Chapter X Bonds and Suretyship
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Chapter X Bonds and Suretyship
A. Introduction
The purpose of this chapter is to provide an overview of suretyship issues that a construction lawyer may encounter. The materials include a discussion of South Carolina case law, and where no South Carolina law exists, the materials look to other states for guidance. The chapter is by no means an attempt to provide an in-depth discussion of all suretyship issues, and the author would point the reader to other sources drafted specifically for that purpose for a more in-depth discussion of surety issues. The author would like to recognize the significant contribution of James E. Weatherholtz and Emily Gifford Lucey, the authors of the First Edition of this chapter, and several North Carolina construction lawyers, whose work product from the North Carolina Construction Law Deskbook, where appropriate, has been incorporated into this chapter and re-printed here with the permission of the North Carolina Bar Association Foundation. Those sections are identified in several footnotes through the chapter.
A surety bond is a tripartite agreement among the surety, the principal, and the obligee. In the construction contract, the parties are typically the surety, the contractor (the principal) and the project owner (the obligee). The owner will request a bond from the contractor to ensure the contractor's performance on the project. If the contractor defaults on the project, the owner can look to the surety to assume the obligations of the principal. In satisfying those obligations, the surety has several options, which are discussed below.
Because a bond is a simple contract, its terms are to be given their plain meaning, and the surety's express obligations in the bond cannot be extended by implication.1 The bond makes the surety and principal responsible to the obligee, and the bond is designed to protect the obligee, not the principal.2 The purpose of a surety bond is to protect the obligee against the principal's potential default.3
Broadly speaking, a "surety" is one who becomes responsible for the debt, default, or miscarriage of another. In the context of this chapter, a surety is a person or entity that binds itself for the payment of a sum of money, or for the performance of something else, for another who is already bound for such payment or performance.4 "A surety must pay the obligee only if the principal defaults, but the surety generally retains a right of indemnification from the principal."5 The "principal retains the primary obligation to perform the contract and the primarily liability for default of the contract."6
Insurance distinguished from suretyship: The South Carolina Insurance Code regulates surety companies.7 However, the South Carolina Supreme Court has stated that "the surety's presence in a regulatory [insurance] scheme does not render common law duties of an insurer applicable to a surety."8 The Court said that courts could analogize sureties with insurance companies for purposes of contract construction, but not for purposes of expanding common law duties in tort.9 Courts have held that surety bonds are to be construed by the same rules that apply to the construction of insurance policies or contracts.10 Additionally, the public policy interests that support and guide the regulation of insurance are not present with sureties.
A United States Supreme Court case, Pearlman v. Reliance Insurance Co., has even noted in dicta that the "usual view, grounded in commercial practice, [is] that suretyship is not insurance."11
B. Performance and Payment Bonds
1. Performance Bonds
The purpose of a performance bond is to guarantee, for the benefit of the owner, the principal's financial responsibility and ability to perform the contract in question. Performance bonds are typically written in the amount of the contract and are always required on federal projects under the Miller Act.12 Under South Carolina's adoption of various Little Miller Act statutes, performance bonds may be required, depending on the size, scope, and type of project.13 On private projects, contractors provide performance bonds at the owner's discretion.
2. Surety's Options on Principal's Default
The liability of the surety typically arises under a performance bond when the principal is in default, either by self-declaration or where the owner has notified the surety of a material breach and declared the principal in default under the terms of the contract in question. After default has occurred and proper demand has been made by the owner, the surety has the right to select its course of action in response. That process raises questions concerning the surety's obligations under the performance bond, and those questions are frequently a source of conflict among the owner, contractor, and surety.
Most bond forms list specific options from which the surety may select its course of action, but there are subtle differences in the categorization of the options and the extent to which the owner has a veto over the surety's selection. For example, the performance bond generally permits the surety to complete the work, but some bonds allow the surety to use the original contractor to complete the contract without the owner's consent.14 In contrast, other bond forms require the owner's consent to surety completion, effectively giving the owner the power to preclude surety completion unless the surety agrees not to utilize the original contractor to do so.15
In addition, owners sometimes incorrectly assume that if the contractor defaults, they need only notify the surety, who will thereafter take over and complete the project. The surety, however, is not technically required to complete the project. Rather, the performance bond guarantees only that the amount stated in the bond (the penal sum) will be made available pursuant to the terms of the bond to pay the cost to complete that portion of the contract that exceeds the amount of the remaining contract funds held by the owner.
The surety has several options upon a principal's default:16
a. The surety can provide financial assistance to the defaulting principal to help the principal remedy the default on its own. (This is obviously a risky option for the surety, but potentially the cheapest one. The principal may simply be experiencing a temporary cash flow problem that an infusion of funds from the surety would remedy.)
b. The surety can elect to allow the owner to remove the defaulting contractor and the surety can then hire a new contractor to complete the project pursuant to a "takeover agreement."
c. The surety can obtain bids for a completing contractor, submit the bids to the owner, and tender the necessary funds to the owner for the lowest completing contractor's bid. (This option is most desirable to the surety on jobs where little or no work has been performed.)
d. The surety can tell the obligee (owner) to complete the project and request payment from the surety. The surety does not have to be involved in the actual completion of the project but will be liable to the owner, up to the penal amount of the bond, for those costs incurred in completing the project that exceed the amount of the remaining contract funds held by the owner. (This option is also risky for the surety because the obligee will have no real incentive to complete the project as efficiently and cheaply as possible.)
e. The surety can perform a good faith investigation to determine whether the default of its principal was proper and justified. If not, the surety can decline to assume any role in the completion of the project. (This option is risky, particularly if the owner proceeds with a costly completion and subsequent litigation determines that the default was proper. In most instances, however, the defaulted principal will be bankrupt and/or the propriety of the default will not be seriously at issue.)
The construction lawyer should carefully review the specific language on private bonds, which may restrict or eliminate some of the aforementioned options.
3. "Takeover" Agreements17
As introduced in option b, supra, upon the default of its principal, the surety has the option of removing the defaulting contractor and bringing in a new contractor to complete the project. This option is not favored by sureties because it exposes the surety to potential liability beyond the penal amount of the bond. In other words, if the surety assumes responsibility for completing the project, the surety will be responsible for the payment of those costs necessary to complete the project, even if such costs exceed the penal amount of the bond. For this reason, the owner-obligee will usually deem it very beneficial for the surety to assume the role of "undertaking surety," thereby assuming responsibility for completing the project.
In the typical situation in which the surety assumes responsibility for completion of the project, the owner-obligee and surety will enter into a "takeover agreement." This document allows the parties to further define their respective obligations and responsibilities after the surety has assumed responsibility for completing the project.
The drafting and negotiation of the "takeover agreement" may provide the parties an opportunity to negotiate more favorable terms governing the scope of their obligations. For example, in exchange for entering into the "takeover agreement," the surety may seek to reduce the amount of liquidated damages which have accrued at the time of its principal's default.
4. Payment Bonds
The purpose of a payment bond is to guarantee payment to unpaid material suppliers, laborers, and certain subcontractors who supply labor and material for use in the project. Like performance bonds, the surety's liability is triggered by the principal's default, which means a failure to pay a "claimant." "Claimant" is a term defined in the particular bond.
The payment bond is for an amount equal to the performance...
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