Chapter 10

JurisdictionUnited States

Chapter 10

Fidelity and Surety Bonds

§ 10.01 Overview

Businesses face substantial risks of contractual defaults and theft. In the construction industry, costs of projects can skyrocket when there are such defaults. The surety plays a significant role in minimizing these risks of default for lenders and various entities that rely upon another’s honesty and performance. Fidelity and surety bonds are very similar and are both included in this chapter, although surety bonds are the primary focus.

This chapter discusses the types of surety bonds and the risks underwritten by them;1 the nature of the relationship between a surety and its principal;2 the mechanics involved in creation of the relationship;3 the nature and extent of liability under a surety bond;4 the commencement and duration of the risk underwritten by the surety bond;5 the right to indemnity under the bond;6 and bad-faith claims handling and damages available to an obligee.7

§ 10.02 Types of Bonds

Surety bonds are often purchased by a party to a contract to provide a financial guaranty to the other party to the contract, or to a third party beneficiary, that effectively insures that the first party (the party purchasing the bond) will perform its obligations thereunder.8 In particular, all surety bonds are underwritten by a third party, usually a financial institution, and their purpose is to ensure the performance of obligations promised in a contract to an obligee or promisee. The person or entity that needs the third party to underwrite the risk of non-performance is known as a principal, who is the obligor or promisor under the contract. The risk underwritten by the bond is the risk of unjustified default by the principal or obligor. The beneficiary of this surety bond is the obligee or promisee, who obtains beneficial interest in the bond as assurance that the promisor or principal actually performs its contractual obligations, the risk of default of which is underwritten by the bond itself.

There are three principal types of surety bonds:

(1) Bid bonds ensure that a contractor or subcontractor will not wrongfully refuse to honor its bid when such bids are relied on by the owner or general contractor in accepting or submitting a bid. 9
(2) Performance bonds ensure that a contractor or subcontractor will not inexcusably fail to perform a contract in accordance with its terms but instead will complete the work. 10
(3) Payment bonds ensure against the risk that a contractor or owner will unjustifiably fail to pay a subcontractor or general contractor for labor or materials placed or used in a job. 11

§ 10.03 Nature of the Surety Relationship

A surety contract involves a tripartite relationship between the surety, the principal, and the obligee. A surety is a person or entity who undertakes, underwrites, or bears the risk of non-performance of the obligation of another (the principal), which is owed under a contract to an obligee. The surety is jointly and severally (with the principal) answerable to the obligee for the principal’s performance or non-performance under the specific contract, the default of which is underwritten by the bond. Stated differently, a surety is liable for the payment of its principal’s debt or the performance of its principal’s obligation under the specific contract, the default of which is underwritten by the bond.12

The surety contract is akin to a guaranty contract because it provides an economic bond to ensure performance under the contract at issue. However, unlike the surety relationship, the guaranty context does not involve secondary liability, but instead involves solely a joint and several primary obligation.13

A surety contract is also distinct from an insurance policy in which there is a relationship between the two contracting parties—the policyholder and the insurance company. Even in the liability or “litigation” insurance context, the duties under the contract are owed to the policyholder, not the third-party claimant.14 On the other hand, in the surety context, the surety obligation runs primarily to a third-party beneficiary of the surety contract—namely, the obligee under a contract between the principal and the obligee, not to the other contracting party that had purchased the bond in the first place—the principal.15

§ 10.04 Creation of Suretyship and the Nature and Extent of Surety’s Liability

There are two requirements for the creation of the suretyship relationship:

(1) a valid and binding contract between the principal and the obligee; and
(2) a valid and binding suretyship contract or bond between the principal, surety, and obligee. 16

Just as with insurance-policy construction,17 the nature and extent of a surety’s liability is determined by the precise terms of the surety bond or contract.18 Although limited by and subject to the terms of the bond,19 the liability of the surety is generally measured by the principal’s liability to the obligee under the separate agreement, the risk of non-performance of which is being underwritten by the surety bond. For instance, the liability of the surety to the obligee under the bond mirrors the principal’s liability to the obligee because the surety is deemed to stand in the shoes of the principal.20

Unless otherwise provided under a surety bond, the surety’s maximum liability will generally be co-extensive with that of the principal.21 This means that the rights and liabilities of the surety are no greater than those of the principal and may be less if the bond limits the liabilities of the surety.22 In fact, the surety will not be liable to the obligee unless the principal is liable.23

§ 10.05 Commencement and Duration of the Risk

The commencement and duration of the risk are determined by the bond itself.24 The bond may have a commencement and/or expiration date.25 Alternatively, the bond might have an implicit commencement or termination date. For example, the commencement and expiration date might be triggered by a specific event, such as architect’s execution of a certificate of completion.26 In addition, the surety’s obligation is usually undertaken at the same time as, concurrently with, and jointly with the principal.27

Payment and performance bonds may differ on the duration of the risk covered. A surety’s liability under a payment bond usually terminates on payment by the principal to the obligee, even if there is a warranty period for the work performed by the obligee. This is because the nature of a payment bond is to ensure the payment for labor and materials, not the performance of the work.28 On the other hand, a surety’s liability under a performance bond will usually run into any express or implied warranty period.29

[1]—Pre-Existing Defaults

Unless otherwise provided in the bond, a surety bond generally does not cover pre-existing defaults, although it may cover work that has already started.30

[2]—Breaches by Principal

An uncured breach by the principal ordinarily requires the surety to complete the principal’s performance or pay the obligee the reasonable costs of completion.31 However, not all breaches will entitle the obligee to terminate a contract and call on the surety to perform the principal’s unfulfilled obligations. The breaches permitting termination are material breaches.32

[3]—Conditions of Liability

Depending on the terms of the bond, a surety’s liability only attaches on a default by the principal,33 and an obligee’s default may be an absolute defense to payment or performance of the surety.34 Case law and commentators interpreting the standard-form A312 Bond, widely used in the industry,35 have determined that lack of “owner default” is a condition precedent to the surety’s obligations thereunder.36

Similarly, a bond may contain more expansive liabilities than the underlying contract, the performance of which is secured by the surety bond. For example, where the bond does not have a “paid when paid” provision, conditioning payment to a subcontractor when the contractor/principal is paid by the owner, a surety’s obligation under a payment bond is triggered on completion of the work of the subcontractor, even if the underlying subcontract has a “paid when paid” provision.37

In order to trigger a surety’s liability under the bond, the obligee must follow all conditions; failure to do so prevents the surety’s liability from accruing.38 An obligee is not required to utilize the surety bond if he or she can complete the performance at a cheaper price than the remaining contract price.39

[4]—Discharge of Surety

The surety’s obligation under the surety bond can be discharged under a variety of circumstances. First, the surety’s obligations are discharged when the principal’s obligation is released or extinguished.40 The surety’s obligation can also be discharged by operation of law. For example, if the obligee commits a material breach justifying rescission or fails to disclose something material to the transaction, the surety cannot be required to complete performance.41 Additionally, a material increase in the risk by the principal may have the effect of discharging the surety’s obligation. Changing the nature or increasing the scope of the obligation secured or changing the identity of the principal are circumstances that will excuse performance by the surety.42

[5]—Right to Indemnity

After paying under the bond, the surety generally retains the right to indemnity against the defaulting principal whose obligation is secured by the bond.43

§ 10.06 Liabilities, Damages, and Bad Faith

Additional remedies may be available beyond payment or performance under a surety bond. These potentially additional remedies include bad-faith and/or punitive damages44 and consequential and/or liquidated damages.45

[1]—Bad-Faith and Punitive Damages

Punitive damages may be awarded for egregious tortious conduct or through a statutory grant.46 Here, the question is whether a bad-faith statute47 or the common law recognizes a claim for bad...

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