Relevant Parties and Surety Bond Terms

To understand the purpose and operation of the various construction industry surety bonds, you should become familiar with the following commonly used terms:

• Surety
• Principal
• Obligee
• Guarantee
• Penal sum
• Premium
• Indemnitor

Surety

The surety (sometimes called the obligor or the bonding company) is a financial institution possessing great wealth and stability. Sureties will be required to furnish convincing evidence of their financial strength and are often required by the terms of prime construction contracts to be registered as approved sureties and to appear as such on a published list maintained by the U.S. government.

Principal

The entity that actually furnishes the bond is called the principal. The surety is the entity that furnishes the guarantee that the bond promises.

Obligee

The guarantee promised by the bond is made to an entity called the obligee. In the case of bid bonds and performance bonds furnished by the prime construction contractor, the owner of the project being constructed is the obligee. In the case of labor and material payment bonds furnished by the prime contractor, the owner is usually the obligee for the use and benefit of subcontractors and material suppliers. In some jurisdictions, the subcontractors and material suppliers themselves are considered to be the obligees. When performance bonds are furnished by a subcontractor, the prime contractor is the obligee.

How do Surety Bonds Work?

The potential liability assumed by a surety greatly exceeds the premium charged for underwriting the performance of the principal. In part, the surety is operating on an actuarial basis, but additional considerations lie behind the willingness of the surety to assume the liability involved. These other considerations are explained in this section.

Indemnity Agreement

The surety bond proper is a legal instrument that results from a separate contract between the surety and the principal, in which the surety agrees, for a price (the premium), to guarantee the principal’s performance with respect to some obligation to the obligee that the principal has assumed. In this sense, the bond is the evidence that the obligee wants to see that this separate contract exists. The separate contract, which the obligee never sees directly, is called an indemnity agreement. In addition to specifying that the surety will provide the required guarantee to the obligee, the indemnity agreement will provide that the principal and all other named indemnitors who may be a party to the agreement will pay the surety back for any losses that the surety incurs in making good the guarantee.

Surety Bonds v. Insurance Contracts

What are the differences between surety bonds and insurance contracts? Under an insurance contract, the insurer agrees, for the premium, to pay damages or replace something that has been lost or destroyed as a result of the occurrence of a covered event, such as an accident or a fire (including claims made against the insured by third parties arising from these occurrences). Surety bonds are very different. In the event of a call against a surety bond, the surety’s obligations are not triggered by an event such as an accident or fire. Instead, the call against the surety’s guarantee is made as a result of some kind of alleged failure of the principal to perform.

How Good Is the Guarantee?

The guarantee is as good as the financial resources and integrity of the surety. The main requirement for serving as surety is that the entity must be perceived as having great financial strength with a history and reputation of living up to its obligations. The obligee would not have confidence in the guarantee unless these requirements were met.

Surety’s Belief in the Contractor’s Ability to Perform

The potential cost to the surety in the event of a call on its guarantee can be enormous. (The penal sum of the performance bond for the Lock and Dam No. 26 contract discussed in Chapter 4 was the full contract price of $227 million.) Insurance contracts may also involve large risks, but there is a key difference. In providing insurance to a contractor, the insurer is betting that it can predict the likelihood of losses on an actuarial basis accurately enough so that it makes money on the average. The competence and financial strength of the contractor are not key factors in the insurer’s decision-making process.

The surety bond case is very different. Since it is the performance of the principal that is being guaranteed, the surety has to believe in the principal and be convinced that the principal has the intention, the resources, and the ability to perform. Even though protected, at least on paper, by the terms of the indemnity agreement, sureties simply will not furnish bonds to construction contractors if they have any doubt about the contractor’s ability to perform.

Bid Bonds

An important element of the bidding process is that owners have the assurance that the bidding contractor who is awarded the contract will accept and sign it and will furnish all insurance policies and additional surety bonds required by the bid documents. If the successful bidder refuses to sign the contract, the owner must accept a higher price for the work or rebid the project. Neither alternative is desirable. Even though the owner can sue the low bidder for damages, the project will be delayed, and it may not be possible to recover all of the costs. The bid bond protects the interests of the owner against this potential loss.

Bid Bond Guarantee

The guarantee of the bid bond is twofold:

1. The surety guarantees to the obligee (the project owner) that the principal will enter into the contract in the event of an award; and
2. The principal will furnish the performance bond and insurance policies required by the contract.

Bid Bond Penal Sum

The penal sum for bid bonds can be expressed in one of two distinctly different ways:

1. As either a fixed amount of money or as a percentage of the bid total, which serves as liquidated damages for failure to enter into the contract. According to the terms of the bond, the obligee does not have to prove actual damages but must merely show that the principal failed to enter into the contract and/or failed to furnish the required insurance policies and other required bonds.
2. The penal sum can be stated in the form of actual damages suffered, up to a stated limit. Here, the obligee must prove the extent of actual damages before the surety will pay on the guarantee.

The first method is more common, and 10% of the total bid is usually the stated amount. However, even though the bond is written in this form, courts sometimes limit the owner’s recovery to actual damages.

Some bid documents provide that bidders furnish a certified check in the amount of 10% of the bid price instead of a bid bond. The checks are returned to all unsuccessful bidders the day following the bid opening—and to the successful bidder when the signed contract and the required insurance policies and bonds are received by the owner.

Performance Bonds

Owners naturally want assurance that, once they have awarded a contract, the contractor will perform according to the contract’s terms. This assurance is provided by the performance bond.

Performance Bond Guarantee

The guarantee is the surety’s promise to fulfill the principal’s obligations to perform the separate contract that the principal has made with the obligee if the principal is unwilling or unable to perform. Before a call against the guarantee can be legally sustained, the obligee must clearly establish that the principal is in default of the terms of the contract. It is sometimes unclear whether the contractor principal is truly in default or if the principal’s performance or lack of performance has been caused by an act or failure to act of the owner obligee or has been the result of some other condition of force majeure. Under these circumstances, establishing a de facto (actual) default can be a complicated matter, which often is settled only in court following protracted litigation.

Surety’s Options to Make Good the Guarantee

Once convinced that the principal is truly in default, the surety has three options for making good the guarantee to the obligee. The second and third methods are more common.

1. Assist the principal to remedy the default. Ordinarily this would be accomplished by advancing funds to the principal but not taking control of the contract.
2. Take control of contract performance and complete the work by engaging another contractor or by retaining the principal and subsidizing project operations and actively directing the work.
3. Allow the obligee to complete the contract by engaging another contractor and, when the work has been completed, pay money to the obligee for any excess costs incurred in completing the work.

Contractor Protection of Bonding Capacity

It may appear from the preceding discussion that the performance bond provides little protection for the obligee after all. This would be more true if it were not for the necessity of contractor/principals to protect their bonding capacity. Since so much construction work is bonded, contractors must maintain their ability to obtain performance bonds. Smaller contractors particularly do not want their surety to receive complaints about their performance, jeopardizing their ability to secure bonds for future projects. For this reason, they are more likely to respond to owners’ demands when complaints over performance arise.

If being declared in default looms as a real possibility, contractors generally do everything possible to avoid the surety taking over their contracts for two main reasons:

1. If the surety should take a loss, the contractor will find it difficult to ever get another bond.
2. Since the surety is indemnified, the contractor loses control of expenditures in the event of a takeover but not the legal obligation to pay the surety back for them. As long as they can maintain operations, contractors naturally prefer to spend their money themselves rather than have the surety or the owner spend it for them.

Labor and Material Payment Bonds

Private construction contracts are subject to mechanic’s lien laws, which enable subcontractors or suppliers to file liens, or legal claims, against the project property if they are not paid by the owner’s contractor for their services or furnished materials. Payment bonds assure that such persons or entities are paid by the surety if the contractor/principals refuse or are unable to pay. If there is no bond and liens are perfected-where, through a lawsuit, liability to pay the amount of the lien is established by a court-owners have to pay the claimant to avoid having their property sold to satisfy the lien. For this reason, private owners want payment bonds.

A mechanic’s lien cannot be placed against federal government or other public property. However, at the federal level, and in most states, public policy demands that subcontractors and suppliers on public projects be paid for their work. Thus, Congress has enacted the Miller Act, and many of the state legislatures have enacted “Little Miller Acts,” both of which, among other things, require labor and material payment bonds on public construction contracts, federal and state respectively.

Labor and Material Payment Bond Guarantee and Claimants

The guarantee of a labor and material payment bond is the surety’s promise that it pays claimants if the principal is unable or refuses to pay them. To understand the guarantee depends on understanding the definition of a claimant. For a person or entity to be a proper claimant, a number of conditions must be met.

First, a construction contract between the principal and the obligee must exist, and this contract must be referenced in the bond. The bond then defines claimants as those persons or entities who have contracts with the principal to perform services or furnish materials on the project pursuant to the principal’s construction contract with the obligee. Thus, someone who wants to collect on a payment bond must first be sure that this requirement is satisfied—that is, that the claimant has a contract with the principal who, in turn, has a contract with the obligee. Some payment bonds go further, including as claimants those persons or entities who have contracts with other entities that, in turn, have contracts with the principal.

In the case of federal contracts for which a Miller Act bond is required, sub-subcontractors and material suppliers to subcontractors of the principal are also treated as claimants. So are material suppliers to sub-subcontractors. Material suppliers to the principal are always considered to be claimants. However, second-tier material suppliers to first-tier material suppliers who hold a purchase order contract with the principal do not qualify.

The federal practice is mirrored in the laws of some states, as the following Kansas case illustrates. The City of Wichita awarded a prime contract to a general contractor for construction of a sewage digester. The general contractor (Penta) then awarded a contract to Wells Products Corp. for furnishing the digester floating cover and gas compressor system. Penta also furnished a public works payment and performance bond in accordance with the Kansas “Little Miller Act” statute. Wells Products Corp. failed to pay J. W. Thompson Co., one of its suppliers, who then brought a claim against the prime contract payment bond. As in federal contracts, Kansas public works payment bonds protect only suppliers to subcontractors, not suppliers to suppliers. It, therefore, became important for the trial court to decide whether Wells Products Corp. functioned as a subcontractor or as a supplier to Penta. J. W. Thompson Co., who was, in effect, a second-tier supplier, argued that Wells Products Corp. had furnished personnel on site for the purpose of assisting in adjusting and starting up the equipment and, therefore, was functioning as a subcontractor. The prime contractor claimed that the agreement with Wells Products Corp. was a sales agreement since the actual contract evidenced all of the “trappings” of a sales agreement and contained none of the clauses usually found in subcontracts. The trial court concluded that Wells Products Corp. was a subcontractor, making J. W. Thompson Co. a proper claimant under the prime contract labor and material payment bond. The Kansas Supreme Court reversed the trial court, deciding instead that Wells was a material supplier, not a subcontractor. The Kansas Supreme Court stated:

Modern conditions frequently demand a high degree of specialization in manufacturers and suppliers. The facts that Wells had the duties to inspect Penta’s installation of the components purchased from Wells, to be present at the start up, and to instruct the City of Wichita employees on the use of the gas compressor system were key factors in the trial court’s conclusion that Wells was in fact a subcontractor. But it is clear that such activities are common in the construction of sophisticated systems.