August 2002
When faced with a default on their projects, many owners have unrealistic expectations concerning the surety’s obligations under the performance bond. Owners feel frustrated when the surety does not aggressively step in to complete the work. However, under most performance bonds, if the contractor/principal is in default, the surety may discharge its obligations by any one of the following alternatives: (1) finance the contractor/principal to complete the work; (2) obtain a new contractor to complete the work under a direct contract with the owner/obligee; (3) complete the work with a new contractor under a contract with the surety; (4) permit or require the owner/obligee to obtain a new contractor; and (5) do nothing and wait for the owner to take action against the bond. As discussed in the lead article on page 1, deciding which option to exercise requires prudent management decisions often based upon reliable, accurate, and expeditious investigations by an experienced consultant.
Financing the contractor/principal to complete the project in many cases is not the most attractive option for the surety, unless the work is nearing completion. As the contractor’s financial problems become known, its most capable employees will leave to obtain more secure employment, and its remaining workforce may attempt to prolong the work to preserve their jobs. Additionally, if more than one contract is in default, whether bonded or unbonded, it is impractical to finance one contract while permitting defaults on others.
In some instances, financing the contractor may be the least costly way for the surety to meet its performance obligations. The workforce and subcontractors may be mobilized on-site and familiar with the work. Although subcontractors are often gun-shy and disgruntled over unpaid requisitions, they are often persuaded by the promises of the surety bankrolling the job. Even though some increases and adjustments may flow to the existing subcontractors and suppliers, the surety can minimize the completion costs by bargaining with the existing team to hold as closely as possible to the previously negotiated prices.
Often owners will prefer to have the surety obtain a completion contractor but the owner may hold the contract with the new completion contractor, because of the perceived control and security it provides concerning the quality and timing of the completion. Further, owners often prefer starting anew with the management of the replacement contractor rather than continuing the frustrations with the defaulted contractor. However, there are risks associated with the clean slate. The potential for unknown remedial costs could fall upon the owner once the surety has established a direct contract between the owner and the replacement contractor. Owners would be wise to clarify these risks and responsibilities with both the surety and the completing contractor. Finally, owners are often tempted to direct substantial changes on a time and material basis to the replacement contractor to deal with marginally acceptable work done by the defaulted contractor, tenant requested revisions, or other desired improvements.
The surety which directly engages a replacement contractor may also face substantial risks. Its exposure may not be limited to the face amount of the bond if it assumes the role of the contractor/principal in completing the work. Therefore, the completion surety will often seek a formal takeover agreement with the owner to limit its exposure, to deal with specific issues, and to facilitate cooperation with the owner and its architect/engineer. Further, the surety’s agreement with the replacement contractor should incorporate existing subcontracts and equipment purchase orders, after making payments for work performed and deliveries made. If the surety has provided both payment and performance bonds, continuing the subcon-tracts and purchase orders may minimize claims made against the payment bond, as well as minimize the cost to complete obligation under the performance bond.
Where cooperations between the owner, its architect/engineer, and the surety cannot be assured, the surety may permit or require the owner to procure its own completion contractor. Although the surety is often better able to locate completion contractors, some owners may have potential candidates immediately available. Further, owners may perceive the surety as an obstacle to securing timely project completion, and with the permission of the surety, the owner will engage the completion contractor with minimal involvement by the surety. In such cases the surety is liable for the cost of completion in excess of the contract balance held by the owner. In this case, the surety’s exposure is limited to the face amount of the bond, however, the surety must assure itself that the owner’s completion costs are not escalated by scope changes and substantial improvements. In order to recoup the excess costs, above the original contract amount, the owner must be careful in re-procuring the work.
In some circumstances, the surety may feel justified in doing nothing in response to the owner’s declaration of default. For example, the surety may allege that:
- the principal is not truly in default;
- the principal is not insolvent;
- the owner has retained ample funds to pay for completion; or
- there has been a gross departure from the terms of the contract.
The surety tempted to do nothing in response to a declaration of default faces unknown costs associated with a lack of control or direction for the project completion. For example, unauthorized changes, improvements, and added costs will generally accompany the completion of a defaulted project, greatly increasing the completion costs and the potential for litigation.
By communication and involvement in the takeover, the surety can minimize its costs and the potential for costly litigation often associated with defaults.
