Chapter 17 Construction Bonds Vanessa S. Werden

What is a bond? A bond is a special form of contract whereby one party guarantees the performance by another party of certain obligations. A bond is a contract, and as such, is interpreted according to the rules of contract law. KEY DISTINCTIONS: Must be in writing and must be the original to be enforceable. A bond may also be referred to as a “contract of suretyship”. Who are the parties to the contract?  the principal, the surety and the obligee

Who makes the promise?  the surety What does the surety promise?  that the principal will perform its obligations Who does the surety make the promise to?  the obligee – because the obligations are owed to the obligee

Three types of bonds are normally used on construction projects: 1. Bid bonds 2. Performance bonds 3. Payment bonds In the context of construction projects, the principal is usually the contractor and the obligee is the project owner. The purpose of a bond is to provide some protection to the obligee, due to the risks inherent in the industry. If the principal fails to perform, the obligee can look to the surety to compensate for the loss or damage caused by the principal.

Surety The surety guarantees the performance of another party. Example 1: The surety guarantees the performance of a contractor for the benefit of the owner of a project. Examples 2: The surety guarantees the performance of a subcontractor for the benefit of a contractor. Principal The principal pays the surety a fee/premium, and in exchange, the surety accepts the obligations to guarantee the performance of the principal. Roles & Responsibilities

How is a bond created? Two separate agreements are made when a bond is issued: 1. Principal & Obligee The principal enters into a contract with the obligee. For example, a contractor enters into a contract with an owner to renovate a building by June Principal & Surety The principal pays a premium to the surety, and in exchange, the surety guarantees performance by the principal. For example, a bonding company issues a bond for the contractor’s obligations as set out in its contract with the owner.

Indemnities & Other Surety Recourses Where a surety has paid out money to satisfy the principal’s obligations, it is subrogated to the rights of the obligee. Subrogation allows the party who pays for a loss suffered by another party to assume the rights of that other party for the purpose of recovering that loss from a third party.  The contractor fails to perform its obligations under its contract with the owner.  As a result, the owner suffers a loss and calls on the bond.  The surety pays out to the owner on the bond.  The surety then has a right of subrogation and can sue the contractor to recover the amount paid out.

Bid Bonds Invitations for a bid usually require that the bid be accompanied by a bid bond in the amount of 10% of the amount of the bid. A bid bond is a guarantee by a surety, for the benefit of a project owner, that if the owner accepts a bid by the contractor in question, and the contractor fails to enter into the contract, the surety will pay the penalty specified in the bond.

Performance Bonds In the construction industry, a performance bond is a bond under which the surety guarantees a contractor’s performance of a construction contract. On large construction projects, the prime contractor often requires its major subcontractors to provide performance bonds. If a subcontractor provides the bond, the prime contractor is the obligee and the subcontractor is the principal.

Performance Bonds (continued…) Performance bonds can have any face value, but they are usually issued in an amount equal to 50% of the value of the construction contract.  This is the face value of the bond, and is the maximum potential liability of the surety in almost all cases. The construction contract is incorporated by reference into the bond.

Once the surety has been put on notice that its principal is in default, it generally has six options: 1. It can have the principal remedy the default by performing its obligations. 2. It can complete the contract itself in accordance with its terms and conditions. 3. It can solicit bids for completion of the work and pay the obligee the difference between the accepted bid and the remainder owing to the principal under the original contract, up to the face value of the bond. 4. It can pay the obligee the amount of the bond. 5. It can assert a defence and refuse to do anything. 6. If there is a genuine dispute between the obligee and the principal, it can take a “wait and see” approach to determine whether the principal is in default.

Defences under a Performance Bond The surety’s obligations and the obligee’s right to demand payment are triggered only when the principal defaults on its obligations. When a claim is made by the obligee, the surety is entitled to raise defences. For example, if the principal is able to raise a defence that the main contract is unenforceable, based on misrepresentation, frustration or lack of consideration, the surety can avail itself of that defence as well.

Payment Bonds A payment bond is a guarantee of the performance of a payment obligation. A party to a contract may require a payment bond when there is a concern that the other party may default on a payment obligation. For example, owners and general contractors sometimes require a labour and material payment bond to protect against liens by unpaid subcontractors, suppliers, and others working below them in the contractual chain.