In today’s tight construction market, larger contractors may be tempted to guarantee bonds for smaller contractors under a joint venture or other surety support agreement that compensates the larger contractor and enables the smaller contractor to provide the required bond for a public works or large non-public project. This presents considerable risk for the larger contractor—and can result in hundreds of thousands, and even millions, of dollars of liability if the smaller contractor runs into trouble on a bonded project. The risk is so great that larger contractors should avoid this type of business deal altogether. But if the temptation is too great to resist, following are some legal safeguards the larger contractor can contractually require to lessen (although not eliminate) the risk of guaranteeing bonds for another contractor.
First, the larger contractor should be actively involved in the bonded project. If permitted, the larger contractor should be a joint venturer or subcontractor that is responsible for substantially all bonded work. At a minimum, the larger contractor should have the right to conduct project oversight, including monitoring finances and work progress. By taking an active role in the project, the larger contractor will be notified of any problems early on and have a better opportunity to correct them.
Next, the larger contractor should insist on funds control. Requiring that owner draws be paid to a third-party escrow that can only disburse funds to subcontractors, suppliers or other legitimate project creditors with the larger contractor’s approval considerably reduces the possibility of misconduct. A main reason the larger contractor incurs losses in a surety support arrangement is because the smaller contractor “borrows” funds from the bonded project to pay non-project-related obligations. Once contract funds are diverted, they cannot be brought back, and the best way to prevent loss of contract funds is a third-party escrow funds control arrangement. The funds control firm charges a small fee, which should be the smaller contractor’s contractual responsibility. It is money well spent from the larger contractor’s perspective.
The smaller contractor must obtain insurance that is acceptable not only to the project owner, but also to the larger contractor. Preferably, the larger contractor should be an additional insured under the project’s insurance policies. If the insurers do not agree to this arrangement, at a minimum the larger contractor should be issued certificates of insurance that prohibit cancelation without prior notice to the larger contractor.
In the event of the smaller contractor’s performance default, the larger contractor should be entitled to step in and take over the project’s bonded work. This is a drastic step, but sometimes a quick takeover can save a project that is heading toward real trouble. The contractual remedy for the larger contractor should be written as a right (not an obligation) to assume responsibility for performing all work needed to complete the bonded project.
In the event of a default situation, the smaller contractor must indemnify the larger contractor against all losses and liabilities, including attorneys’ fees and other litigation expenses that may be incurred in connection with the bonds issued for the smaller contractor. The smaller contractor’s assets should collateralize this indemnity obligation, such as contract funds and equipment at the bonded project, as well as non-project property that may be available to protect the larger contractor. The larger contractor’s security interest in the smaller contractor’s property should be perfected by a public filing that meets the requirements of local law. (Perfection typically is accomplished by filing a UCC-1 financing statement with the Secretary of State’s office, but local filing requirements must be determined.)
Finally, the larger contractor should not guarantee bonds for another contractor—no matter how profitable the job may appear—unless it has full confidence in the other firm’s honesty and integrity. Even if the smaller contractor passes this litmus test as a business partner, the larger contractor should exercise caution and perform due diligence in any type of surety support arrangement.
Jay Mann is a surety, fidelity and construction attorney with Jennings, Strouss & Salmon. For more information, visit www.jsslaw.com or follow @jss_law.