about the benefits of surety bonds, the ins and outs of surety licensing and more information on the contract surety bond claims process below. 

The Industry’s List of Surety Bond Benefits

1. The prequalification process provides assurance that the contractor can fulfill its contractual obligations.
2. Contractors are more likely to complete bonded projects than non-bonded projects because, among other things, the contractor and its owners have signed indemnity agreements that make them ultimately responsible for the cost to complete the contract.
3. Subcontractors, equipment and material suppliers and laborers receive better protection than mechanics liens, stop payment notices and direct breach of contract actions.
4. The surety claims department may be able to provide technical, financial or management assistance to the contractor

Surety Licensing & Bond Verification

Owners and contractors need to verify that the sureties issuing construction bonds are licensed to issue surety bonds in the jurisdiction of the construction project. Also, there have been instances of surety fraud and surety forgeries. Obligees should always verify that the surety approved the bond. The Surety & Fidelity Association of America (SFAA) has surety contact information in its SFAA Bond Obligee Guide. Typically, parties can check the licensing status of a surety by checking on the state insurance department’s website for the surety’s certificate of authority. The National Association of Insurance Commissioners’ website, lists the state insurance departments. The United States Treasury issues certificates of authorities and posts the corporate sureties approved for federal projects at fms.treas.gov/c570/index.html, referred to as “Circular 570” or the “T-List.” Finally, obligees can obtain ratings from financial rating services about the surety.

The Contract Surety Bond Claims Process

1. Bond language–Because surety bonds are contracts, the bond language governs the obligations of the parties, particularly the surety—hence, the need to “read the bond.”
2. Performance defaults

• Surety assistance behind the scenes—There are situations, unbeknownst to the bond obligee, where a surety will provide assistance, typically financial and sometimes technical and contract management, to a bond principal who is struggling to complete a project. Bond obligees should consider approaching a troubled contractor and its surety to discuss such an option before the situation deteriorates beyond repair. Admittedly, some sureties take the position that they have no obligation until there is a default termination and demand on the bond such that they will not respond to such an overture.  
• Performance bond demand—A performance bond is a “safety net” with respect to the performance of a construction contract. It does not assure that there will not be a dispute between the obligee and the bond principal. Indeed, if the bond principal prevails against the obligee, the surety has no liability on its bond. This concept is one of the most widespread misunderstandings about surety. Because it is a guaranty, there must be a primary obligation.  Therefore, if the bond principal’s obligation has been discharged because of the obligee’s material breach of the contract, the surety’s obligation is also discharged.
• Timing in connection with a performance bond demand—Because the surety only has an obligation under a performance bond demand if the bond principal is in default, the surety must investigate the situation to determine whether the contractor has breached its contract. While frustrating to the bond obligee, sureties often do not arrange for completion until they have made that determination. However, some sureties investigate the claim while, at the same time, arranging for completion pursuant to a reservation of rights. Arranging for completion takes time. Once the surety has decided to take over a contract or tender a completion contractor, the surety will arrange for its surety consultant to prepare a bid package and identify potential bidders and, thereafter, a completion contractor. If a contractor has abandoned a project, filed bankruptcy or made an assignment for the benefit of creditors, then the step of determining whether default termination was proper is eliminated and the surety can proceed forward to arrange completion. 
• Early communication with the surety—As soon as there are signs of problems with bond principal’s performance, the obligee should start communicating with the surety to put the surety on notice of the problems. Some sureties may take a proactive approach to investigate even before a default termination arises. Others may simply maintain a watch file to see how things develop. Either way, if the bond obligee has communicated with the surety, the surety will be better equipped to respond to the performance bond demand. Again, while sureties often insist that their hands are tied vis-à-vis the contract until the obligee has terminated the contract, the surety is free to investigate the situation without risking its right to indemnity or claims of interference by its bond principal. Even if the performance bond does not require a meeting with the surety before default termination, the surety industry is typically very appreciative of an obligee arranging such a meeting prior to default termination. It is possible that, through the meeting process, the parties can resolve certain issues, thereby avoiding a default termination. Nonetheless, if a default termination is necessary, the speed by which the obligee provides the information and documentation that the surety and its consultant have requested is extremely important. It is inappropriate for an obligee to respond to the surety’s request for information and documentation by suggesting that the bond principal has all of the documentation and information that the surety needs. The surety has no control over the bond principal or its record keeping, and has no ability to force a bond principal to cooperate with it.  Therefore, the obligee should to do everything in its power to provide the surety with all project files related to the defaulted contractor’s contract.
• Need for formal termination—An obligee must comply with all of the terms and conditions of the bond, including notice and formal termination, if required, in order to avoid a surety’s argument of exoneration. In that regard, many bond forms make the formal termination of the principal’s contract a condition precedent to the surety’s performance obligations.
• Performance bond surety options—Some bonds list the surety’s options for responding to a performance bond demand; some do not. In either scenario, there are industry standards for the various ways in which a surety can respond. 
  • Tender: A surety can identify a completion contractor and offer (“tender”) that contractor to the bond obligee with (a) a completion contract with the completion contractor that encompasses the entire scope of work to be completed, (b) a check for the difference between the completion contract price and the remaining contract balance and (c) new payment and performance bonds. The advantage of the tender option is that the obligee will deal directly with the completion contractor for contract completion.
  • Takeover: A surety can take over completion of the bonded contract by entering into a completion contract directly with a completion contractor. Then, the completing surety will become the obligee on the completion bonds. Alternatively, the surety may complete the bonded contract with a construction manager and direct contracts with trade/subcontractors. Arguably, the surety can enforce its bond principal’s subcontracts by standing in the shoes of its bond principal pursuant to the equitable doctrine of subrogation. However, typically, the surety will negotiate ratification agreements with each of its bond principal’s subcontractors by which the subcontractor ratifies its subcontract obligations to the surety and the surety pays any outstanding balances allowing the subcontractor to start off on a new slate with the surety or the surety’s completion contractor. In all but the most unusual situations, the surety and the obligee enter into a takeover agreement that sets forth their rights and obligations for project completion.
  • Obligee completes: The surety can opt to have the obligee complete. In that scenario, at the conclusion of the contract, the obligee will demand payment from the surety if the obligee’s cost to complete the contract exceeded the remaining contract balance. The only defenses that the surety has to the obligee’s demand is that the obligee failed to mitigate and minimize its costs or went outside the scope of the bonded contract. Because there is no control over the completion or its costs, a surety will typically only use this option if the project is close to completion and the surety approves of the obligee’s plan for completion.
  • Denial of claim: Although couched in terms of a surety option, if the surety determines it has no liability on the bond, it will so announce that to the obligee requiring the obligee to determine how it will go about completing the bonded contract. 
  • Other options: The other “options” available to the surety and the obligee are limited only by the creativity of the players in the process. Such options include up-front cash payments, the principal’s continued performance with or without surety involvement financially or otherwise, obligee or surety supplementing the bond principal’s forces.
  • Completion pursuant to a full reservation of rights: Another approach is for the surety to defer the determination of the propriety of the obligee’s default termination and proceed to arrange completion pursuant to a “reservation of rights” of all parties, the obligee, the principal and the surety.

3. Payment Claims

• The payment bond claim process—A payment bond or labor and material payment bond names the project owner or general contractor as the nominal “obligee.”  However, the beneficiaries of a payment bond are the bond principal’s vendors. 
• Notice and time requirements—Typically, courts enforce both notice and time (deadline) requirements for making payment bond claims. Notice requirements involve the claimant giving notice of its work in order to assure payment as the work proceeds. Because payment bonds are often statutorily required, the legislatures have devised strict timing requirements for making claims and filing lawsuits to recover against payment bonds.  Regardless of whether public or private construction, claimants need to vigilant as to the notice requirements and deadlines. 
• Claimant cooperation—As with performance bonds, sureties have an obligation and right to investigate any and all payment bond claims. Therefore, it greatly expedites that process when payment bond claimants provide any and all information and documentation needed for the surety to conduct its investigation. That documentation includes, but is not limited to, copies of subcontracts or purchase orders, the claimant’s invoices, a record of payments received and delivery slips or other documents showing delivery of material.

Based on the above information, it is clear that surety bonds provide a much-needed safety net for the construction industry as a whole, in addition to consumers, taxpayers and others. Use these guiding principles to assist your company in navigating the world of surety.

This article is the second in a two-part series on the basics of surety bonding. To read Part 1, click here.