By: Bill Shaughnessy, Partner Jones Walker, LLP.
Construction surety bonds are risk management tools utilized by parties on large construction projects. However, bonds are not insurance, and a surety is not an “insurer” of the project. Different from insurance, a surety’s obligation to act typically arises if the principal fails to perform in accordance with the construction contract, and if the claimant satisfies the conditions precedent to enforcing the bond.[1]
This article focuses exclusively on performance bonds on private projects,[2] and highlights practical considerations and surety defenses to enforcement of the performance bond.[3] Spoiler alert – the party making a claim on the bond must strictly adhere to the conditions precedent set forth in the bond throughout the construction project and when calling upon the surety to take action, otherwise the performance bond may be rendered void and unenforceable.
Overview of Performance Bonds.
A performance bond issued by a surety secures the obligations of an underlying contract. On large construction projects, it is very common for the project owner to require its prime contractor to acquire a performance bond to ensure performance of the work, and for the prime contractor to require the same of its subcontractors. In such cases, the underlying obligation is the construction contract between the principal (the contractor or subcontractor) and the obligee (the project owner or prime contractor).[4] If the principal defaults or materially breaches the underlying construction contract, which is often incorporated by reference into the bond, the surety is required to step in and remedy the default.
Typically the penal sum of the performance bond is 100% of the construction contract price, thereby giving the owner 200% protection against the principal’s default (100% contract price, plus 100% of the bond amount).[5] There is often a requirement in the bond that the penal sum of the bond increases with any subsequent increases in the contract price.[6] The bond protection typically runs from the start of the project and through completion of construction contract, with most performance bond forms attempting to limit the bond obligation (time to initiate action against the surety) to a period of one or two years after the contractor completes the work.[7]
The Performance Bond Sets Forth the Rights, Remedies, and Conditions Precedent to Enforce the Bond.
If the contractor or subcontractor fails to perform the work, the performance bond obligates the surety to provide a remedy per the terms of the bond. Performance bonds are a creature of contract and are enforced and interpreted just as the underlying construction contracts would be in the applicable jurisdiction. The bond will set forth what actions are required of the owner in order to invoke the surety to act and remedy the principal’s default.
The surety’s typical options to remedy default include the surety stepping in to help the contractor complete the work, taking over the work, offering a replacement contractor, or financial settlement up to the penal amount of the bond. A surety’s first choice will typically be to assist the bond principal complete the project because there is a greater likelihood of reducing costs, mitigating delays, and the contractor is familiar with the project and already mobilized. However, the question for the surety is whether the contractor is capable and competent to complete the construction work.
In response to a claim on the bond, the surety stands in the shoes of its principal having all possible defenses that the bond principal may have, as well as surety specific defenses. Some of the most common bond defenses raised by sureties are the following: lack of default or wrongful termination, lack of notice of default, material alteration of contract, overpayment, impairment of collateral, advance payments for work not completed, release of security or principal, and statute of limitations.
The surety’s overpayment defense is common and typically raised when the owner issues payment not due to the principal or releases retainage without consent of surety. Because the retainage protects the surety (just as it does the owner), the surety’s consent is generally required prior to a reduction in retainage or release of the final payment. Making such payment without consent could discharge the surety’s obligations.[8]
Finally, owners and contractors should be familiar with and follow the conditions precedent to enforcing the bond. There are a number of examples where a court held the surety was not liable under the performance bond due to the claimant’s failure to follow the procedural conditions precedent to enforcement.[9]
Industry Accepted Form Performance Bonds
There are no statutory requirements for the structure and wording of performance bonds on private projects, therefore, the nature and wording of the bonds is critical. Owners and contractors frequently use industry accepted performance bond forms such as the American Institute of Architects (AIA) and ConsensusDocs performance bond forms. Owners and contractors should be cautious in accepting a performance bond that is not an industry recognized form, and in such case, should provide the bond to counsel to review the contents of the bond before accepting.
In 2020 ConsensusDocs published revisions to its various performance bond (and payment bond) forms.[10] Key changes in the 2020 versions of the ConsensusDocs performance bonds focused on the timeframe for investigating and responding to default, as well as self-help provisions. For example, the performance bonds now require a definitive declaration of default or non-default by the owner upon its investigation. The timeframe revisions make it clear that a declaration of default is a condition precedent to making a claim on the bond. Additionally, the self-help provisions, for example in the 706 Subcontractor Performance Bond form, allows prime contractors more flexibility and to be proactive in addressing the subcontractor’s default, which includes supplement the subcontractor’s work.[11]
Similarly, AIA Form A312 – 2010 provides a performance bond and a payment bond.[12] The most widely used performance bond form in private construction has been the AIA 312 forms. The AIA 312 (1984 edition) was utilized until the A312 (2010 edition) was published in June 2010. Substantive changes to the A312 from the 1984 edition to the 2010 edition included streamlining the process for which contractor defaults can be raised and cured, and clarifying the sureties’ responsibilities depending upon the remedy selected. For example, Section 3.1 of the 2010 edition provides the Owner may request a conference with the Contractor and Surety before declaring the Contractor, but is not required to do so.[13]
One of the most significant changes added to the 2010 A312 was Section 4 which provides that the notice requirement in Section 3.1 “shall not constitute a failure to comply with a condition precedent to the Surety’s obligations, or release the Surety from its obligations, except to the extent the Surety demonstrates actual prejudice.” Therefore, if the surety establishes “actual prejudice” due to the owner’s failure to provide proper notice, the surety’s obligations may be reduced.[14]
Practical Takeaways
1. Whether standing in the shoes as an obligee or principal, it’s crucial to read and understand the terms of the bond. The plain language of the bond will set forth what procedural steps must be taken to enforce the bond, as well as possible defenses to enforcement of the bond.
2. Consider what additional documents are incorporated by reference into the performance bond, including the underlying construction contract, which may provide supplemental or additional basis for declaring default and terminating the contractor. (See e.g., the AIA 312 Performance Bond (2010 edition) incorporates by reference the underlying construction contract.)
3. If available, the owner or prime contractor should require separate payment and performance bonds from contractors or subcontractors to maximize liability of the surety. If not separate, the penal sum of the bonds is typically less than if the bonds were separate.
4. Timely communication and involvement with the surety throughout project construction is important for a host of reasons, including to keep the surety aware of any material changes, avoid overpayment or release of collateral, and to allow the surety the opportunity to timely investigate the facts and circumstances in the event of a principal’s default.
5. The owner or prime contractor should include a clause providing for payment of attorneys’ fees in the event the surety seeks to avoid payment on the bond. Otherwise, most courts will find that each party must pay their own litigation expenses.
6. The owner or prime contractor should insist on the inclusion of a clause providing that the surety will indemnify them for damages arising from the principal’s actions or inactions.
7. The surety may not be liable if the claimant has itself materially breached the construction contract first. Therefore, before formally calling upon the surety, consider the totality of the circumstances surrounding the principal’s default, including your company’s own performance under the construction contract.
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The views expressed in this article are not necessarily those of ConsensusDocs. Readers should not take or refrain from taking any action based on any information without first seeking legal advice
[1] Suretyship has been described by courts as “an accessory contract by which a person binds himself to a creditor to fulfill the obligation of another upon the failure of the latter to do so.” Carney v. Boles, 643 So.2d 339, 343 (La. Ct. App. 1994); see also Gen. Auth. for Supply Commodities, Cairo, Egypt v. Ins. Co. of N. Am., 951 F. Supp. 1097, 1108 (S.D.N.Y. 1997) (“[A] contract of suretyship is ‘[a] contract whereby one person engages to be answerable for the debt, default, or miscarriage of another.’”) [2] This article does not cover performance bonds which may be required under the federal Miller Act or the state versions (Little Miller Acts). [3] Typically if performance bonds are required on a project, payment bonds will also be required. For a more detailed discussion on payment bonds, be sure to check out: Know and Meet Your Notice Requirements or Lose Your Payment Bond Claims, Chris Broughton, Jones Walker LLP, AGC Construction Law in Brief, May 2021, https://www.consensusdocs.org/know-and-meet-your-notice-requirements-or-lose-your-payment-bond-claims/?utm_source=informz&utm_medium=email&utm_campaign=law_brief. [4] Meeting Different Expectations: A Consensus Approach to Bonding, Robert J. Duke (citing AGC of America, The Contract Bond Claims Process (2014)). [5] Tenets of Surety Law, Chapter 1, American Bar Association; (citing Philip L. Bruner & Patrick J. O’Connor, Jr. 4A Bruner & O’Connor on Construction Law § 12.22 (2020 update)). [6] Some performance bonds state provide for the penal sum to automatically increase with change orders, but is capped after the aggregate increases a certain percentage of the original penal sum. [7] The AIA A312 – 2010 Performance Bond form states: “Any proceeding, legal or equitable, under this Bond may be instituted in any court of competent jurisdiction … within two years after a declaration of Contractor Default or within two years after the Contractor ceased working or within two years after the Surety refuses or fails to perform its obligations under this Bond, whichever occurs first. If the provisions of this Paragraph are void or prohibited by law, the minimum period of limitation available to sureties as a defense in the jurisdiction of the suit shall be applicable.” [8] Surety Defenses: Overpayment of Contract Funds and Cardinal Change to Contract, Gary Strong, Construction Executive, March 13, 2021. [9]See e.g. Stonington Water Street Assoc., LLC v. Hodess Building Co., Inc. 792 F. Supp.2d 253 (D. Conn. 2011) (Owner’s failure to comply with the procedural requirements of the bond barred the owner from bringing a claim.); LaSalle Group, Inc. v. JST Props., L.L.C., 2011 U.S. Dist. LEXIS 83548 (S.D. Mich. July 29, 2011) (General contractor’s failure to satisfy conditions precedent relieved surety of obligation to perform.); CC-Aventura, Inc. v. Weitz Co., LLC, 492 Fed.Appx. 54, 56-57 (11th Cir. 2012) (The obligee was required to “first give notice to the surety before [it] undertook to remedy the default itself,” and therefore, the surety was not liable on the bond.). [10] The ConsensusDocs revisions include bonds in the 200 series for general contracting, the 400 design-build series, and the 700 series for subcontracting. [11] Revised ConsensusDocs Performance and Payment Bond Forms, Surety Bond Quarterly, p. 37-38 Winter 2020. [12] Although these forms are designed for the owner/prime contractor relationship on a private construction project, they can be adapted for use between a prime contractor and a subcontractor. [13] Previously, the 1984 version required the owner to attempt to arrange a conference with the Contractor and Surety before declaring the Contractor in default. See David C. Kimball, New Year, New Performance Bond: the AIA 312-1984 Performance Bond Expires Dec. 31, 2011, Robinson Bradshaw, https://www.robinsonbradshaw.com/newsroom-publications-New-Year-New-Performance-Bond-The-AIA-12-19-2011.html, (Dec. 19, 2011). [14] A showing of “actual prejudice” will depend on the facts of the project and the applicable jurisdiction. The U.S. District Court for the District of Columbia, has interpreted the AIA 312 Performance Bond (2010) requirement of establishing “actual prejudice” did not apply to Section 3.2 (termination), but only to Section 3.1 (delayed notice of the actual meeting). See Western Sur. Co. v. U.S. Eng’g Co., 375 F. Supp. 3d 1 (March 20, 2019).