Construction Risk Management

What are Performance Bonds and How Do They Work??

Construction necessarily involves risk on the part of owners, contractors, engineers, and other participants. The more complex a project, the more risk is involved. Surety bonds exist to transfer this risk from contractors to a third party. A performance bond is a particular type of surety bond where a bonding company or surety agrees in writing to provide a stipulated amount as security to an owner for the completion of a contractor’s duties. As consideration, the bonding company usually charges the contractor a premium which is passed on to the owner as part of the cost of the project in the contractor’s tender. Standard construction contracts such as CCDC-2 require that performance bonds are taken out as specified in the contract documents prior to the start of any work. Typically, the bond reflects 50% or 100% of the value of the work. Performance bonds can also be taken out between general contractors and sub-trades to reduce the risk to the general contractor in the event of a sub-trade’s default.

It is important to differentiate a performance bond from other types of risk management. A performance bond is not insurance. Bonds involve a third party surety who is by mutual agreement between the parties to the bond “on the hook” in the event of default:

The premium paid for a surety bond is also not subject to fluctuations due to changes in risk, as the bonding company should satisfy itself regarding the potential performance of a contractor prior to the issuing of the bond and the availability of re-insurance.

As the amount of a bond is usually stipulated, an owner who has received payment under the bond must pursue the contractor for any loss over and above that amount. In light of the fact that the surety assumes liability for all warranties under the construction contract, this amount can quickly become exhausted.

Finally, a performance bond does not normally guarantee that a contractor will pay its sub-trades or suppliers, which is what is known as a labour and material payment bond or “L&M bond”.

What Options Does a Surety Have Upon Default and How Quickly Does the Surety Respond?

In order for a claim to be made, there must first be a default under the contract. The standard bond form CCDC 221 states that a contractor must “promptly and faithfully perform the Contract” and default is defined as “Whenever the Principal shall be, and declared by the Obligee (or owner) to be, in default under the Contract…”

Normally, default is invoked when a contractor ceases to perform the work that was agreed upon. However, case law has also indicated that non-fundamental breaches may be sufficient to call upon the bond. It is for the owner or obligee to determine when a default is serious enough to terminate the contract and call on the bond: Marigold Holdings Ltd. v. Norem Construction Ltd., [1988] A.J. No. 612 (Q.B.). At that time, the surety has a duty to conduct an investigation in order to determine whether amounts are payable under the terms of the bond. Some defences available to the surety are:

(a) Failure to meet obligations: The words “the Obligee having performed the Obligee’s obligations thereunder” in CCDC 221 mean that if the claimant does not meet the obligations under the building contract, he or she may forfeit the right to make a claim under the bond. For example, the owner cannot fail to make payment to the contractor and then call on the surety to perform.

(b) The bond was not signed, sealed or delivered by the parties to it: Magna Contracting & Management Inc. v. Newfoundland (2002) 10 C.L.R. (3d) 183 (Nfld. T.D.); Larbonne v. Shore, [1928] 2 D.L.R. 977 (B.C.C.A.); Paul D’Aoust Construction Ltd. v. Markel Insurance Co., [1999] OJ No. 1837 (C.A.), affirmed [2001] 3 S.C.R. 744.

(c) A claimant should give prompt notice to the surety. Failing to do so prejudices the surety and discharges his or her obligations: Citadel-General Assurance v. Johns- Manville Canada Inc. (1980), 113 D.L.R. (3d) 686 (Ont. H.C.); affirmed 123 D.L.R. (3d) 763, (Ont. C.A.); affirmed [1983] 1 S.C.R. 513; Whitby Landmark Development Inc. v. Mollenhauer Construction Ltd. [2003] O.J. No. 4000 (Ont. C.A.). However, failing to comply with a prescribed notice method does not in itself relieve a surety of liability. CCDC 221 also provides for a two-year limitation under the bond.

(d) An owner cannot increase the risk for the surety without the surety’s consent. A material change to the bonded contract without the consent of the surety will release the surety unless the change benefits the surety: Holme v. Brunskill (1878), 3 Q.B.D. 495; Doe et al v. Canadian Surety Co., [1937] S.C.R. 1. However, consent to a variation will be implied if there are provisions in the contract for changes in the work: Preload Co. of Canada v. City of Regina, [1959] S.C.R. 801 at 829. Even still, as Justice Southin held in Fraser Gate Apartments Ltd. v. Western Surety Co. (1998) 54 B.C.L.R. (3d) 1 (C.A.), a material change may not release the surety completely in that warranties respecting workmanship may have to be honoured.

(e) Actions by the owner that prejudice the surety’s rights may release the surety. For example, remedial steps by the owner which increase the cost of exercising the surety’s rights or premature payments to the contractor made contrary to the payment schedule in the contract will discharge the surety: Mulgrave v. Simcoe & Erie Gen. Ins. Co. (1977), 73 D.L.R. (3d) 272 (N.S.C.A.).

(f) If the bond has been paid out to the stipulated limit, there is no further liability. Assuming that the surety has investigated and found a proper default, the surety has three options. It can:

(i) Complete the project. This option is rarely used as it risks increased costs to the surety;

(ii) Retain the original or a replacement contractor to complete the work. This also risks higher costs than those stipulated in the bond;

(iii) Re-tender the contract for the benefit of the owner and pay any increased costs of such work up to the limit of the bond.

The surety should act promptly and with a view to minimize the negative consequences of the default. Courts will look at the speed of a surety’s response in light of all the factors of the case, including the progress of the work and the impact of any delay. In Frasergate Apartments Ltd. v. Western Surety Co., supra, it was held that the speed of investigation was more important at a critical phase of the work rather than when dealing solely with warranty obligations. Likewise, in Lac La Ronge Indian Band v. Dallas Contracting Ltd., 2004 SKCA 109, the Court held that it was reasonable to wait until spring on a project due to weather conditions in Northern Saskatchewan.

What Claims are Covered Under the Bond?

There continues to be a debate whether a performance bond surety is only liable to cover the cost of “bricks and mortar”, i.e., the principal construction under the contract, or for all the collateral obligations set out in that contract. The two cases which represent this debate are Whitby Landmark Development Inc. v. Mollenhauer Construction Ltd., supra, and Lac La Ronge Indian Band v. Dallas Contracting Ltd., supra.

In Whitby, the Ontario Court of Appeal considered the wording of a performance bond and held that the bond required the surety to fulfill all of the defaulting contractor’s contractual obligations, which included not only completing the physical construction, but also refunding costs savings to the owner. This decision was unusual in that it did not support the conventional view that a performance bond surety was only responsible for completing the actual physical construction in the event of default.

By contrast, the Saskatchewan Court of Appeal in Lac La Ronge reaffirmed the conventional approach to the scope of a surety’s obligations. In both cases the performance bond was the standard CCDC form and incorporated the construction contract by reference. The Court chose not to follow Whitby and stated that a surety was not to be held as an “insurer” and was only bound to complete the actual physical construction. It also concluded that a surety’s liability should be the same regardless of the option that it selected to remedy the contractor’s default.

Leave to the Supreme Court of Canada was not pursued by Lac La Ronge. As such, we are left with no definitive word from the Supreme Court on which case is the proper interpretation of a surety’s obligation under a performance bond. In B.C., Lac La Ronge may mean that a surety’s exposure is limited to the costs of physically completing the construction project. Until a pronouncement is made from the Supreme Court of Canada, sureties will likely re-word their performance bonds to specifically exclude all of the collateral obligations contained in the underlying construction contract.

How Do I Make a Claim Under a Bond?

Given the above discussion, it is clear that a potential claimant should proceed with care when making a claim. There are a few tips to keep in mind:

(a) Before a potential claim, speak to the surety, preferably through legal counsel. The bonding company may be able to help with performance issues with the contractor if problems are at an early stage and be a helpful third party in discussions that may have broken down;

(b) In the event of default, make a formal claim according to the terms of the performance bond promptly by registered mail. Document in writing all communications with the defaulting party and the surety. In addition, owners should ensure that they act early to avoid potential liens on the contract from sub-trades or otherwise;

(c) Be extremely careful regarding remedial steps that have the potential of prejudicing the surety’s rights. It is not up to the owner to complete work and later request that the surety pay the costs for completion. Any steps should be reviewed with the surety to ensure compliance under the bond; and

(d) Review the underlying contract so as not to be met with an argument that there has not been full compliance.

In all situations, legal counsel should be consulted at the earliest opportunity. Doing so will often allow for negotiations to take place that will minimize long-term costs and hopefully provide options to get a “problem” project back on track.

Prepared by former Associate, Lyle E. Braaten