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Home , Construction law, Surety

SPECIAL SECTION: BONDING Q&A THE LEGAL BASICS OF SURETY BONDS BY LYNN SCHUBERT

What Is a Surety Bond and How Are the the bond and any agreement of indem- What Happens with a Claim Parties Involved Defined? nity. The principal must cooperate with on a Surety Bond? A surety bond is a three-party any investigation of an allegation of When a claim is made on a A:agreement assuring the project default and reimburse the surety for any A:bond, the surety must investigate owner (obligee) that the contractor (prin- losses incurred due to the default of the the allegation of contractor default. The cipal) will perform a in accor- principal on its promise. principal must cooperate with the surety dance with the contract documents. and provide the information necessary for When a contractor requires its subcon- Which Require Bonding? the surety to make a decision of whether tractors to obtain bonds, the contractor is The Miller Act of 1935 (origi- it must perform under the bond. For the obligee and the subcontractor is the A:nally enacted in 1893 as the example, the surety will examine the principal. Heard Act) mandates performance and validity of the bond, whether notice of Most surety companies are subsidiaries payment bonds for all federal public works default was proper, whether there were or divisions of companies, and in excess of $100,000 and pay- material alterations or changes in the both surety bonds and traditional insur- ment protection, with payment bonds the scope of the contract or gross overpay- ance policies are risk-transfer mechanisms preferred method for contracts in excess ments, among other information. regulated by state insurance departments. of $25,000. Also, almost all 50 states, the If the surety determines that its obli- Surety is designed to prevent a loss. District of Columbia, Puerto Rico and gations have not become void, the surety The surety prequalifies the contractor most local have enacted sim- will identify its course of action, which based on financial strength and construc- ilar requiring surety bonds on may include: tion expertise. Because the bond is under- public works over certain dollar amounts. •providing financial or technical assis- written with little expectation of loss, the These generally are referred to as “Little tance to the contractor; premium is primarily a fee for prequalifi- Miller Acts.” • arranging for a replacement contractor; cation services. Many general contractors then require •re-bidding the project for completion; their subcontractors to obtain similar or What Are the Obligations of bonds to protect them from contractor •paying the penal sum of the bond. Each Party To the Bond? default. While most states do not require Each of the parties has responsi- bonds on private projects, What Are Rights of ? A:bilities related to each other party. many owners do require them to protect Subrogation is the surety’s right • The principal has the duty to the obligee their project and assets. A:to enforce a third-party’s rights to perform its contract. The obligee like- against the principal. The surety must wise owes a duty to the principal to uphold What Are Attorney-in-Fact and have made a payment to the third party its end of the contract, including payment Power of Attorney? in order to exercise subrogation rights. If in accordance with the contract terms. Most surety companies distrib- the owner declares the contractor in •The surety has a duty to the obligee to A:ute surety bonds through the default and the surety completes the con- take action under the terms of the bond independent agency system. When a con- tract, the surety has rights to undispersed if the principal defaults under the con- tractor or subcontractor needs a bond, the contract funds. The principal must reim- tract. But the obligee has a duty to ful- first step is to contact a surety bond pro- burse the surety for any losses incurred fill its bargain under the contract, again, ducer, also known as an agent or broker. due to the principal’s default. including payment of any sums due The producer generally receives power of If the surety determines that the alle- under the contract, but this time to the attorney, i.e. the producer can sign bonds gation of default is wrong, the surety and surety that performs. on behalf of the surety company for proj- principal stand together to oppose the • The surety and the principal also have ects that fall within acceptable ranges obligee’s claims. In addition to its subro- duties to each other. The surety has the established by the surety company. The gation rights, the surety also acquires pro- duty to determine whether the principal attorney-in-fact is the holder of the power tection against loss through the general is in default, and abide by the terms of of attorney. agreement.

48 | Construction November 2003 SPECIAL SECTION: SURETY BONDING

What Is a General Indemnity Agreement? other companies that sign are liable to subcontractor wants to be sure that the While a surety the repay the surety for amounts it pays on contractor will enter into the contract if A:performance of the principal to the company’s behalf. awarded. The bid bond encourages con- the obligee, the principal remains liable tractors to do just that in order to avoid for its original obligation. If the surety What Legal Benefits Does a Bond having to repay losses to the surety from must perform its duty to the obligee Provide Subcontractors? their failure to do so. The performance regarding the principal’s contract, the provide three basic bonds bond ensures that if the contractor principal is liable to reimburse the surety A:on a construction project: the bid defaults on the project someone else will for that performance. bond, the performance bond and the pay- be there with sufficient funds to see that Because many contracting firms do not ment bond. The bid bond ensures that the the contractor’s obligation to perform is have the capital to assure this repayment, contractor will enter into the contract for completed. Subcontractors value having most surety companies require a general the terms of its bid and supply the required the performance continue with someone agreement of indemnity (GAI) to be additional bonds. The performance bond able to reaffirm the subcontracts without signed not only by the firm, but by indi- ensures the contractor will perform the having to rebid the work under public bid- viduals willing to support the firm. This contract, including paying its subcontrac- ding laws. might be the owner(s) of the firm, the tors and suppliers, and the payment bond The payment bond has the most obvi- spouse of the owner, a parent corporation provides a direct claim for subcontractors ous legal value to subcontractors. If a con- or merely other individuals willing to put for unpaid invoices to the contractor. Each tractor fails to pay for work properly per- themselves on the line due to their belief of these bonds has legal benefits to sub- formed by subcontractors, those subs have in the firm. Under the GAI (sometimes contractors. a direct claim against the surety for sums called simply an indemnity agreement), If a subcontractor submits a proposal justly due.The sub does not have to obtain the principal company and all people or to a contractor to be included in a bid, the its money from the general, but can work directly with the surety. This direct right of claim is especially valuable on a public project where a sub cannot file a against the work.

How Do I Find an Attorney Specializing in Bonding? If there is any question or doubt A:of a contractor’s or the surety’s rights or obligations, it may be advisable to consult an attorney knowledgeable of construction and surety. The American Association (ABA) and Insurance Practice Section’s Fidelity and Surety Committee includes who specialize in surety law. Many state bar associations also have surety commit- tees or committees. For names of lawyers who have knowledge in your area, call the ABA, (312) 988-5607 and request the FLSC membership directory or the pages for a particular state, or call the state bar asso- ciation for a reference.

Schubert is president of The Surety Association of America (SAA). For more information, contact SAA, [email protected], (202) 463-0600 or www.surety.org.

50 | Construction EXECUTIVE November 2003