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Construction Bonds: What You Need to Know

By Derek Mullan, Q.C.
January, 2003 

The three main types of bonds encountered in the construction field are Performance Bonds, Labour and Material Bonds and Bid Bonds.

A Performance Bond is a guarantee that the contractor will perform all of its obligations under the construction contract.

A Labour and Material Payment Bond is a guarantee that all who provide labour and material to the contractor will be paid.

A Bid Bond is a guarantee that if the bidder is awarded the contract, it will enter into the contract in accordance with the terms of its bid.

It is important to recognize from the outset that a bond is NOT an insurance contract. Since some insurance companies issue bonds as well as insurance contracts, this may account for some of the confusion. Not everyone is aware of the difference, but they are totally different animals.

A bond is essentially a guarantee. It is a three party agreement between a surety, principal and obligee. The guarantor (read surety or bonding company) guarantees the obligations of the contractor (read principal) to the owner (read obligee). The bonding field has its own language.

On the other hand, an insurance contract is a two party agreement between the insurance company and the insured. In an insurance contract, the insurer agrees to pay the loss upon the happening of a defined contingency. The insurance premiums are based on an actuarial calculation of losses. Losses are expected. There is NO LOSS expected in a bonding situation. The premiums for a bond are based on the cost of extending credit and administering the contract.

If a loss does occur, the surety expects to recover such loss from the indemnitors. The indemnitors are usually the owners of the contractor company and their spouses. By separate agreement with the surety, they have agreed to pay the surety should it be called upon under the bond to pay the owner (obligee).

Well before a bond is issued, the surety will have investigated fully the character, capacity and credit worthiness of the contractor (principal). It will have obtained the above-mentioned indemnity agreement from everyone who has an equity interest in the contractor as well as their spouses before it even issues the bond.

If a claim is made by an owner (obligee) on a bond, the surety will investigate to make sure that the owner (obligee) has performed all its obligations. The surety does this because it does not want to jeopardize its rights of recovery from the indemnitors. Therefore, before the surety responds, the surety will seek the assistance of the indemnitors to consider the claim from the contractor’s perspective. The surety has to be certain that the contractor is in fact liable to the owner.

After the surety receives notice of default, say under a Performance Bond, it is entitled to a reasonable time to investigate the situation and determine if in fact there has been default. Once satisfied there has been default by the contractor (principal) and it has no defence, then the surety has three basic options; namely, to remedy the default, to complete the contract, or to obtain a bid for completion.

Remedying the Default

If the default occurs because of a shortage of working capital on the part of the contractor (principal), then the surety could provide financing to allow the contractor (principal) to finish the project.

Completing the Contract

This option is rarely used by the surety, but there is nothing to prevent it from completing the contract. Since the surety does not usually have construction personnel on staff, one variation of this option is for the surety to subcontract the work back to the contractor (principal) or to create a new company which employs the key personnel of the contractor (principal).

Obtaining a Bid for Completion

This is the most frequently employed option and involves obtaining bids from other contractors for completion of the contract. The unsuccessful bidders who originally bid the job are often approached by the surety to give a price for completion of the contract.

While these are the three main options available to the surety once default occurs, it must be stressed that this assumes that the surety has no defence available. There are a number of defences available to the surety, the most frequently encountered of which are failure to notify the surety of default, material variation of the contract and failure to deliver the bond to the owner (obligee). While these may sound like unduly technical defences, since bonds are guarantees, all the old common law defences are therefore available to the surety.

Owners' Obligations Under a Performance Bond

It is a condition of the surety’s obligation that the owner must have performed its obligations under the contract. The owner’s failure to fulfill its obligations excuses the surety from responding.

Under a Performance Bond it is the right of the owner to insist that the surety performs the contract on behalf of the contractor. An owner should ensure that it fully provides the surety with an opportunity to perform the contract. The owner cannot proceed and perform the contract itself and assume that, at some future time, the owner will be entitled to collect payment for any losses it suffered in the process, from the surety.

It is very important that an owner follows the right steps to properly advance a claim under a bond. The owner should carefully review the wording of the bond under which the claim is made and comply with the requirements set out in the bond itself.

For an owner to claim under a performance bond, the contractor must be in default under the contract. The case law provides that "default" refers to only those defaults that are of such a serious nature that the owner deems it proper to make a declaration of default and to call upon the surety to perform its obligations under the bond. However, the owner would be well advised to notify the surety whenever significant problems with respect to the contract arise.

If the owner wishes to make a claim, the owner’s first obligation is to promptly notify the surety in writing of the default. If the owner fails to notify the surety, the surety may be released from its obligations. Also, the notification of default should be timely, so that the surety has the opportunity to choose one of the options available to it and is not prejudiced by delay of the owner. The surety is entitled to a reasonable period of time to investigate the alleged default.

Performance Bonds generally provide that the surety has the right to choose the arrangement to complete the contract, and hence the owner may not take any unilateral actions without consulting the surety. If the owner does take unilateral actions without consulting the surety, the owner risks releasing the surety from its obligations. The owner should fully cooperate with the surety, in order that the surety cannot later deny liability on the ground that the owner acted without the knowledge or the consent of the surety.

Performance Bonds generally provide that an action under the Performance Bond must be commenced within two years from the date on which final payment under the contract falls due. It is important to note that the date of final payment is the relevant date. The safest practice for an owner would be to make a claim on the bond immediately upon default by the contractor.

The Surety's Defences to Performance Bond Claims

Standard Performance Bonds contain the following language:

"Whenever the Principal shall be, and declared by the Obligee to be, in default under the Contract, the Obligee having performed the Obligee’s obligations thereunder [the Contract], the Surety may ...".

As mentioned above, for an owner to claim under a Performance Bond, the contractor [principal] must be, and must be declared to be, in default under the contract. Also, if the owner wishes to make a claim, the owner’s first obligation is to promptly notify the surety; otherwise, the surety may be released from its obligations.

The words "the Obligee having performed the Obligee’s obligations thereunder" mean that if the owner [obligee] does not fulfil the owner’s obligations under the building contract, the owner forfeits his right to make a claim under the Performance Bond.

In particular, an owner may jeopardize his right to claim under a Performance Bond in the following situations:

  1. Material Change to the Contract

    The surety bonds a specific contract and takes the risk that the contractor will not perform a specific contract. The owner cannot increase the risk for the surety without the surety’s consent. Therefore, if there is a material change to the contract without the consent of the surety, the surety will be released, unless the change is unsubstantial or benefits the surety. What would constitute a "material change", would depend on the interpretation of the contract. Most contracts assume that there will be changes to the scope of the work, and would include a "Changes in the Work" clause in the contract. An example of a material change is where the scope of work has been increased to such an extent that it changes the nature of the contract. A material change may also be where the owner has agreed to waive any delay or adjust the construction schedule.

    For a surety to avoid liability, the changes in the contract must be material, must prejudice the surety and must be without the consent of the surety.
     

  2. Improper Payment of Contract Funds

    Payments made contrary to the payment schedule in the contract will also discharge the surety. This may happen where the owner advances funds to the contractor in order to ease the contractor’s cash flow problems and the advances are out of proportion to the work that has been completed. Courts have held that the owner has prejudiced the surety in such circumstances, because the amount of funds available to the surety to complete the contract have been reduced.

    However, where an owner advanced payment to the contractor, acting in good faith and relying on a erroneous architect’s or engineer’s certificate, it is doubtful that the surety would be released from its obligations.
     

  3. Extension of Completion Date

    A variation of the completion date may also constitute a material change of the contract which may release the surety. Owners should be very careful that they do not do anything which could be interpreted as consenting to an extension of the completion date.

If you have any questions regarding the issues presented in this article, or construction bond claims generally, please do not hesitate to contact either of the writers.

Link to In-Depth Paper:
Construction Bonding Guide
 
 

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