Construction Bonds: Common Mistakes and Misconceptions

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March 16, 2008

Just about every government-funded construction project involves statutorily-mandated performance and payment bonds. Many large-scale privately-funded construction projects also involve performance and payment bonds required by lenders to protect their loan or by the owner as a means to control risk. Here are the most common mistakes and misconceptions we have seen as to bonds and bond claims and our advice on how to avoid them.

  1. If the owner wants performance and payment bonds on a private project, the bid documents should require the bidding contractors to submit bid bonds by which a surety pledges it will bond the contractor if it is awarded the contract. We have seen a number of cases where bid bonds were not required, the contract was signed, but the contractor with the low bid could not obtain a bond. Predictably, the owner liked the price, the contract was signed, the contractor later defaulted and went out of business and the owner bore the loss.
  2. If a default occurs, the terms of the bond should be followed precisely without deviation. Notice letters to the surety should be sent by certified mail and the language of the notice letters should cite to specific terms of the bond and recite the precise verbiage of the terms. The letter must declare a default.  Failure to follow these rules may lead to litigation.
  3. Owner clients often ask us when, on a troubled project, it should put the performance bond surety on notice of contractor problems. The answer is that, absent other considerations, if you are asking the question, it is probably an appropriate time to notify the surety. Keep in mind, however, that, although a surety may commence to investigate the issues raised, which may cause the contractor to address the issues, it is unlikely that the surety will become actively involved in the project until the owner declares a formal default pursuant to the terms of the performance bond. By and large, putting the surety on early notice of problems, short of declaring a default, does not harm and may, in fact, help.
  4. Although you may have followed the terms of the bond in making a claim, do not forget that, if the surety fails to act, you may need to file a lawsuit in order to obtain the protections of the bond and put the surety’s money in play. We raise this because, in many states, there is a short statute of limitations on actions on bonds. For example, in Pennsylvania, an action on a bond must be filed within one year. In addition, many bonds may have limitation of action provisions which require that a lawsuit be brought within a specific period of time. This period likely trumps the period set forth in any statute. We have seen a number of owners and contractors forfeit valid claims, particularly on payment bonds, for failure to file a lawsuit within either the contracted or statutory period.
  5. Upon a declaration of a default on a performance bond, the surety accedes to all the defenses of the contractor and has its own independent defenses. Remember that the surety is entitled to the use of the collateral - the contract balance - to complete the job and the owner must be careful not to pay out excess contract funds at, or prior to, the time of contractor’s default such that it would impair the surety’s ability to remedy the default by use of the contract balance. That is why a timely notice of default is critical.
  6. Performance bonds compel the surety, upon default, to perform the terms of the underlying contract. Many owners, we have found, do not realize that performance of the underlying contract normally includes post-completion obligations, including compliance with warranty requirements (in the absence of a separate warranty bond) or requirements to pay subcontractors and suppliers. If the contractor shirks its warranty obligations or fails to pay subcontractors and suppliers, owners may be able to declare a default under the performance bond and compel the surety to perform.
  7. When a contractor defaults and the performance bond is called, the surety has several options, including to pay out the penal sum to the owner, have the owner hire a replacement contractor and to simply pay the difference to complete the work beyond the available contract balance, or to take over the project and bring on board a replacement contractor, using the contract balance to pay for the work while making up for any shortfall with its own funds. Many owners do not realize that, with this last option, the surety generally has the right to hire back the defaulted contractor, or its key personnel, in order to complete the project.

Performance and payment bonds play an important role in managing risk on construction projects. In order to gain the protection of such bonds, however, care must be taken to do so properly and to understand both the benefits and consequences.

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