A performance bond ensures the timely satisfaction and completion of a construction contract. Where a performance bond is issued on a contract between an owner and a general contractor, for example, the surety has guaranteed to the owner (the “obligee”) that it will complete the contract in accordance with its terms if the contractor (the “principal”) defaults. But there are common mistakes made in relation to performance bonds and the performance of the underlying contract that leaves the obligee with less protection than was intended, or worse, no protection at all. Understanding these mistakes and risks is therefore key to ensuring that a performance bond’s guarantee of the underlying contract is enforceable. Although this article is by no means comprehensive, it highlights several of these common mistakes and the resulting risks.
- A performance bond is not an insurance policy.
First and foremost, a performance bond is not an insurance policy. But too often, obligees treat the bond as if it is merely a source of payment for damages caused by a principal’s default, allowing damages caused by an underperforming or non-performing principal to accrue and then seeking payment from the surety at or even after the project’s completion. But a surety’s performance bond guarantee is more than a guaranty to pay damages caused by default.
Under a typical performance bond, a surety has four options after the principal defaults: work with the principal to cure the default; complete the contract itself; procure a replacement contractor to complete the contract, or pay the costs to complete the contract (up to the bond limit). It is the surety, not the obligee, that decides which of these options to take. Importantly, if an obligee treats a performance bond like insurance and fails to involve the surety until the end of the project, the surety may take the position it was deprived of its full array of performance options. As a result, the bond could be unenforceable.
- The terms of performance bonds govern the rights and obligations of the parties.
Obligees often accept performance bonds as proposed by the principals and sureties without scrutinizing their language. A performance bond is a contract, and the performance bond’s language governs the bond’s guarantees and the parties’ rights and obligations in its performance. Before accepting a performance bond, it is therefore critical to ensure that the bond’s language reflects the obligee’s understanding of what is being guaranteed. For example, if an obligee intends to have the performance bond guarantee both completion of the project and any post-completion warranty work, the performance bond’s language must reflect that intent.
In some jurisdictions, a performance bond is presumed to have incorporated the underlying construction contract in its entirety. In these jurisdictions, the surety’s liability is therefore presumed to be coextensive with the principal’s liability. For example, if the underlying contract makes the contractor liable for liquidated delay damages, the surety is also presumed to have accepted this liability.
But in other jurisdictions, the performance bond must expressly incorporate the underlying contract in its entirety for all of the principal’s liability to flow through to the surety. If it does not, the surety’s performance obligations and liabilities are ascertained from the four corners of the performance bond. If, for instance, the performance bond states only that it guarantees the completion of the underlying construction project, then it arguably does not guarantee the performance of post-completion warranty work. Accordingly, the obligee must scrutinize the performance bond’s language before acceptance to ensure that the promises of the surety meet the expectations of the obligee.
- Declaring a default in a timely manner.
A surety’s obligations under a performance bond do not arise unless and until the principal defaults in its performance of the underlying contract. By extension, an obligee must be diligent in declaring a default under the construction contract and in accordance with its terms.
It is not uncommon for an obligee to try to work through issues with an underperforming principal in hopes that their performance will eventually improve, without formally declaring a default. All the while, the project suffers further delay and damages continue to accrue. But by delaying a declaration of default under the construction contract, an obligee can unknowingly undermine the protection of a performance bond.
As discussed in the context of treating performance bonds like insurance policies, an obligee’s actions that prejudice the surety could give the surety defenses that render the bond null and void. Delaying a declaration of default until the situation has become unmanageable and damages have unnecessarily accrued could likewise prejudice a surety and put the bond’s enforceability at risk. To avoid this risk, it is therefore critical for the obligee to timely declare a default in accordance with the terms of the construction contract and involve the surety as soon as the default becomes apparent. Often, the surety can work with the principal and the obligee to get the project back on track and avoid unnecessary delays and damages.
- Providing notice of the principal’s default to the surety.
Lastly, timely notice of a principal’s default under the construction contract is critical to enforcing a performance bond. Many performance bonds require that the obligee notify the surety of the principal’s default within a specified time after it occurs. And if the performance bond contains such a notice provision, missing the notice deadline may constitute a material breach by the obligee and absolve the surety of its obligations. Accordingly, once a default becomes apparent, the obligee should review the performance bond to identify any notice provisions and other conditions precedent to the surety’s obligations.
In conclusion, a performance bond is a valuable tool in an obligee’s risk mitigation strategy. But understanding what a performance bond is, what it guarantees, and the obligations it imposes on the obligee and the surety is crucial to avoid common mistakes and the associated risks when dealing with performance bonds.
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