The Dotted Line: What happens when a bonding company is called in

Sometimes, as a condition of winning a construction job, contractors are required to guarantee that they will pay their bills and perform their contracted scopes of work by providing the owner with payment and performance bonds. Public agencies often require these instruments, issued by a surety bond company, but some private owners insist on them as well.

Payment and performance bonds, said attorney Michael Kurzman, partner at the law firm of Weiss Serota Helfman Cole & Bierman P.L. in Ft. Lauderdale, Florida, are two distinct documents. When a general contractor provides a payment bond to the owner, it is ensuring that the project’s subs and suppliers will be paid. Similarly, a bonded subcontractor is guaranteeing payment of the bills related to its scope of work.

If a contractor is unable to carry out the work in its contract, then the owner can go to the bonding company and have it complete the project under the terms of the performance bond.

Construction companies that bid on federal contracts of $150,000 or more must be bonded under the terms of the Miller Act, as implemented by Federal Acquisition Regulations. States also have bonding requirements for government construction work through “Little Miller Act” laws. 

While insurance companies are where contractors most often go to secure performance and payment bonds, bonds are not insurance. Unlike a general liability policy that pays for claims — and perhaps leave the policyholder with higher premiums come the next renewal — contractors must reimburse sureties for claims paid. Sureties most always have the contractor’s principals personally guarantee repayment if the company is unable to do so.

“The surety usually has the principal and spouse sign the indemnity agreement so that they have plenty of leverage in order to get paid back,” Kurzman said.

In addition, said attorney John Sebastian, managing partner at Watt, Tieder, Hoffar & Fitgerald LLP’s Chicago office, sureties are not protected by the automatic stays that keep creditors at bay in the event of a contractor's bankruptcy. So, subcontractors and suppliers should still get paid for a bankrupt contractor’s bonded projects.

Also, unlike liability insurance, the qualification process to secure performance and payment bonds is a rigorous one that has the surety company perform credit and background checks on the contractor and whoever is providing the guarantee. Past credit and performance history, along with the size and type of project, help determine the price for the bonds, which, on average, range from 0.5% to 1% of the contract amount, according Andrew Thome, president and CEO of J.W. Terrill, a Marsh & McLennan Agency company.

Of course, there are plenty of jobs where performance and payment bonds, like many construction contracts, sit in a drawer and never see the light of day until a problem comes along.

The most cut and dry part of the process, Kurzman said, is when someone makes a claim on the payment bond. “They're much different animals than performance bonds,” he said. They usually result in relatively quick payment to subcontractors and suppliers, and these claims don't typically impact the progress of the job.

Payment bonds on public projects are also somewhat of a safety net, Thome said, because contractors cannot secure payment against public property via a mechanic’s lien.

A complicated process

Making a claim against a performance bond is a little more complicated. At that point, Kurtzman said, the bonding company has four options:

1.  Write a check to the owner and walk away. “Then it’s up to the owner,” he said, “to take that money and finish the project. If it costs the owner more than that, then the owner loses that difference.”

2. Deny the claim if it concludes the owner has wrongfully terminated the contractor. “In that situation,” Kurzman said, “the owner has to finish the job.” Parties in this scenario often end up in court if the owner must deal with cost overruns.  

“If the ultimate trier of fact decides the contractor did a bad job and the owner was justified in terminating, then [the contractor and bonding company] would be on the hook for the loss,” he said. “If the court determines that the contractor was doing a fine job and the owner was wrong [to terminate], then the owner doesn’t recover the money.”

3. Take over the job and finish the project. The surety might decide to hire the original contractor back, Kurzman said, because it usually has the most vested interest in getting the job done since it and one or more principals has an indemnity agreement with the surety anyway.

Depending on the contractor’s overall situation, Thome said, the bonding company could also help fund the original contractor’s completion of the project.

In a quite different scenario where the surety company anticipates a loss, Kurzman said, it sometimes asks the bonded contractor to cover any potential losses with new collateral to make sure the surety is protected. What might happen in that situation is that the bonded contractor will offer to complete the job in order to control the job’s costs and maybe not incur as much of a loss. If the contractor doesn’t have the wherewithal to complete the job, though, then the surety will find another contractor and go back to the original contractor to make up for any losses.

“So, behind the scenes, there’s a lot going on between the surety and the principal of the bonded company,” he said.

Even if the owner, or in the case of a subcontractor then the general contractor, is adamant that the company in default not be let back on the job, courts have found that since it’s the surety’s responsibility to get the job done, then it can hire whoever it wants.

4. Find another contractor to complete the project.

Astaldi Construction Corp. this year, for instance, defaulted on four highway projects for the Florida DOT, handing them over to the bonding companies. Other contractors have since taken over the projects.  

A situation like Astaldi's, Thome said, can result in a more streamlined approach to a performance bond claim compared to one that involves a dispute about whether the contractor is in default or not. “That’s a lot of gray in the industry,” he said.

If a bonded subcontractor defaults, the general contractor would have to make a claim against the bond. “It’s the same process,” Kurzman said, “only it would be the GC going to the performance bond surety to have them finish the subcontractor’s work.”

No matter what, Thome said, the surety has to investigate every claim and make sure there’s a default. After the investigation, he said, “they’re going to come up with a resolution that’s the most timely and economical for the parties involved.” That resolution, he added, has to comply first with what’s laid out in the construction contract, the bond form and then case law in the jurisdiction, which makes each claim unique and difficult to generalize about how each will proceed.

When a surety company gets involved with a project, other contractors still working on the job might be left wondering how their contracts and schedules will be affected.

The surety company is "going to want to see all the documents and read everything, and figure out what happened on the job.”

 Michael Kurzman, 

Partner at the law firm of Weiss Serota Helfman Cole & Bierman P.L. 

The surety, Sebastian said, whether it re-hires the bonded contractor or hires a new one, typically ratifies all existing subcontracts, which requires it to confirm the existing subcontract terms and bring subcontractors that are still working up to date on payments. Subcontractors that have completed with their work have to look to the payment bond to be made whole.

Plus, there's always a battle between the owner and the surety or the developer and the surety over scheduling, Kurzman said, and how long they need to investigate the claim. “They're going to want to see all the documents and read everything,” he said,”and figure out what happened on the job.”

That can create enormous frustration, he said, especially on jobs where failure to keep to the schedule was the reason for default in the first place.

When all is said and done, said Kurzman, the surety may never recoup what it has to pay out in bond claims. “That is the risk of their business.”  

The outcome often depends on how good a job the surety did underwriting the bonds. “They're not going to give a bond to just anybody,” he said. “They're going to make sure that there's a viable entity there.”

The Dotted Line series is brought to you by AIA Contract Documents®, a recognized leader in design and construction contracts. To learn more about their 200+ contracts, and to access free resources, visit their website here. AIA Contract Documents has no influence over Construction Dive's coverage within the articles, and content does not reflect the views or opinions of The American Institute of Architects, AIA Contract Documents or its employees.

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