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Surety 02

Killer Bond Forms and Contract Provisions (Part 1)

Marilyn Klinger | June 1, 2007

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Construction worker signing a contract

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.

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 acknowledgment 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.

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.

Thanks should go to Pierre Le Compte of The Hartford for identifying the subject matter for this series.

Read more on this topic.

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1 See, e.g., Caron v. Andrew, 133 Cal. App. 2d 402 (1955).