The concept of surety dates back to the story of Genesis.[i] In modern-day construction, the concept of suretyship takes the form of a written bond. Ordinarily, a contractor enters into a contract with an owner for a particular construction project. The owner, in turn, may require that the contractor provide a performance and payment bond. In private construction projects, the owner decides if it wishes to incur the expense of the bond. On public projects, the requirements for surety bonds, and many times the exact amounts of the bonds, are dictated by statute. Although the contractor purchases the bond, the cost is ultimately factored into the bid price. As a result, the owner indirectly absorbs the cost to the bond. On some projects, the contractor may require that its major subcontractors and suppliers obtain performance and payment bonds naming the contractor as the obligee (the entity protected by the bond). Performance and payment bonds provide separate and distinct protections.
- 1. Performance Bonds
A performance bond is unique because it is a tri-party agreement between the owner (oblige), the contractor (principal), and the surety. A performance bond is designed to protect the owner from the contractor’s failure to complete the work. Once the principal or contractor discharges its duties and completes the project, the surety is also discharged because the obligee (owner) is entitled only to one aggregate performance. If the principal defaults on the underlying contract, however, the surety has a contractual obligation regarding the completion of the project. The scope of the surety’s obligation and any defensive processes are fact specific and depend upon the language of the bond.[ii]
- 2. Payment Bonds
The United States government and most states have provided, through legislative enactment, protections to ensure the payments of those who assist in improving real property. On contracts with the federal government, these protections are provided through the Miller Act. The state legislative enactments are generally referred to as public or private works acts, depending on whether the contract or improvement of the real property is entered into with a government entity or private owner. Payment bonds protect (1) the owners and their land and (2) those who furnish the services, labor, material, or equipment for the construction.
Generally, when a private owner enters into a contract with the contractor to construct an improvement on a piece of property, a laborer, supplier, or subcontractor who performs labor or supplies material but does not get paid for the work performed or materials supplied will generally be entitled to a lien on the property. Public land, however, is not susceptible to seizure, so a claim on public works property may not be secured by a lien on improvements to the property. As an alternative, the Miller Act and most states’ public works acts provide that a public owner that enters into a contract with a contractor must require the contractor to provide a surety bond to protect subcontractors, suppliers, and laborers. Private owners may also protect themselves and their property by requiring a general contractor to provide a payment bond. Thus, there are three types of generally recognized payment bonds:
- United States Public Works – Miller Act Payment Bonds: Only first- and second-tier subcontractors and suppliers are covered by the Miller Act bond. The purpose of the Miller Act payment bond is to shift the ultimate risk of nonpayment from the contractor’s subcontractors, workers, and suppliers to the bonding company. Courts liberally construe the Miller Act to give effect to this purpose.
- State Public Works Projects: Many states have adopted “little Miller Acts” that generally follows the same scheme as the Miller Act. Many states, however, have different procedural requirements that fulfill the same intent.
- Private Bonds: An owner may require contractors to provide a payment bond not otherwise required by statute or contract. Such bonds are sometimes referred to as common-law payment bonds, which are private contracts enforceable according to their terms so long as the bonds are not illegal or against public policy.
- 3. Bonds Are Contracts / The Written Agreement Controls
While there are many reported cases and rules of “suretyship,” a bond remains a written contract. Therefore, although certain bond forms are widely used, such as the AIA A312 Payment and Performance Bonds,[iii] the first critical step for analysis of the protection afforded by a bond is to read the terms and conditions of the bond carefully. The full extent of the parties’ rights, liabilities, and defenses are determined by the four corners of a particular bond. Thus, regardless of any general rules of suretyship outlined in any treatise or construction case, the starting point is always the precise terms of the bond. Contract interpretation determines the terms of the parties’ agreements; everything else is secondary.
- 4. Bonds Are Not Insurance
An unfortunate misconception is to equate surety bonds with insurance policies. Although many bonding companies have the word “insurance” in their names, a surety bond is not insurance and must not be analyzed under a traditional liability insurance framework. There are four fundamental differences between insurance and suretyship:
- The suretyship obligation is a three-party agreement between the principal (contractor), the obligee (owner), and the surety. Insurance is a two-party contract between an insurer and its insured (beneficiary).
- A surety does not anticipate any losses. If the surety pays a claim, it has a common-law right of indemnification. This right of indemnification shifts the ultimate costs or loss back to their principals (contractor). Insurance companies, by contrast, expect losses from fortuitous events in which there is no immediate control.
- Sureties are different from insurers with respect to the manner in which the premiums are calculated. Bond premiums are not designed to create a pool of available reserves to draw upon when losses occur. Liability insurers, however, calculate their premiums over many policies and through the use of actuarial tables and loss experience data.
- The biggest difference between a surety and an insurance company lies in the rights and remedies available in the event of a claim. Insurance companies’ rights and defenses are limited. If a claim falls within the scope of the insurance coverage, the insurer must pay the claim and absorb the loss. In contrast, a surety has a variety of rights and defenses that it may assert against an obligee (owner) and, through common-law and/or contractual indemnification, may shift the cost of any claims or losses to its principal.
- 5. Combined Payment and Performance Bonds
Some bonding companies combine the performance and payment obligation into a single bond, sometimes referred to as a “contract bond” or “labor and materials bond.” Generally, if a combined bond form is used, a single penal sum is provided. In other words, whereas a performance bond may protect the obligee (owner) from a performance default in the full contract amount and a separate payment bond will provide further protection for the full contract amount, a combined payment and performance bond will only afford protection up to the amount set forth in the bond, which is generally the contract amount. Thus, a combined payment and performance bond offers only half the protection that separate bonds provide. Obligees (owners and general contractors) are well served to obtain separate payment and performance bonds, each in the amount of 100% of the award contract.
Comment: Bonds are contracts and can be customized. The customization can work to the advantage or disadvantage of the obligee, and thus, the terms and conditions of each bond should be checked carefully. Simply “obtaining” a bond from a contractor or subcontractor may provide insufficient protection if the terms and conditions of that bond are narrow or afford little coverage. Another issue that commonly arises in today’s market is that, due to the consolidation of bonding companies, there are now only a few bonding companies responsible for most of the construction bonds in the United States. Smaller bonding companies offer what appear to be bonding services to contractors who may have difficulty obtaining surety credit from larger companies. Oftentimes, these smaller bonding companies end up providing bonds at high rates with little coverage in the event of a default. Thus, the financial wherewithal of the bonding company and the terms and conditions of the bond should always be reviewed as part of a diligent effort to ensure that the purchaser of the bonding services is obtaining the protection it seeks.
[i] Genesis 43:9
[ii] 2010 AIA Revisions to A312
[iii] 2010 AIA Revisions to A312