Under a construction contract, there is an Owner (project owner), Contractor, and Subcontractors. For the purposes of this article, the term “Obligee” refers to whoever has contracted with a lower tier party (Owner if contracted with Contractor or Contractor if contracted with a Sub). The term “Principal” refers to the lower tier party that provided the performance bond (Contractor if contracted with the Owner or Sub if contracted with the Contractor). The party that provided the bond is the surety.
The surety provides third-party assurance of the principal’s performance. The surety does not “assume” the primary obligation, but is secondarily liable. The principal remains primarily liable for performance of its contract. The obligee is protected by the bond against financial loss as a result of the principal’s default. The bond does not, however, guarantee that disputes will not arise between the obligee and the principal. If there is a legitimate dispute between the principal and obligee, the surety is not normally in a position to resolve it. That does not mean, however, that the surety will turn its back on a project dispute or disagreement. Disagreements can become disputes. Disputes can become breaches of contract. Breaches of contract can become defaults that justify termination of contracts.
Here are some reminders & tips when considering making that critical decision to default, terminate, and file a performance bond claim. However, please note that I am NOT an attorney, and one should seek legal counsel in contractual disputes and the performance bond claim process.
- Read your contract. Ensure that you are in compliance with your own contract terms, that the contractor/sub that you are in dispute with is indeed in formal breach of contract, and that you do indeed have grounds to default, terminate, and pursue a performance bond claim. Make absolutely sure you know what you’re getting into.
- Read the bond form. By accepting the bond in the first place, the bond form essentially becomes part of the contract and must be adhered. The bond form lays out the responsibilities of the surety and the procedures they will follow. Only upon conformance with these procedures will the surety perform. Important points/steps on typical bond form (AIA A312, for instance):
- If the Contractor performs, then the Surety & Contractor shall have no obligation under this bond. This may seem obvious, but we’ve seen cases where obligees expect the surety to be involved & to perform even when the contractor is still working under the contract and performing work. The contractor and the surety cannot both perform at the same time. The surety is secondarily responsible for performance.
- Obligee provides notice of consideration of default and requests a meeting. This is an important step where the disputing parties come together to discuss the project. This one provision in the bond form has probably saved the sureties millions of dollars, as it requires two parties (Obligee & Principal) to communicate and potentially work out or at least lighten their dispute.
- Obligee must declare a contractor/principal default and terminate the contract. This is perhaps the most crucial step in the surety’s performance. In a recent court case, Arch Ins. Co. v. The Graphic Builders LLC, a federal judge ruled that a GC could not make claim on a defaulting sub’s performance bond unless & until the GC formally terminated the defaulting sub.
- Obligee agrees to pay the contract balance to the surety.
- The surety has some options of proceeding with their performance. These include:
- A “tender offer,” where the surety will provide a replacement contractor and the obligee will deal directly with the new contractor.
- A “take over,” where the surety will take over the project and hire the replacement contractor & any other professionals directly
- Or, if the surety believes the obligee is unjustified in their termination in the first place, the surety may deny the claim altogether.The surety must be very sure of their position in selecting this response.
Overall, a performance bond claim is a serious matter as part of a contract dispute, and any party that commences with the claim process should be prepared for what they’re getting into. No one ultimately wants a bond claim to occur, and theoretically they should never happen, as the parties that enter into the contract should perform their respective obligations in the first place. But this does not always happen, which is why there is a place & purpose for bonds.
This article was written by Ben Dycus.
Ben has been with Houchens Insurance Group since 2008, when he started as an intern in our Lexington office. He became the Lexington surety department’s sales leader in 2012 and continues in this role today. He works with clients in various industries & situations where bonds may be needed, primarily in the construction industry. He understands the importance of the surety relationship in establishing, maintaining, and growing surety programs and accommodating individual bonds needs with the utmost efficiency, effectiveness, and proactiveness, supporting his clients and freeing them up to optimally pursue their business & personal goals.
