Remedies and Recovery:

In the last issue of Claims Canada, Education Forum reviewed basic principles of surety and discussed three kinds of construction contract bonds: bid bonds, performance bonds, and labour and material payment bonds. In this issue, we look at some of the surety’s options for responding to a claim.

Unlike insurance contracts, where underwriters expect losses, suretyship is premised on the theory that no losses will be incurred. If a default occurs, the surety expects to recover any payments made from the principal, from other indemnitors, or through other forms of security. The surety has remedies both before and after it has paid a loss.

Before paying: remedy, completion, retendering

When the principal is in default under a performance bond, the bond specifies the surety’s options for discharging the obligation:

• remedy the default

• complete the contract

• retender the contract and arrange for a new contractor to complete the work remaining

Remedying the default: If the contractor is competent and the default is caused by lack of capital, the surety can finance the contractor to complete the contract. This has the advantage of maintaining job momentum and avoiding the costs of a shutdown.

Although the amounts advanced are labelled loans, they are almost always a permanent loss to the surety. The funds loaned to the principal do not automatically reduce the penal sum of the bond, so the surety risks incurring higher total costs on the claim than the penal limit of the bond. To avoid this, the surety may ask the obligee to execute a completion agreement in which the financing reduces the penal sum of the bond.

The surety must have the complete cooperation of the principal, must have absolute confidence in the character of the principal and its management staff, and must be convinced that the arguments in favour of financing outweigh the potential disadvantages.

Completing the contract: If the work is so close to completion that it would be awkward to award the job to another contractor, and if financing the contractor is not practical, the surety may choose to hire its own consultants or contractors to complete the defaulted project. Setting a definitive cost of completion can be difficult, but efforts must be made to eliminate substantial overruns and unnecessary financial surprises. Steps should also be taken to limit the surety’s liability to the penal sum of the bond — a takeover agreement may be executed in which the obligee acknowledges that the bond limit will apply. Even so, the surety may be liable for warranty obligations that extend past the completion of the physical construction.

Re-tendering the contract: In this alternative, the surety retenders the project, obtains another contractor to complete the work, and then has the new contractor enter into a direct contractual relationship with the owner (obligee) to complete the work. The surety seeks the same types of bonds from the new contractor as were part of the original construction contract. The surety reimburses the obligee the difference between the remaining contract funds and the cost of completing the work using the new contractor. This option is preferred in many contract defaults because it establishes a specified loss amount prior to completion of the contract. However, government performance bonds often forbid re-tendering; the government cannot contract with a replacement contractor without violating the various statutes governing the public bidding process.

Buying the bond back

Buying the bond back is an extra-contractual alternative; it is not a specified option in the performance bond. Where the obligee is able to complete the construction project itself, the surety may negotiate a settlement and pay a sum of money in exchange for the obligee surrendering the performance bond. This cash buyout alternative can be suggested at any time in the adjustment process.

After paying: salvage

The surety’s rights to recover losses after payment are referred to collectively as salvage. Salvage includes the surety’s right to contractual indemnity and subrogation, as well as its common law and statutory rights against its principal, indemnitors and their bankruptcy estates, if applicable. Subrogation is generally limited to the surety’s efforts to recover from third parties responsible for, or contributing to, the surety’s losses.

To fulfill its primary obligation to the obligee, the surety must consider its various salvage prospects, rights of indemnity and subrogation, and any other avenues of recovery when determining the best means of responding to a surety loss. The consideration of salvage is an important part of the overall strategy in investigating, adjusting and resolving all bond claims.

Indemnity: Most surety bonds are backed by an indemnity agreement (a side contract) executed by the principal and by other related companies and individuals. This is known as contractual indemnity. The agreement provides separate rights to the surety to have property assigned or transferred to it, to have loss payments reimbursed, or to recover funds to relieve a default directly.

As soon as a surety has notice of a potential claim, all indemnitors should be notified in writing of their financial exposure to the surety. This often galvanizes indemnitors to respond to the default or potential default directly, although the surety should still monitor the situation to ensure that bond obligations to the obligees are carried out diligently.

Sometimes indemnitors are unwilling to cooperate; they may defend against the surety’s claim for indemnification on the basis that the surety either paid too much or went beyond the principal’s responsibility. For an indemnitor to succeed in this line of defence, it must prove that the surety’s actions showed a lack of good business judgment and a lack of good faith. Some indemnity agreements permit the surety to pursue the indemnitors immediately upon posting a claim reserve, and this can be an effective strategy against a hostile indemnitor.

The highest return on an indemnity agreement is usually realized at the first report of a loss. This is an important consideration when the surety is considering options for discharging obligations under the bond.

Subrogation: Through subrogation, the surety can advance claims against implicated third parties such as the obligee’s engineers, architects and other sub-trades not necessarily contracted to the principal. Quite apart from the construction project itself, claims can also be advanced against other professionals upon whom the surety relied: for example, insurance brokers and chartered accountants.

Indemnity agreements and subrogation are the cornerstones of suretyship: they ensure that the principal remains primarily obligated in the event of a claim. They also provide incentives to keep costs to a minimum.

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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In a performance default situation, the surety’s choice of whether to remedy, complete or retender may depend on factors such as

• how much work remains to be done

• the quality of the work completed by the principal

• the potential for additional claims or delay penalties

• the funds available

• the financial involvement of the indemnitors

• the cooperation of the principal and the obligee