Performance Bond Claims are not fun for anybody. It is my hope that no contactor ever goes through this experience. Fortunately, performance bond claims are rare, but they do happen. Below are the important things to understand during a performance bond claims including a couple of tips on how to avoid them.
What Is A Performance Bond Claim?
First, we need to understand that performance bonds guarantee that a project will be completed according to the contract. You can find more information on performance bonds here and here. Surety Bond underwriters would not write a performance bond if they did not believe the contractor (Bond Principal) could complete the project. Similarly, a contractor would not enter into a contract and put up a performance bond unless they believed they could finish it successfully. However, a performance bond claim is just that. It is a situation where the contractor either voluntarily admits that they cannot complete the contract or an Obligee (owner or upstream contractor) believes the contractor cannot finish the work.
Review the Contract and Bond Form
The first step for both the contractor and the Obligee, should be to review the contract and the bond form. The contract and bond form will outline the events that need to occur for a valid performance bond claim. The bond form will also say who can make a claim against the bond. Most performance bonds are written to one obligee. This obligee is usually the project owner or an upstream contractor. However, some bond forms do include a Dual Obligee Rider. This adds another obligee to the bond and therefore another party that can make a claim. Performance bonds with a dual oblgiee are usually put in place to protect a lender on a private project.
Most contracts and bond forms require that the Obligee give the contractor notice of “Default” before making a claim on the performance bond. In most circumstances, the contractor has a period to “cure” this default. Be advised that the current trend is moving towards a very short or almost impossible cure period such as “Two Calendar Days”. Again, the bond form is important and many Obligees have crafted their own forms. Some bond forms require a meeting between the Obligee, Principal and Surety before a claim can be made against the bond. This gives the Surety and the Principal an opportunity to correct the situation. Most contracts do require a termination for a bond claim to proceed. Until a formal termination occurs, the Principal is still responsible for the contract. As discussed, each contract and bond form can be unique, but most require four common elements for a valid performance bond claim:
- The Principal has breached the contract.
- The Obligee has declared the Principal to be in default and that default is un-curable.
- The Obligee has performed their obligations under the contract including payments.
- The Obligee has terminated the Principal under the contract.
Once these steps have taken place, the bond company is usually in a difficult position. They must investigate the claim fairly. They must take precautions to accurately determine if a legitimate default and termination has taken place. If they proceed with an invalid claim, the Principal and indemnitors may have a valid defense to not indemnify the surety bond company for those costs. This is one complaint that Obligees have against performance bonds. They believe it takes too long to pay a valid claim and has given rise to competing products such as subcontractor default insurance. Other comparisons between surety bonds and subcontractor default insurance can be found here.
Investigating a Performance Bond Claim
Once a surety bond company receives a bond claim from an Obligee on the bond, they must investigate to see if the claim has merit. This includes reviewing the contract, bond forms, laws and statutes and gather information from the contractor (Principal). This is often a time-consuming process for the Principal and many contractors push back against gathering this information for the surety. However, the General Indemnity Agreement the contractor signed to get bonds, gives the surety bond company access to the contractor’s files and records. Any push back only slows down the process. The contractor should expect to have frequent contact with the surety’s claim staff throughout the process. Surety bond companies are not contractors. Often, they will get third party consultants involved to help in this process.
What Could Be Covered Under a Performance Bond Claim?
As we discussed, performance bonds guarantee the performance of a contract. Many different items go into a contractor completing this obligation. Typically, the surety will be responsible for the following during a performance bond claim:
• The costs to complete the unfinished portion of the contract.
• Any delay damages that the Principal would be liable for under the contract such as liquidated damages.
• Payroll taxes on Federal projects
• Lender and interest costs (if there is a Dual Obligee Rider)
Keep in mind that this is for performance bond claims. Performance bonds are often written along with a payment bond and other claims could have coverage under that bond.
What Are Defenses to a Performance Bond Claim?
A surety bond company gets to “step into Principal’s shoes”. That means they do have valid defenses against claims in these scenarios:
- The Obligee has not performed under the contract including payment.
- The Obligee released the Principal of their obligations.
- The Obligee’s premature release of retainage or other security.
- Material alterations in the contract.
- The Penal Sum
The Penal Sum Defense
The Penal Sum is the amount of the performance bond. Normally performance bonds are written for 100% of the contract value. The Penal Sum is an absolute defense for surety bond companies on a performance bond, although there are options that can jeopardize that defense which are discussed below. For example, a surety writes a contractor for their Principal in the amount of $5 million. Halfway through the project, it is discovered that the Principal made a mistake in their estimating. Between remaining costs and delay damages, the Obligee submits a performance bond claim for $7 million. The Penal Sum of the bond is $5 million, and the surety can refuse to pay anything over this amount.
Depending on the circumstances, the surety could be released of all liability or only the liability that relates to the damage of each defense.
The Surety’s Claim Options
Once the surety has investigated the claim, they must decide the best course of action. Some bond forms and contracts spell out which option they must take bust most leave are silent and give the surety one of these options:
- Tendering a New Contractor
- Financing the Principal
- Obligee Completion (Do Nothing Approach)
We will discuss each of these in more detail.
Tendering a New Contractor
Tendering a new contractor involves a surety company finding a completion contractor to take over the remaining portion of the work. The surety negotiates a new contract along with the price and terms. Then the surety tenders the completion contractor and new contract to the obligee for approval to complete the project. Usually the new completion contractor gives the obligee new performance and payment bonds for the new contract as well.
Advantages of Tendering a New Contractor:
- The Surety Knows their Liability on the Project – Additional costs are the responsibility of the new completion contractor.
- Protects the Surety’s Rights Against Obligee – If the surety believes the Principal was improperly terminated, they can tender a completion contractor and protect their rights against excess cost of completion.
- .The Surety Assumes no New Third Party Liability
- The Surety Protects their Penal Sum Defense – This is very important to the surety.
- Not The Contractor Of Record – The surety does not have to act as contractor and manage the project.
Disadvantage of Tender:
- More Expensive Than Financing – Financing the Principal is usually cheaper.
- Principal Cannot Complete the Work – Normally, the surety cannot tender the Principal to finish the work. The surety will have to pick a different option if they want the Principal to complete the project
Tendering a New Contractor is the most common way surety bond companies handle performance bond claims.
Financing a Principal
Financing the Principal is exactly what it sounds like. The surety company supports the contractor to cure their default on the project and keep them from being terminated. This support can be direct, such as lending the Principal money, or it can be indirect such as guaranteeing bank loans or even in the form of extending more surety credit despite the default. For the surety to finance a Principal, a surety must absolutely believe that the Principal is a very capable company that can turn things around. Normally, this occurs when the surety has exposure on multiple bonded projects and only one is having an issue. There are advantages and disadvantages to the surety for financing a Principal. These include the following:
Advantages of Financing a Principal:
- New Contractor Learning Curve – If a new contractor is brought it to complete the project, it will take time to determine where the Principal left off. They may even have to deconstruct parts of the project. This creates additional expense to the surety.
- New Contractor Markup and Profit – Taking over work for other contractors is risky. Most contractors performing this work do so at a premium to protect themselves. Again, this drives up the cost to the surety.
- Subcontractors and Suppliers Cannot Renegotiate – When a new contractor is brought in, subcontractors and suppliers can renegotiate their contracts. They will certainly do so at an increased cost. By financing the Principal, these subcontractors and suppliers remain under their original contracts.
- Mobilization – A new contractor will have to mobilize. Depending on the project, these costs can be significant. There could also be some significant de-mobilization costs associated with the Principal and the surety could be liable for these costs. Financing the Principal eliminates these costs.
Disadvantages of Financing a Principal:
- The Principals estimates of remaining costs may be inaccurate – When making the decision to finance a contractor, the surety is relying on both the Principal and maybe consultants to make an estimate of remaining costs to complete the project. However, many factors could make these estimates incorrect and the surety could have significantly more costs to complete the project. On the other hand, hiring a new contractor is often at a fixed price and the surety will know exactly what their liability will be.
- The Surety May Have to Cover Unbonded Costs – Often, to keep the Principal going, the surety may have to help with overhead on unbonded projects to keep the contractor in business. This could significantly increase their expense and exposure.
- Insolvency – By the time a performance bond claim plays out, the Principal may be insolvent. There may be little motivation to complete the project and/or repay the surety.
- Financing Does Not Decrease the Penal Sum on the bond – Any money that is lent to the Principal does not decrease the surety’s exposure on the bond.
Throughout the years, I have had numerous contractors seek to have the surety finance them when they have a problem. I strongly encourage contractors to avoid this at all costs. In almost all these situations, the contractor was in trouble and felt like the surety would lend them money to get through it. The thinking is that surety has so much exposure that it would make sense to help the contractor through a rough time. Unfortunately, that is not the case. Surety Bond companies are not banks, and they are not contractors. Most surety bond companies are set up so that once a claim is filed, your broker and your underwriter are mostly removed from the process. The claim is usually handled by attorneys and they make business decisions. Although contractors always believe the best decision is to finance them, that is almost never the case in the surety’s view. Here is an example of why that may be the case.
Assume that a General Contractor performing Federal work does $50 million in annual revenue which is all bonded. They make 5% gross margin on their projects and a 2% net profit. Therefore, the need to do $50 million in revenue to make a net $1 million. Now let us assume that they have a performance bond claim on $5 million project. The project is 80% complete so they have $1 million left to complete (assumes the profit is gone). If all the other projects are performing well, a contractor may look at this situation and assume that it makes sense for surety to finance the $1 million. The surety will likely see that their exposure is $1 million, pay the claim and move on. This is because financing the contractor comes with so many unknown risks. Even in the best-case scenario, the surety likely must support another $50 million in bonded work for the contractor just to get paid back. If any problems arise on any of those projects, the liability will be far more than the $1 million they had in hand. This is an oversimplified example but should illustrate the point of why sureties almost never finance the contractor.
For this reason, financing contractors is very rare. Contractors would be wise to seek out all other lending solutions before asking the surety to finance them. With SBA backed loans, peer to peer lending, receivable financing and equipment loans, there are many places to look for lending before even considering these options. Although these may have high rates or tough terms, the contractor has a chance with continuing operations. My experience is that the surety companies will usually not finance the contractor and likely put them out of business.
Another option available to the surety is takeover. In a performance bond takeover, the surety “steps into the shoes” of the Principal. By doing so, they surety abandons its rights as surety, however. The surety selects a completion contractor and subcontracts the work to them. The surety collects progress payments from the Obligee and pays the completion contractor. In this process the surety can monitor the cash and at to it from their own funds, as necessary. The General Indemnity Agreement signed with the Principal normally gives the surety the right to use the Principal’s equipment, inventory and other assets to complete the project.
Advantages of Takeover:
- The surety can select the completion contractor – This can include the Principal
- Bonding to Surety – The surety can get the completion contractor to provide performance and payment bonds to the surety which reduces their risk.
Disadvantages of Takeover:
- Lost Penal Sum Defense – By stepping into the contractor’s shoes, the surety becomes responsible for completing the project and cannot use the bond penalty as a defense. This opens them up to significant liability.
- Third Party Liability – By taking over the project, the surety opens themselves to third party liability claims. Sureties will be especially careful when the project involves high risk or guarantees.
- Third Party Costs – Sureties are not contractors and will likely have additional costs for administrating the project.
Takeover is the most preferred method of handling performance bond claims by most obligees. Some bond forms specifically require it. However, takeover is the least preferred option by most sureties as it opens them up to significant unforeseen risks and costs.
Obligee Completion (Do Nothing Approach)
Obligee Completion is often referred to as “The Do-Nothing Approach”. The surety chooses to let the Obligee complete the project. There are valid reasons why a surety may do this. They may feel that the Principal has credible defense to the default such as nonpayment by the Obligee. They could also choose this option if the uncompleted portion of work and damages were close to or exceeding the penal sum of the bond.
Advantages of Obligee Completion:
- The Surety preserves its rights under the bond.
- The Surety Incurs No Third-Party Liability
- No Third-Party Administrative Costs
Disadvantages of Obligee Completion:
- The Surety Has No Control Over Work Completion – They do not get to select a completion contractor or negotiate the terms and costs.
- Delay Damages – By doing nothing, the surety could significantly increase the delay damages claimed on the project.
Subrogation Rights and Performance Bond Claims
Contractors involved in a performance bond claim should be aware of the surety’s subrogation rights. When a surety gets involved to resolve a performance bond claim, they also get the right of subrogation against the Principal. That means they get to take over the contractual benefits of the Obligee, suppliers and other that they have made whole. Normally sureties use this to get access to contract proceeds. This often plays out against lenders when a contractor gets into financial trouble. Lenders and sureties routinely fight over access to a contractor’s assets such as receivables. However, case law has routinely sided with the surety in these situations. This holds true against other parties as well such as bankruptcy trustees.
The General Indemnity Agreement
Performance Bonds are written on the Principal of Indemnity. That means that if a contractor has a performance bond claim, the surety will seek reimbursement for all costs associated with investigating the claim and paying or completing the project. These obligations are spelled out in the General Indemnity Agreement (GIA) that contractors sign before they can get performance bonds. Its very important to review this document when you are involved in a performance bond claim. You can read more about this here. The GIA outlines your responsibilities to the bond company. There are usually requirements to cooperate and provide timely information. The GIA will also spell out who is an indemnitor on the bond. The construction company will always be an indemnitor. There could also be related companies, unrelated companies, owners and their spouses or even third-party indemnitors. Generally, these indemnitors are joint and several which means the surety can seek reimbursement from any or all of them. Additionally, the GIA usually has a collateral provision that requires indemnitors to post collateral in favor of the surety if a claim arises. Getting the advice of a good attorney is a good idea when you are involved in a performance bond claim. Be careful though. Very few have a specialty in surety bond claims, and you want to be working with somebody experienced in this field.
Avoiding Performance Bond Claims
Performance bond claims often take contractor out of business and should be avoided at all costs. Below are the two causes of performance bond claims that I have seen frequently throughout my career:
Poor Internal Controls
If there were one piece of advice that I would give all contractors, it would be to upgrade their internal systems. Most contractors think their systems are good and most are wrong. Construction is a very risky, cash intensive business. There is typically not any room for mistakes. At any point, contractors should be able to pull an accurate report on their cash, financial position, job costs, etc. Companies that cannot do this often will not discover a problem until its too late. Bad jobs tend to get worse very quickly.
A second part of internal controls is checks and balances in your estimating department. Make sure projects over a certain dollar amount are checked and rechecked by more than one person. It only takes one bad estimate to put you into bond claim and maybe out of business.
Subcontractors are the single biggest risk most contractors have on any given projects. However, many contractors do not want to protect themselves by getting subcontract bonds or other means that will protect them. They feel the extra cost will make them not competitive. The fact is that subcontractor problems create huge costs and lost profits. It does not take many going poorly before a contractor will have problems of its own.
By having better practices for just these items, contractors can significantly reduce their chances of ever getting into a performance bond claim.
It is our hope that no contractor has a performance bond claim. We ask our clients to contact us early when there are signs of trouble so that we can provide guidance and assistance before it gets to the point of being a claim. Knowing more about the process should help all contractors avoid performance bond claims. At MG Surety Bond, we are bond experts and happy to help or provide consulting to any contractors, anytime.