December 13, 2005

What Happens When a Contractor’s Performance or Payment Bond Is Called On

When the surety receives notice of a payment bond claim, it typically embarks upon a number of simultaneous inquiries to explore the legitimacy of the claim, any disputes regarding the claim and to determine whether contractual or bond defenses exist. Payment bond forms typically have limits on how many tiers of subcontractors may make a claim on the bond, how long rights to claim against the bond survive and particular notice requirements — all of which may differ from form to form and any of which may serve to form the basis of a surety claim defense.

The surety will routinely ask the claimant for detailed information regarding the claim, such as the applicable contract, documents that substantiate the claim, information regarding when the claimed work was performed and when the claimed payment was due, payment applications, among other information. The surety will also usually ask the bonded contractor for its position on the claim, i.e., is the claim admitted or disputed and, if so, the nature of the dispute. The surety needs this information so that it may assess both the claimant’s position and the bonded contractor’s position, as the surety has obligations to both of them that may be in conflict — it is obligated to pay the proper claims of claimants, but it is also obligated to the bonded contractor not to pay if the claim is not proper, as it may lose its rights to reimbursement from the bonded contractor if it wrongly pays a claim. For example, the bonded contractor may respond that the subcontractor’s claim is invalid because it did not perform its work and, thus, the bonded contractor contends not only that no sums are due to it, but that the bonded contractor has a claim against its subcontractor. This type of conflict, if a seemingly legitimate dispute, may throw the surety into a quandary: to pay or not to pay?

If the surety’s investigation reveals that the sums are properly due and owing to the claimant, and that no defenses exist to payment, the surety will typically seek to have the bonded contractor pay the claim directly. If the bonded

contractor fails to pay the claim, but offers no basis for a defense to the claim, the surety may pay the claim itself and seek indemnity from the bonded contractor. If the bonded contractor maintains that defenses exist to the claim, the surety may deny the claim but seek an additional confirmation from its bonded contractor that if the claimant sues on the payment bond, that the bonded

contractor will defend and indemnify the surety from the lawsuit.

Performance bond claims are frequently far more complicated to assess. Typically, the performance bond surety’s obligations are tied to the “default” of the bonded contractor. Bond forms vary widely in their triggering events, and some require not just a “default,” but a “default and a declaration of default,” by the owner, while others may require a default and actual termination of the contractor’s employment under the bonded contract by the owner. Others may permit partial defaults and partial terminations — it all depends upon the particular bond form and the terms of the bonded contract, which will be read together in assessing the parties’ rights and obligations.

When a performance bond surety receives an owner’s notice of a claim,

it usually acknowledges receipt of the notice, reserves all of its rights and defenses, and embarks upon an investigation. Again, the surety has obligations to multiple parties that may be, and frequently are, in tension. It owes its contractor/principal the obligation not to honor improper claims, and it owes the claimant the duty of honoring its proper claims. The surety must typically conduct its investigation and make a determination of how it intends to proceed either within the time period stated in the applicable bond, or in a “reasonable” period of time if none is stated. Of course, what is “reasonable”

in a given context is open to much debate and is a ripe area for litigation.

Under the pressures of a halted project, an owner demanding that the surety promptly honor its obligations, and with the contractor denying that it defaulted or arguing that its default should be excused by an owner’s non-payment, a surety must make some difficult decisions. If its investigation leads it to conclusion that the bonded contractor was not in default, or that the obligations under its bond were not properly triggered, the surety may opt to simply sit on its rights and deny the owner’s claim on the bond. It then leaves the owner to fend for itself in completing the project.

In so doing, however, the surety leaves itself exposed to the likelihood of litigation with the owner. Wrongly selecting the sit-on-its-rights option also potentially subjects the surety to increased exposure. If a court determines that the surety wrongfully failed to honor its obligations, it may be exposed to damages in excess of the penal sum of its bond (a potentially unlimited risk). (See the casenote in this edition of the newsletter on bad-faith claims against sureties.) Further, by allowing the owner to complete, the surety loses the ability to limit its exposure by controlling the manner in which the project is completed, and loses a chance to negotiate a favorable up-front cash settlement with the owner.

Alternatively, if the surety concludes that its bonded contractor was in default and that its bond obligations have been properly triggered, and the surety decides to do something, it has a wide variety of “somethings” to choose from. The surety may (1) finance the bonded contractor’s completion of the contract; (2) takeover the performance of the contract by hiring a new completion contractor; (3) tender a new contractor to the owner for the owner to contract with for completion (while agreeing to pay completion costs in excess of the bonded contractor’s remaining contract balance); (4) offer a straight cash settlement to the owner in exchange for a release; (5) reserve its rights to contest the default at a later date and enter into a takeover agreement with the owner while agreeing to fund the completion in the first instance, once the available contract balance is exhausted by the owner; (6) or embark upon any creative type of negotiated resolution of the matter with the owner that is mutually agreeable to the owner and the surety. All of these options have risks and benefits to the surety — options it must weigh while naturally being pressured by the owner to take over and complete the project immediately.

Contractors threatened with default often seek to have their sureties assist in funding their own completion of the contract work, as this may avoid a default and termination. Typically, the surety will only finance the bonded contractor’s completion if the surety determines that doing so will cure a solely cash flow–induced default on a project that it believes will ultimately be profitable if completed by the bonded contractor.

Owners usually prefer to have the surety take over and complete the project. This option is often the cleanest for the owner, but poses substantial

exposure for the surety, as some jurisdictions dictate that in so doing, the surety has committed to complete the bonded contract regardless of cost. The surety often tries to limit its risk in the takeover scenario by attempting to

negotiate a “takeover agreement” with the owner, which limits the surety’s exposure. The surety may also favor tendering to the owner a new contractor for completion, whose obligations are guaranteed by another surety’s performance bond. By doing so, the surety limits its exposure to the difference

between the available contract balance and the price of the new contractor (which often is competitively bidding for the completion work with a surety with substantial bargaining power).

Whatever course the surety takes, it must always be mindful that when the time comes for it to seek indemnity for its costs from the bonded contractor and/or other indemnitees, they will likely be scrutinizing every act by the surety for defenses to the surety’s claim. Thus, the defaulted bonded contractor should not simply step back and permit the surety to take whatever course it chooses. The contractor should be active in monitoring the surety’s completion efforts, should provide written notices of warning to the surety if the contractor believes the surety is over-spending, and should generally be pro-active in its efforts to contain the surety and its expenditures. By doing so, the contractor may limit the surety’s expenditures and can begin to make a useful record for defending the inevitable effort by the surety to seek indemnity.

Like a Good Marriage —It’s Not All Bad

Your relationship with your surety is not all downside, though. First and foremost, contractors get the primary benefit they seek from sureties — the ability to secure a contract where a bond is required. Also, sureties often have great resources that they can, at their discretion, bring to bear to assist a struggling contractor on a bonded job. Sureties may make financial advances to prop up contractors that are having cash flow problems. Sureties can get involved before a default to work with the contractor and/or the owner to prevent defaults. With a contractor’s agreement, a surety can even take over part of a bonded contract to diminish the administrative and resource burden on an overextended contractor. Sureties also often have a variety of resources to prop up a struggling contractor, such as expert consultants, accountants and lawyers.

Again, the surety will typically expect to be completely reimbursed for the costs incurred in providing assistance to its contractors. These costs incurred in getting the job done, however, may be lower than the costs that would be incurred should a contractor be defaulted and terminated.

Read Your Pre-Nup Before You Sign

This very general overview of surety-contractor relationships should give contractors insight into what they are committing to when they walk down the aisle with their surety. Like a marriage, this is a long-term, complex relationship with many pros and cons, and potential risks and potential rewards. But, remember, every surety’s contracts, every surety’s bonds and every surety’s GAIs are different. As with every other contract, they should be read and their risks and benefits understood before they are signed. Once signed, and once the surety posts bonds for the contractor, it is bound to that surety, at least for the life of the bonded contracts— and likely beyond.