Contractor and Surety: Till Death Do Us Part

July 7, 2008 — 1,498 views  

The well-publicized contraction of the surety market, resulting from aggressive surety underwriting in the late 1990s, the general economic dip in the early 2000s and the post-9/11 insurance industry crunch, has refocused industry attention on surety bonds, principally because bonds are increasingly difficult to procure.

While most participants in the construction industry have some experience with bonds, there is widespread confusion, even among the most experienced players, regarding the types of bonds that are available, how bonds and sureties function, the remarkable power contractors give to sureties (often unknowingly), and about the differences between insurance and surety bonds.

A frequently overlooked aspect of a contractor’s relationship with its surety company is the General Agreement of Indemnity (GAI) — overlooked that is, until the bond is called on and the surety starts dipping into the contractor’s corporate assets, and possibly the personal assets of the owners and their families, to recoup losses. Only then do contractors get a crash course on the commitments that they have made, and learn that there is no divorcing their surety.

While the particulars of how bonds, GAIs and contractors’ relationships with their bonding companies will vary from state to state, from bond form to bond form and from GAI to GAI, some general principles apply fairly uniformly across the board. This article will give those unfamiliar with bonding a general overview of basic bonding principles — with a special emphasis on the broad rights and powers that contractors frequently give to their sureties through the GAI: the bonding prenuptial agreement.

Bonds — What They Are and Why You Need Them

Construction projects are high-risk endeavors. They are complex projects, unique from one to the next, performed by competitive bidders motivated to cut their risk-reward ratio very close in order to secure the contract. Sophisticated owners know that a contractor’s performance can be affected by a wide variety of factors, only some of which are truly within the contractor’s control. The owner, too, shares in this risk. If its contractor fails to perform, an owner is exposed to increased costs of completion, costs of delayed completion, potential breaches of its commitments to lenders, investors and customers, costs of renting cover facilities, and/or lost rents and profits from the uncompleted project. Additionally, when a contractor defaults, an owner must now go to the marketplace and hire a replacement contractor, often under critical time constraints that preclude the full economic benefit of competitive bidding. The owner also bears the risk that liens will be filed against its project by unpaid subcontractors and suppliers. These liens may expose the owner to liability for payment and their clouding the owner’s title may be a breach of the owner’s obligations to its lenders.

Most public and many private owners seek to transfer these inherent risks to a surety, by requiring their contractors to post the most frequently encountered bonds — performance and payment bonds. Performance bonds are a surety’s guaranty that it will stand behind a contractor’s obligations to perform under its contract; payment bonds are a surety’s guaranty that a contractor will honor its obligations to pay its subcontractors and suppliers. They are routinely procured

simultaneously for one premium, typically between 1 and 3 percent of the “penal sum,” the maximum value of the surety’s guarantee (absent extraordinary circumstances), usually equal to the value of the bonded contract.

Thus, the short answer to why contractors need to post bonds is simply that many owners, public and private, absolutely require them.

Dispelling the Primary Misconception — Surety Bonds Are Not Insurance Policies

Because most surety bonds are issued by insurance companies (since they have the sufficient financial wherewithal to make owners comfortable that they can back up a promise with cash), bonds are often confused with insurance products. Bonds are not insurance; on the contrary, they are additional risks that contractors take on. They are not risk management tools for the bonded contractor — they are risk management tools for the owner.

An example will illustrate the difference. A liability insurance carrier

normally does not look to its insured for repayment if the insurer has to pay out on a claim. Thus, if a contractor is sued due to a job site personal injury and its insurer settles the claim, the contractor’s commercial general liability carrier does not seek reimbursement from the contractor for the loss.

The same is not true for a bond loss. The bonded contractor did not pay the bond premium to protect itself from the risk that it would default on its contract obligations. As discussed above, the contractor procured the bond to meet the owner’s requirement that the contractor provide the owner with additional security that the contractor would honor its contractual performance and payment obligations. Thus, if the surety has to step up and make good on its promise to back up a contractor’s bonded performance or payment obligations, the surety is going to seek to recover from the contractor every penny that the surety incurs in meeting the contractor’s obligations. Thus, posting a surety bond is similar to posting a bank letter of credit — it is not insurance that protects a contractor from its own defaults.

Moreover, if the contractor does not have the funds, the surety is likely going to look to the contractor’s principals personally — to their personal bank accounts, to their personal investments, possibly even to the equity in their homes.

Your Prenuptial Agreement —the GAI

Unless a construction company is among the biggest and best capitalized, a surety will not issue bonds on the company’s behalf unless the surety receives indemnity agreements from the company itself, its principals and possibly other indemnitors, such as principals spouses (collectively, the Indemnitors), with enough collective assets to satisfy the surety that if it has to pay out on the bonds, it will be able to recoup its losses. It cannot be overemphasized that the surety’s perspective on its bonds is that they should be risk-free to the surety — the surety should, in theory, never lose money when it writes a bond. In the ideal world of suretyship, it should collect its premium and have enough protection from the Indemnitors and that it should be able to recoup whatever it expends in meeting its bond obligations. The surety bond market contraction is, at least in part, a product of sureties’ lack of vigilance in these underwriting procedures and the resulting unreimbursed, sometimes catastrophic, losses.

While there are a variety of similar common law (noncontract-based) rights that a surety may have to recover its losses even without a GAI, sureties routinely have the Indemnitors sign a very broad GAI, which gives the surety even greater powers. Normally, a blanket GAI is signed at the outset of a contractor’s relationship with a bonding company, which will apply to all bonds thereafter issued.

While GAI forms vary, they typically give the surety the following rights: (1) the right to seek complete indemnification from the Indemnitors for all costs,

damages and expenses that the surety may incur as a result of a bond claim; (2) the right to demand that the contractor and/or the Indemnitors pay claims against the bond in the first instance, so the surety does not have to; (3) the ability to demand that the Indemnitors post a cash collateral “reserve” to ensure that if the surety is required to pay a bond claim, it has the Indemnitors’ cash on hand to make itself whole and will not have to chase down the Indemnitors after the fact; (4) the right to settle bond claims in its sole discretion and to seek

indemnity from the Indemnitors even if the Indemnitors disputed the claim against the bond and/or dispute the manner in which the surety settled the claim; (5) the ability to demand financial information from the Indemnitors, to examine their books and records, and to request financial information from the Indemnitors’ banks, credit agencies, etc.; and (6) the right to refuse to issue any additional bonds at any time.

GAIs also give sureties the ability to take over bonded projects if the surety determines that doing so would either avoid a default or mitigate the damages from a default. The GAI usually has provisions that give the surety the rights (but not the obligations): (1) to take over the contractor’s bonded contract using the contractor’s resources; (2) to negotiate settlements with the owner; (3) to agree to changes in the contract with the owner; (4) to make loans or advances to the contractor or others for what the surety judges to be the benefit of the bonded contract; and (5) to require that all funds due to the contractor on a bonded contract be paid to the surety instead of the contractor.

And, of course, the surety will seek to have all costs it incurs reimbursed by the Indemnitors — this is a primary point of tension between sureties and their contractor customers.

Peckar & Abramson, P.C.