Building on a Promise: Construction Surety Bonds

Suretyship is the act of legally becoming liable to one party for the debt, default or failure to perform of another party. There are many types of surety bonds, including fiduciary bonds, court bonds, permit bonds, licence bonds and tax bonds. In this article, we look at construction contract bonds.

In technical terms, a surety bond is an agreement in which the obligor (the surety) guarantees fulfillment to the obligee of the principal’s obligation to perform the stated task. In construction, the contractor (usually a general or sub-contractor) is the principal, and the obligee is the beneficiary of the bonded obligation. The largest purchaser (beneficiary) of construction bonds is the federal government, although provincial and municipal governments also require bonds for major projects and private construction projects may require them as well. Large general contractors may require that their key sub-trades provide bonds to secure their sub-contracts.

Three types of bonds are common in construction projects: bid bonds, performance bonds and labour and material payment bonds.

Bid bonds

A bid is an offer to enter into a contract. A bid bond, submitted with the bid, is a joint promise of the principal (the bidder, who is primarily liable) and the surety (who is contingently liable) that the principal will enter into a formal contract. A default occurs if the principal fails to enter into the contract after the bid is accepted.

The most common causes of default are the following:

Bidder undergoes financial collapse after submitting the bid: In this case, the loss adjuster determines the validity of the bid and the acceptance by the obligee, and reviews any other bids that were made. If the bidding prices are close, the obligee can contract with the next lowest competent and comparable bidder, and the surety will settle the claim for the difference (within the specified bond limit).

Obligee causes delays in executing the contract: When delays occur, the principal may find it difficult to do the job at the original price quoted, especially if sub-contractors and material suppliers are facing cost increases. When hardships are clearly established, the principal and the surety may be relieved of any further obligation. A thorough investigation into the reasons for any delays must be conducted.

Bidder revokes the bid after finding a mistake in it: This is the most common reason to withdraw a bid or to refuse to enter into a contract. Preparing a bid is complex: large amounts of information are required and the bidder must rely on many sources not directly under its control. Generally, the bidder is not free to withdraw a bid after making a unilateral mistake and will not be relieved from the bid commitment when mistakes are the result of the estimator’s poor judgment or misinterpretation of the contract specifications. However, in some instances, the bidder may be relieved if there is an honest mistake of fact — such as addition or subtraction errors, typographical errors or transcription errors — that affects a material element of the agreement. To determine the nature of the mistake and assess liability, the loss adjuster should review the original tender specifications, the contract general conditions, the bidder’s working paper and the actual bid.

Performance bonds

The basic function of a performance bond is to guarantee to the obligee that the principal will perform as contemplated in the contract and that, in the event of a default, the obligee can claim relief under the bond.

In construction performance bonds, the contractor or sub-contractor (the principal) has the primary obligation to build the project. The obligee is the owner of the construction project or the general contractor. The surety and the principal are jointly and severally liable to the obligee for claims under the performance bond. The surety will be relieved of any duty to the owner if the contractor performs.

For an obligee to claim under the performance bond, the principal must be declared to be in default of the contract and must actually be proven to be in default, independently of the obligee’s assertions. The usual procedure is that the obligee declares the principal in default and makes a claim against the surety to force performance of the construction contract. Upon receiving a notice of loss, the surety should not be hasty in concluding that an actual default has occurred; a loss adjuster must thoroughly investigate the reasons behind the notice of default.

For example, if a contractor fails to perform on schedule, the owner can invoke a termination provision by providing details of the delay and giving notice of its intention to terminate the contract. But the contractor may have valid reasons for not continuing the work and therefore have grounds to refute the owner’s position.

When a default is alleged, the surety has a duty to investigate it promptly. Any delay could potentially increase the cost of completing the project, cause other financial loss exposures to the obligee, and result in allegations of improper claims handling and additional damages.

Labour and material payment bonds

A labour and material payment bond guarantees to an obligee that the principal will pay its sub-contractors and suppliers for labour and material used in the performance of the contract. This bond is purchased in addition to the performance bond.

Although the obligee is the specified beneficiary, the bond generally allows for defined classes of unnamed suppliers and sub-contractors to make claim directly to the surety. The principal need not be in default of its contract with the obligee to qualify the labour and material claim–a surety should investigate each and every claim, even if the principal is still engaged in the contract and default is not apparent.

Generally speaking, all forms of labour improving the construction project are claimable under the payment bond. The bond further provides coverage to those parties providing essential services and certain equipment rentals. However, capital purchases made by the principal are not covered.

Following the financial collapse of a major contractor, the surety will face a large number of labour and material claims. Given that each bonded project is a separate and distinct contract, parties must identify precisely which project or projects are involved. This is especially important when the bond is limited to 50 per cent of the contract value — labour and material claims can exceed bond limits, and bonds do not contain provisions with respect to priority or timeliness of payments. The surety has an obligation to determine, within reason, the full extent of the labour and material bond obligations on any project before making payment. In cases where the claims exceed the bond limit, an effort should be made to determine the full debt obligation and make settlement on a pro rata basis, if possible.

In the next issue of Claims Canada, Education Forum looks at some of the surety’s options for responding to a claim.

This article is based on excerpts from the study material in the Claims Professional Series of applied courses -a core of the CIP Program that helps adjusters learn the functional knowledge and skills required of their profession.

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Who’s Who in Construction Bonds

The principal = the contractor — the party that’s supposed to do the work

The obligee = the beneficiary under the bond — e.g., the owner of a building under construction

The obligor = the surety — the party that provides the guarantee

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