There are three parties to performance bonds in the construction context: the "obligee," which is the entity who is owed the contract performance and who is protected by the bond; the "contractor," who owes obligations to the obligee to complete its contract work in accordance with the contract requirements; and the "surety," generally an insurance company that engages in the practice of suretyship, that agrees in the case of contractor default to complete the work of the contractor, pay others to complete the work of the contractor, or pay the obligee the amount of the performance bond.
Additionally, they are sometimes required by the owners of private commercial construction projects. In fact, due to the negative economic impact of the current coronavirus pandemic, we can expect the frequency with which performance bonds will be required on commercial construction projects to increase.
Performance bonds are paired with payment bonds on government projects and are almost always paired with payment bonds on private projects. Payment bonds are distinguishable from performance bonds in that they are intended to protect lower-tier contractors from the threat of non-payment by the general contractor or the contractor above them in the construction chain.
This article focuses on performance bonds, but a future Ward and Smith article will cover payment bonds. Critically, while a performance bond is intended to guarantee contract performance in accordance with contract terms, it can be rendered void and useless if the obligee fails to comply with any requirements contained in the bond. Thus, it critical for construction project owners and general contractors to read your performance bonds carefully to ensure that you do not take actions or fail to take actions , which might negate your rights and protections under your bonds.
Performance bonds are treated and interpreted as contracts and can be breached and enforced like contracts. If there is a contractor default, the terms of the bond will lay out any actions that are required of the obligee before the surety's obligations to correct the contractor's default arise.
Additionally, the terms of the bond set out the surety's liability and provide the actions it may take in responding to a contractor default. Notably, many performance bonds contain provisions that require the obligee to provide the surety with notice of the contractor's default before the surety's obligations to cure the contractor's default under the bond arises.
As an example, the form AIA performance bond requires the obligee to do at least the following before the surety's obligations under the bond arise: 1 declare the contractor in default, terminate the contract, and notify the surety that such actions have been taken; and 2 to agree to pay the balance of the contract price in accordance with the contract terms to the surety or to a replacement contractor the surety selects.
In some instances, the surety must also provide the contractor and the surety notice when it is considering declaring the contractor to be in default, in which case the surety can request a conference with all parties to the bond in an effort to reach a resolution which allows the contractor to correct and continue its performance of the contract.
Only after complying with these notice requirements, does the surety's obligations under that performance bond arise. Upon receipt of proper notice in conformance with the terms of the bond, the surety's obligations become due, and it can elect one of multiple courses of action to correct the contractor's default. The surety can either:. If the surety fails to perform its obligations in a reasonable time, the form AIA performance bond requires the obligee to provide additional notice to the surety demanding that the surety perform its obligations under the performance bond before the surety will be deemed to be in default with respect to the surety's obligations under the bond.
While not all performance bonds are as demanding of the obligee as the AIA , it provides a good example of requirements that might be contained in your bond, which, if not complied with, could result in a loss of your rights under the bond.
North Carolina case law does not directly address the consequences of an obligee failing to provide notice as required by a performance bond, but numerous cases from the federal courts and other state jurisdictions have made clear that such a failure constitutes a material breach of the performance bond and excuses the surety from its obligations under the bond. This is because the purpose of the notice of default requirement is to provide the surety an opportunity to protect itself against loss by participating in the process of selecting a successor contractor and ensuring that the costs of fixing the original contractor's default can be mitigated as much as possible.
Where notice of default is not provided to the surety, it is deprived of its mitigation rights and suffers injury.
Thus, where the obligee takes action by hiring a replacement contractor or otherwise fixes the contractor's default before notifying the surety of the default and fails to provide the surety an opportunity to mitigate the damage from the contractor's default itself, courts from other jurisdictions have concluded that the obligee has materially breached the performance bond and that the surety is excused from performing under the bond.
It appears likely that North Carolina courts will adopt this reasoning if the issue arises. Therefore, if you fail to provide proper notice of default under your performance bond, you could lose the right to enforce the bond and the valuable protections that it provides. As the above demonstrates, performance bonds are very different from payment bonds. The surety is not guaranteeing that it will cover the costs of contractor default but is instead only guaranteeing to perform its obligations in accordance with the terms of the bond.
The very nature of a performance bond is that the surety does nothing on the vast majority of projects. When the surety does have to act, it is entitled to protect itself by receiving prompt notice and an opportunity to cure the default if the bond so requires.
If quick action is required, the obligee can hire a replacement contractor to correct the work and seek recovery of any extra-contractual expenditure after completion. While completing the project with a replacement contractor can sound attractive, this option can often lead to significant problems between the obligee and the surety. Further, the surety may challenge the reasonableness of the completion costs. Regardless of when and where a meeting occurs, the obligee should provide the surety access to the project records and all documentation that supports the declaration of default.
Access to the project also should be freely given to any consultants or representatives of the surety. Remember, the surety can breach its obligations under the bond. A performance bond is a contract. An unreasonable grasp onto a defense to avoid performance is an example of that breach. If the surety breaches its obligations and refuses to perform, the obligee should move forward with completion and seek reimbursement from the defaulted contractor and the surety for costs to complete.
Chapman practices construction law with a focus on the litigation and resolution of construction disputes. In addition, he regularly assists clients in preparing and negotiating contracts and other procurement documentation. He can be reached at jschapman fordnassen. One such reason is nonpayment from the obligee to the principal for the services rendered.
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Close Search. What Is a Performance Bond? How a Surety Company Will Handle a Call on a Performance Bond When a bond obligee, the project owner, decides to call a performance bond, the claims process is set into motion. They must: Ensure that the obligee has submitted a formal written claim that the bond principal, the contractor, has breached the terms of the contract and is now in default. Verify that the obligee has fulfilled their side of the agreement. Help Finance the Principal Some surety companies will try to find a resolution to the default issue between the obligee and principal by financing the principal, either by lending the contractor money or securing a bank loan.
When the owner has satisfied the requirements under the performance bond, the surety will be required to act in accordance with the performance bond. From there, the surety has options when faced with a general contractor default. Usually, owners, without any real construction management capabilities, prefer for the surety to elect to take over and complete the scope of work in the prime contract. Guarantee Co. XL Specialty Ins. A well drafted takeover agreement should include and specify the following:.
See id. If, after the general contractor defaults on a construction project, the surety elects to take over its work, it is important for the owner and the surety to execute a takeover agreement. The takeover agreement establishes a clear understanding of the scope of remaining work to be completed by the surety.
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