Surety Bonds: Backstopping Contractors PDF

Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Chapter 25 Surety Bonds:...

Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Chapter 25 Surety Bonds: Backstopping Contractors © 2015 Cengage Learning Engineering. All Rights Reserved. 1 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Learning Objectives Understanding the basic mechanics of the most common surety bond systems: performance bonds and payment bonds. Identifying the conceptual differences between insurance and surety bonding. Exploring options for sureties after a bonded contractor defaults on its performance obligations. © 2015 Cengage Learning Engineering. All Rights Reserved. 2 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Introduction Triangular arrangement: Surety obligates itself to perform or pay a specified amount of money to an obligee (creditor) if the principal debtor does not perform. Principal = contractor. Obligee = owner. Terminology of Restatement (Third) of Suretyship and Guaranty (1996). https://store.legal.thomsonreuters.com/law-products/Restatements-of-the- Law/Restatement-of-the-Law-3d-of-Suretyship-and-Guaranty/p/100029721 © 2015 Cengage Learning Engineering. All Rights Reserved. 3 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Mechanics of Suretyship Owner requires contractor to obtain specific bonds through the bidding documents or contract. Bidding prime passes cost to owner through bid price. Bond runs in favor of owner. Indemnity agreement between contractor and surety promising to reimburse for losses incurred under the bond. Penal sum: amount of the bond, usually full price of the contract. (Bonds are a form of protection for the owner against non-payment, lack of performance, company default, and warranty issues.) © 2015 Cengage Learning Engineering. All Rights Reserved. 4 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Need for Bonds in Construction Industry Construction industry is filled with risky actors undertaking risky activities. Bonds necessary to protect owner and to conduct initial screening of (bonded) bidders. Public contracts usually require performance and payment bonds to protect public money. © 2015 Cengage Learning Engineering. All Rights Reserved. 5 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Surety vs. Insurer Bonds back up business expectations and cover business losses. Sureties seek to recover losses from the bonded principal.  Surety covers risk through an indemnity agreement. (an arrangement whereby one party agrees to pay the other party for any damages regardless of who is at fault.) Insurers can’t initiate actions to recover from the insured.  Instead, insurers spread this risk among a pool of policy holders. © 2015 Cengage Learning Engineering. All Rights Reserved. 6 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Ancillary Bonds  Bid Bonds.-Is part of a bidding process by the contractor to the project owner, to provide guarantee, that the winning bidder will undertake the contract under the terms at which they bid.  License Bonds. - is one that is required by a municipality or other public body as a condition to granting a license or permit to engage in a specified activity, this bond guarantees that the party seeking the license or permit (the obligor) will comply with applicable laws or regulations.  Lien Release Bonds.- Posted by an owner whose property is subjected to a mechanics’ lien; the lien is then transferred from the property to the bond.  Subdivision Bonds. – A bond guaranteeing public improvements promised by a developer building a housing subdivision. © 2015 Cengage Learning Engineering. All Rights Reserved. 7 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Performance Bonds: Surety’s Promise to Owner Figure 25.1 © 2015 Cengage Learning Engineering. All Rights Reserved. 8 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Performance Bonds: Surety’s Promise to Owner Performance bond provides protection for the project owner in the event that the bonded contractor fails to perform its obligations. Joint and several liability. Conditional obligations. © 2015 Cengage Learning Engineering. All Rights Reserved. 9 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Triggering the Performance Bond Obligation Under AIA documents, three steps owner must take to trigger surety bond obligations: Hold a conference with surety and contractor;  Notice to the other parties, possibility to give contractor a chance to cure. Declare the contractor in default and terminate the contract;  Breach must be material, principal unable to properly complete the project within a reasonable time. Tender the balance of the construction funds to the surety.  Task of completing the project shifts to the surety. © 2015 Cengage Learning Engineering. All Rights Reserved. 10 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Performance Bond Surety’s Options Four options under AIA documents: Arrange for the original contractor, with the owner’s consent, to complete the contract; Complete the project itself, including through the use of independent contractors; Obtain bids or negotiated proposals from qualified contractors acceptable to the owner and arrange for the owner to continue work with that new contractor, backed up by new performance and payment bonds; Waive its right to perform and complete, and instead (i) pay the owner its costs of completion or (ii) deny liability in whole or in part. © 2015 Cengage Learning Engineering. All Rights Reserved. 11 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Performance Bond Surety’s Options Under the four options, the surety may have to choose between the positions of owner and contractor, with potential liability for claims on either side. May be in best interests of terminated contractor for the surety to complete the contract under a reservation of rights. © 2015 Cengage Learning Engineering. All Rights Reserved. 12 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Surety’s Defenses Surety may generally raise any defense to performance that would be available to the contractor. Owner actions which discharge/release the surety. Material increase in project scope without surety consent. Owner failure to comply with his/her obligations under the bond. Owner advances to contractor for work not performed which decreases funds available to surety. © 2015 Cengage Learning Engineering. All Rights Reserved. 13 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Performance Bond Surety’s Liabilities Liabilities in the obligation to perform the construction contract: Correction of known defective work. Finishing incomplete work. Mixed picture for liabilities for delayed completion. No liability for punitive damages that might have been awarded against the contractor. © 2015 Cengage Learning Engineering. All Rights Reserved. 14 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Payment Bonds: Functions Undertaking by the surety to pay unpaid subcontractors and suppliers. Requirement in public contracts. Mechanism to avoid liens in private construction. Protects competent subcontractors. © 2015 Cengage Learning Engineering. All Rights Reserved. 15 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Payment Bonds Figure 25.2 © 2015 Cengage Learning Engineering. All Rights Reserved. 16 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Who Can Sue on the Payment Bond? Subcontractors may sue directly on the payment bonds as third-party beneficiaries. The further down the chain of subcontractors, the less likely that a claimant can successfully sue on the bond. Complicated planning in multi-prime contracts. © 2015 Cengage Learning Engineering. All Rights Reserved. 17 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Payment Bond Liability Subcontractors or suppliers can recover the reasonable value of work performed or supplies provided, all sums justly due. Profit? Increased costs of performance? Sureties typically are not allowed to assert the contractor defense of a “pay when paid” clause. © 2015 Cengage Learning Engineering. All Rights Reserved. 18 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Asserting Claims: Time Requirements Requirements for providing notice to surety within certain time limits. Time limits on surety response to claims. © 2015 Cengage Learning Engineering. All Rights Reserved. 19 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Reimbursement of Surety Sureties make strong efforts to recover on the loss when they are required to take over or pay out on a bond. Indemnity agreement between contractor and surety. Good faith requirement on surety actions. Surety will seek to obtain remaining funds from owner, including retainage, and will pursue possible claims against the owner. © 2015 Cengage Learning Engineering. All Rights Reserved. 20 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Regulation: Bad Faith Claims Sureties are regulated at the state and/or federal level. Minimum financial capability requirements. Increasing allowance of claims against sureties for bad faith settlement practices. © 2015 Cengage Learning Engineering. All Rights Reserved. 21 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Bankruptcy of Contractor If a contractor goes bankrupt, the bankruptcy trustee will usually choose not to continue obligations under the contract. Owner cannot recover much from a bankrupt contractor. Bankruptcy of contractor does not discharge surety’s obligations because this is part of function of bonding requirements. © 2015 Cengage Learning Engineering. All Rights Reserved. 22 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Approach in International Contracts International approach: unconditional bank guarantees, standby letters of credit, or “on- demand” bond. © 2015 Cengage Learning Engineering. All Rights Reserved. 23 Construction Law for Design Professionals, Construction Managers, and Contractors Sweet and Schneier Summary Surety bonding requirements serve to backstop the contractor’s performance and protect the interests of owners and subcontractors. Although similar in some respects to insurance, sureties operate differently from insurers in the event of contractor failure to perform or to pay subcontractors. © 2015 Cengage Learning Engineering. All Rights Reserved. 24