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November 2008 >>
Through the Looking Glass: Contract Terms from a Surety Perspective
Through the Looking Glass
Although contractors and sureties share the same goal of ensuring proper and timely completion of a project, a surety’s concerns are often invisible to the contractor. Because sureties and contractors review a contract for risk allocation much differently, both parties must make an effort to understand all contract provisions, as well as how the contract’s performance or payment bond terms affect the overall risk.
When unwittingly incorporated into the bond, unfavorable terms in an underlying contract may expose a surety to excessive liability and unanticipated risk, and even may waive the surety’s rights. In contrast, should a surety fail to incorporate certain provisions from the underlying contract, this oversight may limit the surety’s rights. Because the contractor is a signatory to the bond and ultimately liable to the surety, these matters are critical to the contractor’s risk analysis as well.
To avoid the potential pitfalls of unfavorable or unenforceable terms, contractors should understand how a surety examines an underlying contract.
Incorporating Contract Terms
How a contract controls a surety’s rights often is determined by whether the bond expressly incorporates the underlying contract. Courts often apply the doctrine of incorporation by reference to impose or abdicate the liability of a performance bond surety.
Not every bond incorporates the underlying contract. Standard bond forms, such as the AIA 312, regularly contain provisions incorporating the contract. Other bonds, usually those provided by an obligee or government owner, often contain no such provision. For this reason, and often unbeknownst to contractors, sureties must consider how a contract is incorporated into the bond.
Liquidated Damages Provisions
Incorporation of the contract can affect a surety with regard to liquidated damages provisions. When a project is delayed and a principal defaulted, the obligee often seeks delay damages from the surety. Unlike a contractor, which may be directly liable for liquidated damages, the surety’s liability may depend on whether the bond incorporated the contract’s liquidated damage provision.
In Florida, for example, although a surety’s liability is coextensive with that of the principal, the surety’s liability for liquidated damages is limited to the provisions of the bond. If the bond does not expressly incorporate the underlying contract, the surety may not be responsible for delay damages.
Contractors should recognize that the enforceability of a liquidated damages provision against a surety may depend on the bond’s incorporation of the underlying contract.
Arbitration Clauses
A surety’s rights also are affected by arbitration provisions. Claims between the owner and contractor may be subject to arbitration, and a takeover surety may wish to take advantage of an underlying contract’s arbitration clause to avoid litigation.
Many federal courts have held that a surety may enforce a contract’s arbitration clause only when the bond incorporates the contract by reference. Based on these decisions, contractors should understand that, in some jurisdictions, a surety may take advantage of a contract’s arbitration clause if incorporated into the bond.
Warranty and Latent Defect Provisions
Nothing surprises a surety more than having to defend a performance bond claim several years after a project is completed. But, courts often impose liability on a surety resulting from latent defects and warranty items. These decisions are heavily affected by the law in the project’s jurisdiction. Contractors should be aware that critical to a surety’s decision to bond a project is a thorough understanding of the contract’s warranty provisions, as well as the state statutes regarding construction defects.
The typical warranty on a construction contract is one year after substantial completion. State-imposed statutes of limitations are often much longer, and in some jurisdictions, the surety’s obligation may extend well past the warranty period.
Contractors and sureties should recognize the potential liability for both parties may extend beyond the warranty provided in the contract.
Pay-When-Paid Clauses
In addition to identifying contract clauses that may affect a surety’s rights, contractors also should be aware of contract provisions that do not apply to the surety. For example, pay-when-paid clauses are commonly included in subcontracts, but sometimes cannot be asserted by the surety.
The purpose of the pay-when-paid clause is to withhold payment to a subcontractor until the prime contractor is paid by the owner. Ordinarily, when the surety steps in to complete a defaulted project, or enters a takeover agreement, the surety funds the project on its own until it is indemnified or receives payment from the obligee. In this situation, the surety may want to take advantage of a pay-when-paid provision to avoid paying subcontractors before receiving payment from the obligee or principal.
Several jurisdictions refuse to enforce a pay-when-paid clause to bar immediate liability of a surety unless the clause is in the bond itself. Even if the clause is validly enforced by the contractor, the surety may not be able to take advantage of such a provision.
Contractors and subcontractors should recognize such clauses and be familiar with their potentially restrictive application against a surety. This is a particularly troubling situation because a clause that is enforceable by the contractor could be unenforceable if the surety is found liable and has to seek reimbursement from its principal.
As contractors and sureties review contract terms differently to calculate their overall risk, each should be wary of the pitfalls included in the terms of the underlying contract. Although no one can predict the claims that may be asserted on a project, understanding how the terms of the underlying contract affect a surety’s obligation will prepare both the contractor and the surety to defend against illegitimate claims.
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Friday, September 3, 2010