This is the sixth post in our Construction series, Protecting Payment. In the last post I suggested surety bonds as one way an owner could either avoid or “remove” liens. Consistent with our focus on the theme of protecting the right to payment, this post will focus on payment bonds for private construction. Payment bonds usually provide a shorter and straighter path to payment than construction liens, but bond claims are not fool proof. Every potential bond claimant needs to remain aware of the limitations.
Private project owners have the choice to require their prime contractor or contractors to provide surety bonds. The cost of the bond premium usually rolls into the contractor’s price, but provides important value to the owner. Most construction surety bonds come in two parts. One is a performance bond for completion of the contract work. The other is a payment bond for labor and materials. The bonded contractor then also has the choice to require similar bonds for its protection from subcontractors.
A surety is a guarantor standing behind the commitment of its bonded contractor to perform the contract and pay for labor and materials. A surety bond is not insurance, however. The surety never plans to pay claims out of its own pocket like an insurance company. The surety has a contract called a General Agreement of Indemnity (GAI) with its contractor. The GAI spells out rights of the surety and responsibilities of the contractor including the obligation to ultimately hold the surety harmless from claims. Both the contractor and the surety share the economic interest of vetting claims carefully and resisting them where there are disputes or defenses. The bonds themselves have time limits to make and enforce claims and may limit who can make a claim at all. Any party who expects to look to a payment bond to protect its rights to payment on a construction project should get a copy of the bond and read it to know what the terms are. An owner that wants to invoke a contractor’s bond cannot, itself, be in default under the contract.
Not every contractor can provide a bond. The process of obtaining bonds from a surety is similar to obtaining a line of credit from a bank. It involves financial and other business analysis of the contractor to determine the degree of risk that the surety is willing to underwrite. That is why the issuance of a bond is some assurance that the contractor met the surety’s requirements.
In most cases a party makes a claim on a payment bond with a written notice to the owner, contractor and the surety. An owner can also make a claim on its prime contractor’s bond where, for instance, a lien has been filed. The surety will investigate the claim by sending the claim to the bonded contractor for an explanation and attention. If the claim is valid and not disputed the surety will look to its contractor to pay the claim. If the contractor disputes the claim the surety will generally deny the claim and look to the contractor to defend it. If the dispute, itself, is “invalid” or if the contractor is not able to pay the claim, the surety may have to step in and pay or defend on its own.
A surety‘s obligation is co-extensive with its bonded contractor. If the contractor does not owe a claim or has some defense to the claim, the surety is entitled to rely on the same defense, plus a surety has some defenses of its own, based on the terms of the bond, such as the requirements for timely notice of claims. The GAI also entitles a surety to additional rights including the right to freeze contract balances in the owner’s hands or demand that the contractor produce collateral to protect the surety’s ability to be indemnified if the surety risks paying out of its pocket.
Using a payment bond to “bond off” a threatened or recorded lien is a creative way to use the surety’s guaranty. This can be accomplished with a statutory procedure or even with a written agreement which results in the lien being released from the property and the claim transferring to the bond. This can free the property for a sale or a new mortgage. The bond should provide that the surety simply pays the claim (if the owner has not done so) either when it is reduced to judgment or by agreement. This can bypass many of the headaches of a lien foreclosure such as priority battles and sheriff sales which can run up costs and delay payment of the claim.
When owners, contractors and potential claimants understand surety bonds and use them creatively, payment bonds can be the right tool to protect the right to payment and to protect an owner from claims.