Summer 2012 • Issue 44, page 20

An Overview of Construction Bonds in Receivership

By Sykes, Jeffrey, Douglass, B. Scott & Tausend, Eric *

With the economy continuing to stagnate, more construction projects are faltering, ultimately ending up in receivership. When these distressed properties wind up in receivership, it is crucial to be aware of an important asset potentially available to a receiver: the surety bond.

As discussed below, there are several types of surety bonds that may be in effect on a given construction project. Enforcing these bonds can add value to the property, ensure completion of the project, and protect the project from claims. In some circumstances, receivers may be able to directly enforce surety bonds.1 In other circumstances, receivers may be able to cause others to enforce them. Either way, enforcing surety bonds may ultimately add value to the property, thereby enhancing returns on the completed project.

In the first part of this article, we will discuss the basic types of surety bonds and some elemental aspects of suretyship. In the second part of this article, we will address the surety’s obligations and rights.

  1. Types of Bonds
    Surety bonds generally fall into one of two categories: statutory bonds and common law bonds. Bonds issued pursuant to a statute, typically in the context of public work projects, are statutory bonds. The provisions of the statute requiring the bond’s issuance are generally read into a statutory bond. In contrast, common law bonds are not issued pursuant to a statute. Because common law bonds are not issued pursuant to a statute, there is often more room to negotiate the specific terms of the bond. Within both the statutory and common law categories of bonds, there are, in turn, several types of construction surety bonds, including performance bonds, payment bonds, and subdivision-related bonds.

    1. Performance Bonds
      Performance bonds, as their name suggests, ensure performance of the construction contract. They incorporate the underlying construction contract by reference, and are designed to protect the project owner from losses arising from the default of the contractor in completing the construction contract. A construction lender frequently will be added to the performance bond as a dual obligee, entitling the lender to the same protections of the bond. In some instances, a general contractor can be the beneficiary of a performance bond, if the bond was obtained by a key subcontractor or supplier.

    2. Payment Bonds
      Payment bonds are designed to ensure that the contractor fulfills its payment obligations to those subcontractors and suppliers who furnish labor and materials in connection with the project. They generally guarantee that the contractor will pay the proper and valid contract claims of those entities furnishing labor, materials, and/or equipment in connection with the project. Payment bonds are useful in resolving mechanic’s liens that are oftentimes recorded once a project becomes distressed. The terms of the bond govern who may make claims against the payment bond, though generally, payment bond claimants encompass the same project participants who can pursue lien rights under California’s mechanic’s lien laws.

    3. Subdivision-Related Bonds
      Traditional subdivision bonds, similar to performance bonds, assure the completion of the improvements that accompany a subdivision. These bonds are typically required by the public entity approving the subdivision and are furnished by the subdivision’s developer.2 The bonded improvements often include the subdivision’s streets, sidewalks, sewers, and storm drains. Generally, subdivision bonds are issued to public entities, but in some circumstances they are issued to homeowners associations, or similar entities. Other subdivision-related bonds ensure that a developer performs its obligations to subsidize a homeowners association or a time share association, by paying its portion of dues or assessments until all units are sold.3

  2. Suretyship
    Construction sureties issue bonds for a particular construction project. These bonds are referred to as tripartite contracts because they involve three parties: the surety, the obligee (who is typically the owner under a performance bond, or a subcontractor/supplier under a payment bond), and the principal (who is typically the general contractor under either a performance bond or payment bond). The bond is a contract whereby the surety guarantees to the obligee that the principal will perform its underlying contractual obligations or that the surety will either perform or pay damages resulting from the principal’s lack of performance.4 Where a principal defaults, the surety’s liability is normally capped in the bond to the specific dollar amount of the bond, which usually is equivalent to the original contract amount set forth in the underlying construction contract between the owner-obligee and contractor-principal. This cap is commonly referred to as the penal sum of the bond.

    Surety bonds often contain confusing, archaic language regarding the obligations of the surety. Such language, referred to as defeasance language, typically provides that if the contractor performs its obligations under the contract, then the surety’s obligations under the bond shall be null and void, otherwise the surety’s obligations remain in full force and effect.5 Disputes about the meaning of this awkward language often arise, generally requiring courts to interpret the meaning of the bonds and the obligations they impose.6

    The importance of suretyship cannot be overstated. In the public construction context, surety bonds are a public works contractor’s lifeblood because bonds are normally required for public works projects. And on private projects, bonds serve to protect an assortment of project participants with financial interests in the work. For instance, a private owner’s lending institution may require that payment and performance bonds be procured as a condition for extending project financing. Similarly, the private owner may require a payment bond because it has an immediate need to sell the property after the project is completed and cannot risk the recordation of mechanic’s liens by unpaid subcontractors or suppliers, which would cloud the property’s title and hinder the subsequent sale. Alternatively, a general contractor may need a surety bond guaranteeing the performance of a subcontractor or supplier to protect against the risk of the general contractor’s own default should the subcontractor or supplier on the project not perform. Thus, suretyship protects valuable financial interests and can be used by a receiver in connection with a distressed project for a variety of reasons.

    It is important to note that suretyship is not the same as insurance. While suretyship involves a tripartite arrangement between the obligee, principal, and surety, contracts of insurance involve only the insured and the insurer.7 Other important differences include the fact that surety bonds incorporate the underlying contract, and unlike insurance contracts that are typically offered by insurers on a take-it-or-leave-it basis, surety bonds are often negotiable and not considered contracts of adhesion. Furthermore, in an insurance context, the insurer indemnifies the insured, and no one indemnifies the insurer. In contrast, within the suretyship context, the surety is answering for the debt or default of the principal, and as will be discussed in the second part of this article, the principal is usually required to indemnify the surety for any sums expended by the surety in response to an obligee’s claim.

    The surety’s liability is often referred to as secondary because the principal (the contractor or developer) has primary liability. Because the surety’s liability is secondary, a surety is only liable upon the principal’s default or failure to perform. What constitutes a default will vary depending on the underlying contract, but typically, a material breach of the principal’s obligations is required.8 Following such default, the obligee must then provide notice to the surety that its principal is in default and demand the surety’s performance on behalf of its principal under the operative bond.9 Determining whether a default has occurred requires a case-by-case analysis of the particular facts at issue. Whether a default has occurred is often a crucial issue to all of the parties involved. Because the surety has no liability unless the principal has defaulted, the surety may argue that there has not been a default, and therefore that it is not liable on the bond. Similarly, unless a principal is insolvent, it may well contest the obligee’s assertion that the principal is in default. If the principal succeeds in showing that it is not in default, then the surety’s performance in response to a declared default, if any, will be deemed to have been voluntary, and the principal is under no obligation to indemnify or reimburse the surety.10

    Receivers should also be aware that a performance bond surety’s potential liability may extend to post-completion claims, such as warranty and defect claims, when the principal cannot or will not respond to such claims.11 For a surety to be liable for a post-completion claim, the bond principal must either have remaining obligations under its contract with the obligee or, under certain circumstances, the post-completion claim must be for latent defects in the work. To determine a surety’s potential liability for post-completion claims, careful attention must be paid to the bond language, the language in the underlying contract, and the facts giving rise to the claim. Post-completion claims may still be limited based on the language in the bond, or by an applicable statute of limitations or statute of repose.

  3. Conclusion
    In Part II of this article, we will discuss the performance options available to the surety after the principal has defaulted, indemnification of the surety by the principal, and common defenses available to the surety. Although this article has provided an introduction to surety bonds, it is not intended to be, and should not be considered, legal advice. Receivers should proceed cautiously when seeking to enforce surety bonds. Receivers also should be careful to follow proper procedures in enforcing the bonds. Doing so will permit the receiver and the estate to obtain the maximum benefit from the bonds.

1 Though the scope of a receiver’s authority will vary depending on the terms of the appointment order, generally included in the receiver’s authority is the power to exercise contractual rights of the owner, including those arising from a surety bond.
2 See e.g. Cal. Gov’t Code § 66499(1).
3 Cal. Code Regs. Tit. 10, § 2792.9 – 2792.10 (2012); Cal. Bus. & Prof. Code § 11241. California’s Department of Real Estate also frequently requires a Common Interest Completion Bond for condominium projects. These bonds typically ensure that the developer will complete construction of the condominium project’s common interest areas and facilities.
4 The Restatement of Security defines “suretyship” as follows: “Suretyship is the relation which exists where one person has undertaken an obligation and another person is also under an obligation or other duty to the obligee, who is entitled to but one performance, and as between the two who are bound, one rather than the other should perform.” Restatement of Security § 82 (1941); see also Cal. Civ. Code § 2787 (“A surety . . . is one who promises to answer for the debt, default, or miscarriage of another . . ..”); Am. Contractors Indem. Co. v. Saladino, 115 Cal. App. 4th 1262, 1268 (2004) (“A surety bond is a written instrument executed by the principal and surety in which the surety agrees to answer for the debt, default, or miscarriage of the principal.”) (internal quotes omitted).
5 See e.g., Pac. Employers Ins. Co. v. City of Berkeley, 158 Cal. App. 3d 145, 148 (1984).
6 See e.g., Jacobs Assocs. v. Argonaut Ins. Co., 282 Or. 551, 554, 580 P.2d 529, 530 (Or. 1978) (“The difficulty is caused by the archaic form which continues to be used in surety bonds.”); Liberty Mut. Ins. Co. v. Greenwich Ins. Co., 417 F.3d 193, 195 (1st Cir. 2005) (“In the archaic form sometimes used for surety bonds, the bond read that it would be void if [the principal] carried out its obligations under its agreement with [the obligee] but ‘otherwise’ [the principal and surety] were each jointly and severally liable in the amount of the bond.”).
7 See e.g., Cates Constr., Inc. v. Talbot Partners, 21 Cal.4th 28 (1999) (discussing the differences between insurance and suretyship); Meyer v. Building & Realty Servs. Co., 196 N.E. 250, 253-54 (1935) (same).
8 See e.g., L & A Contracting Co. v. Southern Concrete Servs., Inc., 17 F.3d 106, 110 (5th Cir. 1994).
9 An obligee is not required to default terminate the principal under the underlying contract, unless required to do so under the express terms of the bond.
10 See e.g,. Auto Owners Ins. Co. v. Travelers Cas. & Sur. Co., 227 F. Supp 2d 1248, 1269 (M.D. Fla 2002); Seaboard Sur. Co. v Dale Construction Co., 230 F.2d 625, 630 (1st Cir. 1956).
11 Although post-completion warranty claims may be covered by a performance bond, separate “warranty” or “maintenance” bonds also may be available to a receiver to cover these claims.