Killer Bond Forms and Contract Provisions (Part 1)
June 2007
Recently, both public and private obligees,
including both property owners and general contractors, are rewriting the bond
forms that they are requiring their contractors or subcontractors to provide.
Their rewrites include arguably onerous terms for the surety industry and are,
in some cases, altering the standard legal responsibilities of the surety industry.
by Marilyn
Klinger*
Sedgwick,
Detert, Moran & Arnold LLP
The rewrites could have the effect of eliminating the fact that surety is
a form of guaranty, which means that the surety can have no liability unless
the bond principal has liability. They are also attempting to speed up the response
time of the surety industry.
In doing so, these obligees are exhibiting a lack of understanding of the
surety business. First, they do not understand that a surety cannot investigate
a bond default and determine its liability on a bond in the time span that they
are suggesting. Second, they are expecting the surety industry to have at its
disposal each of the kind of contractor needed to complete any particular project
that has gone into contractor default at a moment's notice.
The following are some examples of these new bond provisions, and commentary
as to the meaning and impact of those provisions on the liability of the surety
industry. This expert commentary will be on ongoing series.
Surety Declaration re Bonding Capacity during Bidding Process
Provide the following declaration on Surety's
stationery and include in the submittal to Obligee:
The undersigned declares under penalty of perjury that Principal is able
to provide payment and performance bonds in accordance with Obligee's requirements
of 100% Payment and 100% Performance bonds. This declaration is made with
the acknowledgement that future work and commitments may impact the bonding
capacity of Principal. This statement is true and correct and that this
declaration was executed in _________, on __________ [date].
It is unclear what a governmental entity is focusing on when it requires
the above statement from the surety who provides a bid bond on behalf of a bidder.
Surety indemnity agreements typically provide that the surety is not bound to
provide the final bonds (payment and performance) when it provides the bid bond
and that it can refuse to provide any bonds, including the final bonds, for
any reason or no reason at all. Arguably, this clause does not remove that protection
from the surety who issues the statement because it simply says that the principal
is "able" to provide payment and performance bonds. And it further says that
that "bonding capacity" could change as a result of future work and commitments
(presumably work and financially related).
Nonetheless, the governmental entity that decided to require this statement
must have had an experience in connection with the bid bond surety's issuance
of the final bonds. Possibly, a surety issued a bid bond with no intent of issuing
the final bonds and the public entity got wind of such occurring. There are
situations where a bond principal is having certain problems and, in working
with its surety, arranges for the issuance of bid bonds to show that the principal
is still a "player." Presumably, the surety and the contractor will agree that
the contractor will present a very high bid to assure that it is not the low
bidder. However, there can be situations where even the third or fourth bidders
can win the award, if the lower bidders are disqualified or able to withdraw.
As noted above, whether this statement could have the further effect of somehow
binding the surety to issue the final bonds if the owner awards the project
to the principal, is another question. Presumably, if the obligee can make a
case that the surety issued the bid bond with no intention of issuing the final
bonds, at a minimum, the obligee would have some kind of claim against the surety
above and beyond the bond penalty of the bid bond. However, it is difficult
to imagine a situation where that would occur or where the obligee's damages
would exceed the bond penalty of the bid bond, in any event.
There is a device that is used in the surety industry called a "good guy"
letter. They are letters that sureties will provide to various potential obligees.
They occur in connection with the prequalification process. They essentially
state that the principal is an account of the surety. They might say what the
credit line is, although typically not. However, they might provide that the
principal is able to obtain a bond for the identified project or that the principal
is able to obtain a bond up to a stated amount.
The above-quoted provision is similar to a good guy letter. However, it would
be unusual to provide a good guy letter in conjunction with the bid process
and with a bid bond as the implication of providing the bid bond in the first
place is that the surety would not agree to the bid bond if it were not prepared
to issue the final bonds. In fact, surety underwriters generally underwrite
the bid bond process and simply double-check to make sure there are no changes
when they authorize the issuance of the final bonds.
Surety Forced To Complete
1. Surety may remedy the default
subject to ¶3 herein; or
2. Obligee, after reasonable notice to Surety may, or Surety upon demand of
Obligee shall arrange for the performance of Principal's obligation under the
Contract.
Obviously, by this clause, the obligee has the ability to require the surety
to complete the bonded contract. As of the writing of this paper, this requirement
is fairly rare. While the distinctions have blurred over the years, there was
a time when performance bonds divided into completion bonds or indemnity bonds.
Completion bonds had, as their cornerstone, the requirement that the surety
complete the bonded contract. Indemnity bonds, on the other hand, gave the surety
the option of either completing the project or indemnifying the obligee from
the excess costs of completing the contract. In most situations, under an indemnity
bond, the surety would choose to complete the contract so that it could control
the costs for that completion.
Today, we are seeing obligees take the standard indemnity bond and morph
it into a completion bond that also includes an indemnity obligation to reimburse
the obligee for all damages arising from the principal's default. Provisions
that so provide are discussed below.
No Penal Sum Cap
3. The Contract Balance shall be
credited against the cost of completing the Contract. If Obligee completes,
and the cost exceeds the Contract Balance, Surety shall pay to Obligee such
excess, but in no event shall the aggregate liability of Surety exceed the bond
amount. If Surety arranges completion or remedies the default, that portion
of the Contract Balance required to complete the Contract or remedy the default
shall be paid to Surety….
Reading this clause with the clause just above and, further, assuming that
the obligee has demanded that the surety arrange for the performance of the
principal's obligation under the contract, the obligee will argue that there
is no cap on the surety's liability in completing the contract. The obligee
points to the clause above that provides that if the obligee completes, the
surety's obligation to pay the obligee for the excess cost of completion shall
not exceed the bond amount. Then, the obligee points to the fact that there
is no similar clause applicable to the situation where the surety completes.
And, the obligee points to the law, which is fairly universal around the country
and certainly in California, that provides that a takeover surety waives the
penal sum of the bond.1
Accordingly, the obligee argues that it can force the surety to complete,
based on the express terms of the bond, and if it does, there will be no cap
on the surety's liability to complete the contract. In other words, the surety
cannot simply write a check for the penal sum of the bond and walk away.
Read more on this topic.
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