A Georgia Practitioner's Guide to Construction Performance Bond Claims - Cheryl S. Kniffen

• Publication year: 2009

A Georgia Practitioner's Guide to Construction Performance Bond

Claimsby Cheryl S. Kniffen^*

I. Introduction

The recent ills of the construction industry have resulted in bonds being required in record numbers on both public and private projects. Typically in a construction project on which a surety bond is required or demanded, the contractor will provide both a performance and a payment bond.¹ This Article focuses exclusively on the performance bond and the claims and defenses related to that bond. This Article also offers practical advice to the general practitioner navigating a performance bond claim or raising defenses to a performance bond claim.

The use of performance bonds dates to the beginning of the construction industry.² While not referred to as performance bonds, in ancient times bondsmen would secure real estate to ensure the performance of a contractor.³ Despite their long history, however, performance bonds are often misunderstood and confused with liability insurance. Given the ever increasing complexity of the construction industry and the confusing caselaw created when courts attempt to apply insurance principles to performance bond claims (or refer to performance bond and payment bond claims interchangeably), the general practitioner can easily become confused when asserting or defending performance bond claims. This primer on performance bond claims in Georgia is offered as a road map for navigating such claims.

A. The Nature of Performance Bonds

In a performance bond, a party known as a surety agrees to be responsible for the performance of a contractor on a project.⁴ In the performance bond arrangement, there are two underlying agreements. The first is the construction contract, a two-party agreement between the bonded contractor and either the owner or general contractor for the construction project. The second is the performance bond, which is a tripartite agreement under which the surety assures the performance of the construction contract by pledging that if the bonded contractor should fail to perform as required, the surety will be obligated to complete the contract work or be responsible for the cost thereof.⁵

The three parties in all performance bond arrangements are (1) the principal—the bonded contractor whose performance is guaranteed by the performance bond and who is the primary obligor on any obligations arising from the bond; (2) the obligee—the owner of the project (or the general contractor if the principal is a subcontractor), who receives assurance of performance of the contracted work; and (3) the sure-ty—either an individual or more typically a corporate entity that acts as a guarantor or secondary obligor of the contracted work through issuance of a performance bond.⁶ The performance bond is essentially a guarantee that if the principal obligor (the contractor) fails or wrongfully refuses to perform the work governed by the construction contract, then the secondary obligor (the surety) will either perform in the principal's place or pay damages to the obligee (the owner or general contractor) for the breach of its principal.⁷

As a prerequisite to issuing the performance bond, the surety will usually require the principal to execute a general agreement of indemnity. In that agreement, the surety is assured by the principal that should any claim be made upon the performance bond, the surety will be held harmless and indemnified by the principal for all claims and demands that are made upon the surety.

The relationship created by the issuance of a performance bond may seem rather simplistic. The surety acts as a guarantor for the principal who ultimately must either complete the contract or be liable for all sums spent completing the contract work. However, the complexity inherent in the construction industry often jeopardizes the success of projects and makes the process of making and defending performance bond claims complicated. While many contractors are construction "professionals," others are not.⁸ The risks inherent within the project itself are added to the risk of the contractor not being qualified to complete the project. These risks include (1) design errors made by architects and engineers that can delay the project for months; (2) severe weather, such as earthquakes, hurricanes, tornados, and extreme heat and cold, which can shut down the project for days and sometimes longer; (3) site risks, such as subsurface conditions and environmental contaminations; (4) material shortages and delays; (5) vandalism and theft on the job site itself; and (6) because performance bonds are generally required on all governmental projects, political risks, such as delays caused by administration changes or the contractor falling out of political favor.⁹

The greatest risk on any project, however, is contractor insolvency and default caused by the inability of the contractor to purchase needed materials or pay essential laborers.¹⁰ Most of a contractor's profits on any project are made toward the end of the job after materials have been purchased and laborers have been paid. It is not uncommon for contractors to teeter on the brink of insolvency, using funds from one project to finance another. When a contractor falls behind in payments to suppliers and subcontractors, the service and material providers refuse to provide products and labor until paid. This results in substantial delays to the project and, on many projects, the assessment ofliquidated damages when the construction contract provides for them. Because contractors are generally only paid for work they have performed, and a portion of that amount is typically withheld by the owner as a retainage for additional security, even a slight financial difficulty can quickly spiral out of control. This leaves the contractor either financially drained or in bankruptcy and leaves the owner with only the security offered by the performance bond.

Given the difficult terrain of the construction industry, the performance bond has become the quid pro quo for almost all governmental contracts and is becoming increasingly popular in private sector construction contracts. The appeal of the performance bond is clear. Given the increasing complexity of construction projects, owners (the bond obligees) seek the security provided by the surety in the event that the contractor fails to perform the contract work—the promise that the surety, as a guarantor to the project, will perform the underlying construction obligations.

B. Distinguishing Between Suretyship and Insurance

For those who are not involved in the construction industry, and sometimes for those who are, there is confusion about the concept of suretyship and how it differs from insurance. This confusion is understandable because state legislatures generally lump suretyship into the insurance code out of convenience. Thus, sureties, like insurers, are regulated by the insurance code.¹¹

The rationale for the inclusion of suretyship in the insurance code is that most corporate sureties are also insurance companies with separate divisions of the company offering suretyship products. These divisions differ from those offering insurance. Because such companies should properly be governed by the insurance code to the extent that they offer insurance products, it is generally perceived as easier to regulate them through the insurance code and the insurance commissioner's office. The regulation of sureties by the insurance code often confuses courts and leads to decisions in which regulations that are purely designed for insurance are extended to suretyship.

Rather than being akin to insurance, suretyship is more analogous to the lending of credit by banks. The similarity of the surety/principal relationship to that of the bank/loan customer relationship is highlighted by the prevalent practice outside the United States of construction project owners requiring contractors to furnish bank guarantees or stand by letters of credit in lieu of performance bonds.¹²

In an insurance arrangement, insurance companies collect insurance premiums, or fees from policy holders, based upon the assumption that a certain number of those policy holders will have losses for which the insurance company will become liable.¹³ Some amount of loss is expected and reserves are established to cover those losses by adjusting the premium to accommodate the anticipated loss.¹⁴ Losses, however, are not anticipated in the surety relationship. Sureties, like banks making loans, issue bonds only if the borrower/principal is considered viable and credit worthy.¹⁵

A surety examines a contractor's specific risk factors, including (1) what reputation the contractor has developed in the industry and if he has fulfilled his obligations on past projects; (2) whether the contractor is capable of successfully performing the bonded project with adequate personnel, resources, and expertise; and (3) whether the contractor has adequate financial resources to weather problems that might occur on the project. By contracting with a bonded principal, an owner or general contractor is assured that the surety has conducted a preliminary review of the contractor's finances, business model, and prior projects, and is comfortable with the contractor's ability to meet obligations with regard to the bonded project. Almost all projects are plagued by a number of unexpected problems, and if a contractor has a precarious financial situation when the project begins, the contractor's ability to weather those bumps is severely diminished.

Regardless of a surety's diligence during the underwriting process, no surety can be certain that it will not experience losses on the bonds it issues. Because no losses are anticipated in the suretyship arrange-ment,¹⁶ in consideration for the surety agreeing to issue a bond for a principal, the surety typically requires the principal, the principal's owners, spouses of owners, or other key personnel to...