Contractors often believe the risks included in performance bonds fall solely on surety companies. However, the interests of the contractor and the surety are aligned, because whatever the contractor is obligated to by way of the contract, so is the surety through the performance bond form. Conversely, by indemnifying the surety against loss, the contractor is on the hook for whatever the surety guarantees through the performance bond form. Thus, it is beneficial for contractors to know some of the basic provisions that can add risk to a performance bond form. While the contractor may rely on their agent and surety to review the bond forms and advise them of these risks, it is helpful for the contractor to have a basic understanding in order to facilitate communication and potentially aid in negotiating different terms with the owner or general contractor.
Timeframe for the Surety Company to Perform
When a surety company receives a claim from a project owner or general contractor, called the obligee, the obligee generally wants the surety to remedy the issue immediately in order to continue progress on the project. While this is understandable, the surety has an obligation to their contractor that they provided the bond on behalf of, called the principal, to investigate the claim before taking any action. This means that they will contact the principal to get their side of the story to compare it to the claim made by the obligee and the obligations under the contract.
In an effort to try to expedite the timeframe in which sureties have to take action, obligees sometimes include language in the bond form that requires them to perform under the bond within a very short and unrealistic time period such as 10 days for example. As you can imagine, unraveling a complex dispute between multiple parties, arranging for consultants, and possibly examining the project site can take time. When a surety is forced to draw a premature conclusion based on limited and incomplete information, it creates a significant risk of making the wrong decision. The liability for that poor decision eventually will fall on the principal by way of the indemnification agreement signed with the surety.
Therefore, ensuring that bond form language allows sufficient time for the parties involved is paramount, and a more standard and reasonable timeframe is 30 to 45 days to allow a surety to do a complete investigation.
Options for the Surety to Perform
Performance bond forms often state the options sureties have in the event the principal is defaulted by the obligee. For example, the ConsensusDoc 206 includes the following:
- Complete the Work, with the consent of Owner, through Constructor;
- Enter into a takeover agreement with the Owner to undertake Contract Work completion;
- Arrange for the completion of the Work by a contractor acceptable to Owner and secured by performance and payment bonds equivalent to those for the Contract issued by a qualified surety. Surety shall make available as the Work progresses sufficient funds to pay the cost of completion of the Work less the Contract Balance up to the Bond Sum; or
- Waive its right to complete the Work and reimburse Owner the amount of its reasonable costs, not to exceed the Bond Sum, to complete the Work less the Contract Balance.
Some bond forms will specifically exclude option number one allowing the surety company to use the principal to complete the work. This option can be extremely important for both the surety and the principal, because no other contractor will know the job better and hiring a new contractor will often cost much more given the many unknowns they are walking into.
Any limitations of these options create additional risk for the surety and principal.
Automatic Increases in the Performance Bond Penalty
Change orders are inherent in the construction industry, so it is not uncommon for the final contract price to be higher than the original amount. For this reason, many obligees have started to include language that automatically increases the performance bond amount in lockstep with change orders that are issued to the contract. The problem this creates is sometimes projects can have such significant changes that they turn into something that was unexpected by any of the parties involved including the obligee, principal, or the surety. When a project doubles in size, for example, there is certainly a reasonable argument that it wasn’t what was intended from the outset by the contractor or the surety company. In these situations, it is helpful to have language that requires the obligee to get a specific written consent from the surety company in order to increase the performance bond amount.
The best practice is for a bond form to include language requiring a surety’s consent to increase the bond amount over a certain percentage of the original contract such as 25%
Contractors don’t always have the discretion about which performance bond forms to use. However, when it is possible, using a performance bond form that addresses the risks outlined, it can help avoid making a bad problem even worse.
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