July 12, 2018
Author: Jack Rephan
Organization: Pender & Coward, P.C.
Bonds issued on construction projects are often thought to be like policies of insurance. However, a surety bond is not an insurance policy. A bond does not “insure” payment to persons providing labor and materials on a project; nor does it “insure” that a project will be completed. Unlike insurance, coverage under surety bond is limited by the terms of the bond and in most cases, it is limited to the penal sum of the bond. There are also events which must occur or fail to occur before a surety issuing a bond for any obligation and a surety has certain defenses to claims against its bond that can eliminate the very security which otherwise would be provided by the bond. The law relating to surety and sureties is also very different from that relating to insurance.
A. Parties to Surety Bonds
Parties to surety bonds are commonly referred to as the obligee, the obligor or the principal, and the surety. The obligee is the party so named in the bond and for whose benefit the bond was issued. There can also be beneficiaries to the bond even though they are not named in the bond. The obligee is the party who is entitled to enforce the bond in the event of a contractor’s default. The obligor or principal is the party providing the bond to the obligee. The surety is a commercial company or individual authorized to provide the bond and who provides the bond and issues it on behalf of the named principal.
B. Types of Bonds
There are generally three (3) types of bonds used in construction, namely, (a) bid bonds, (b) payment bonds and (c) performance bonds. The purpose of a bid bond is to compensate the obligee in the event that the obligor refuses to enter into a contract or fails to furnish any required payment of performance bonds. Bid bonds only protect the obligee or project owner. They are not intended to offer any protection to those providing labor or materials in the construction of the project. Payment bonds are used for this purpose. Although the parties covered by payment bonds are not named in the bond, nevertheless, as beneficiaries, they are given right to pursue claims against the payment bond to recover payment for the value of the labor and materials they furnish. There are both statutory bonds for public projects, including both federal and state projects, and there are also bonds for private projects. Payment bonds, in effect, provide another source for the recovery by unpaid subcontractors and suppliers in addition to any other available remedies or contract rights they may have.
The third type of bonds is a performance bond; the purpose of which is to protect an owner in the event the contractor defaults and fails to complete the project. In essence, the purpose of a performance bond is to provide for the completion of the project either by the surety or by a contractor hired by the surety to complete the project upon the contractor’s default. However, the surety issuing a performance bond, does not guarantee the completion of the project but only a source of funds from which the costs of completing the project may be recovered in the event an owner finds it necessary to bring an action against the performance bond surety for the cost of completing the project.
II. Statutory Payment Bonds
A. After July 1, 2011, performance and payment bonds are required in Virginia on any public construction contract exceeding $500,000 under Virginia’s “Little Miller Act”, Virginia Code § 2.2-4337 through 2.2-4341, as amended. 1 However, for contracts with the Virginia Department of Transportation, payment and performance bonds are required where the contract exceeds $250,000.
B. Required on federal construction contracts under Miller Act, 40 U.S.C. § 270a (a)(2) for contracts exceeding $100,000.
C. Payment bonds are statutory substitute for mechanics liens on public property.|
III. Private Bonds
A. Owners of large private construction projects will often require contractors to provide a performance bond and a payment bond.
B. AIA form of payment bond is widely used. Bond is similar to statutory bonds except notice requirements may differ. Also, coverage of private bond may be prescribed by bond.
IV. What Persons Are Covered by Statutory Payment Bonds?
A. Federal Construction Projects
1. All persons having a direct contract with the contractor furnishing the payment bond.
2. All persons supplying labor or materials to a subcontractor.
3. The term “subcontractor” means a person having a direct contract with the prime contractor. Therefore, sub-subcontractors are not within definition of term “subcontractor”.
B. Public Contract Projects in Virginia
1. Persons supplying labor or materials to the prime contractor furnishing the payment bond.
2. Persons supplying labor or materials to “any” subcontractors.
3. While coverage under Virginia Little Miller Act is as least equal to that under the federal Miller Act, whether broader coverage is provided under Virginia Little Miller Act payment bonds has not yet been tested.
C. Who Are Protected By Private Payment Bonds?
1. Persons covered are normally described in the payment bond.
2. Coverage under AIA form of Payment Bond is for persons supplying labor, materials or equipment to the prime contractor or to a subcontractor.
V. Items of Labor, Material or Other Costs Covered.
A. Neither the federal Miller Act nor Virginia Little Miller Act spell out what cost items are within the coverage of bond. However, the scope of coverage has been extensively litigated on federal projects and the decisions of the courts provide some guidance as to what is or is not covered.
1. Examples of covered items are:
(a) Direct labor;
(b) Materials incorporated into work;
(c) Materials not incorporated into work but consumed in work or necessary to perform work;
(f) Items specifically fabricated for project but not yet installed or delivered to job site;
(g) Rental equipment required to perform contract (in Virginia, equipment must be used on site);
(h) Routine repairs, spare parts, etc;
(i) Insurance premiums for specific coverages required by contract or law for the project;
(j) Premiums for performance and payment bonds.
2. Some of the items not covered are:
(a) Unpaid workers compensation;
(b) Commercial General Liability Insurance premiums;
(c) Major repairs to capital equipment;
(d) Bank loans;
(e) Payroll taxes;
(f) Lost profit;
(g) Attorneys fees.
3. The courts are divided as to whether damages for delay are covered.
4. Interest on the amount due for labor and materials furnished will generally be covered.
VI. Notices Required to Preserve Rights Under a Payment Bond
A. Federal Contracts
1. No notice is required of first tier subcontractors or material suppliers.
2. Second tier subcontractors or suppliers must give written notice to prime contractors within 90 days of last day labor or materials were furnished, otherwise any suit against the bond will be barred.
B. Virginia Contracts
1. No notice is required of first tier subcontractors or material suppliers.
2. All other persons supplying labor or material must give notice to prime contractors within 90 days of the date claimant supplied the last of the labor or furnished the last of the material for which the claim is made. Virginia Code §2.2-4341, as amended.
3. Retainage is excepted from the notice requirement.
C. Private Payment Bonds
1. The bond itself will designate notice requirements.
2. AIA Payment Bonds have strict notice requirements.
(a) First tier claimants must give notice to both the owner and surety within 90 days after last of labor or materials were furnished.
(b) Other claimants must give notice to the contractor and owner within 90 days after the last labor and materials were furnished, give the contractor 30 days to respond to claim and, if contractor rejects claim or does not respond, give a second notice to the surety, with a copy to the owner, stating that a claim is being made under the bond, along with a copy of the previous written notice to the contractor.
VII. When Suit Must Be Filed Against the Payment Bond
A. Under both the federal Miller Act and the Virginia Little Miller Act, suit must be filed within one (1) year after the date the claimant supplied the last of the labor or materials for which a claim is being made.
B. Under most private bonds there is a requirement that any suit be brought within one year from the date the last of the labor or materials were supplied as in the case of statutory payment bonds.
VIII. Claimants Have the Right to Obtain a Copy of the Payment Bond
A. Any person certifying that he has provided labor or material on a federal project can request a copy of the payment bond provided by the general contractor. Normally, the request is made to the contracting officer. Or a request can be made under the Freedom of Information Act.
B. On Virginia construction projects, a copy of a payment bond can be obtained under the Virginia Freedom of Information Act.
IX. Surety Stands in Shoes of Contractor
A. The general rule is that, when a claim is made against the payment bond, the surety may assert any defenses against the claim which the general contractor may have.
B. Under current law in Virginia, the surety may not assert the defense of a pay-when-paid clause unless the pay-when-paid clause is explicitly incorporated into the payment bond.
C. The fact that the contractor is not indebted to a subcontractor at the time a claim is asserted against the payment bond is no defense, as would be the case under Virginia’s mechanic’s lien statute.
X. Performance Bonds
Both the Federal Miller Act and Virginia’s Little Miller Act require that a prime contractor post a performance bond in addition to a payment bond to protect the government or the public body by requiring that the surety assume responsibility for the completion of the contract upon the default by the Contractor. The surety normally has several options including (1) elect to complete the project using the defaulted contractor; (2) hire another contractor to complete the project; (3) pay the expenses of completing the contract to the government or to the public body; or (4) do nothing.
The performance bond is intended to protect the government or other public owner; not to pay subcontractors and suppliers. These parties will have to look to recovery under the payment bond.
B. Default Required to Obligate Surety
The event which triggers the obligation of a performance bond surety to complete the work or to exercise one of its other options is the declaration of a default by the owner. Some performance bonds also require that the surety be given written notice of the contractor’s default before the surety becomes obligated under the performance bond. Under the Federal Requisition Regulations Section 49.402-3(e)(1), when a determination is made that a default appears imminent, the contracting officer is required to provide written notice to the surety and if the contractor is subsequently terminated for default, a copy of the notice of default must be sent to the surety.
C. Damages Recoverable Under Bond
Upon the prime contractor’s default, the cost recoverable by the government or the public owner in an action on the performance bond typically those costs which exceed the contract price which are incurred by the government or public body to complete the work, are limited, however, to the penal amount of the bond. The performance bond surety also can be liable for delay damages due to late completion including liquidated damages. In Virginia a liquidated damage provision will, in most cases, also be enforced by the courts against the competing surety in the case of an inexcusable delay in completion of the contract by the surety.
D. Statute of Limitations
In Virginia, there is a five (5) year statute of limitations for any action on a performance bond by the Virginia Department of Transportation. In all other cases, an action on a performance bond must be brought within one (1) year after the completion of the Contract including the expiration of all warranties or the discovery of the defect or breach of warranty that gave rise to the action.
In the case of an action upon a payment bond, venue for any action on a performance bond is generally the place where the project is located.
Payment bonds offer valuable protection for subcontractors and suppliers furnishing labor and materials to prime contractors and to first tier subcontractors. Payment bonds also provide protection to owners and prime contractors who require payment bonds from their subcontractors against claims of unpaid suppliers of labor and materials. However, the protection of a payment bond will be lost where notice requirements are not strictly complied with or limitations on suits under the bond are overlooked. The courts in Virginia strongly enforce these requirements and anyone doing work on a bonded project should be aware of them.
While performance bonds are intended to provide protection to an owner in the event of the default of the contractor, it should be remembered that such protection may be limited or non-existent if the conditions precedent to the surety’s obligations under the bond are not met. Also, there are a number of technical defenses a surety might raise even where the contractor has been declared to be in default. Nevertheless, even when a default has occurred, many large projects can be saved and costly litigation avoided when the owner, surety and defaulting contractor are able to agree upon a completion agreement providing for the orderly completion of the project with the participation of the surety.
1 For contracts entered into before July 1, 2011, performance and payment bonds were required where the contract
2 Prior to July 1, 2011, notice to the prime contractor was required to be given within 180 days of the date the
claimant supplied the last of the labor or furnished the last of the material for which the claim is made.