Surety bonds have been an essential element of a comprehensive risk management program on large construction projects for more than 150 years. Typically, government and institutional construction projects require the contractors who are bidding on large construction projects to submit bid bonds in support of their initial tender and a Performance Bond and Labour and Material Payment Bond if the tender is accepted.
Quite apart from the security afforded by surety bonds themselves, the mere fact that a contractor has qualified for bonding provides a measure of security to those with whom the contractor is dealing, whether it be the owner of the project or the general contractor. Sureties spend a great deal of time and expense in the underwriting process to qualify a contractor before it will issue bonds on its behalf. Sureties conduct a rigorous pre-qualification review of the contractor to ensure that they possess the requisite expertise and experience required to complete the project in respect of which the Surety Bonds are to be provided. As part of the underwriting process, the Surety will assess the financial health of the contractor including a review of cash flow, cost control mechanisms, working capital and the contractor’s relationship with its financial institution. The Surety will examine whether the contractor has sufficient personnel, equipment, working capital and expertise to complete a particular contract given the demands of the other projects in which the contractor is involved and the nature of the project under consideration. One of the risks to a surety is a contractor that grows too large too quickly. Once a Surety has completed the underwriting process and has committed to provide surety bonds for a particular contractor, each individual contract is reviewed and assessed on a project by project basis given the demands of that particular project on the other projects in which the contractor is involved.
Unlike most insurance products in which an exposure to a loss arising from fortuitous events is expected, Surety Bonds are underwritten with the expectation that the Surety will never suffer a loss for which it will be unable to recover from its Indemnitors. As a condition of establishing a bonding facility on behalf of a contractor, the Surety will almost invariably require the contractor, its related companies and its principal shareholders to enter into an Indemnity Agreement pursuant to which each of the Indemnitors agrees to indemnify and save the Surety harmless from any loss or damage, including adjusting, investigation and counsel fees for which the Surety may be exposed as a result of issuing bonds on behalf of the contractor.
The Bonds
Until relatively recently, the general wording of surety bonds has remained more or less consistent for more than 100 years. The obligation under most surety bonds in couched in terms that, if the contractor, defined as the “Principal” under the Bond, performs its contract with the owner or general contractor, defined as the “Obligee”, the Bond will be void; otherwise, the Bond will respond to a default on the part of the Principal provided certain conditions are established. In the 1995 decision of the House of Lords in Trafalgar House Construction (Regions) Ltd. v. General Surety & Guarantee Co. Ltd. , the House of Lords undertook a review of the essential nature of surety bonds and commented as follows:
“My Lords, it only remains to draw attention, as did Lord Atkin, to the archaic nature of this bond. In the Workington case [1937] A.C. 1, 17, he said:
“I may be allowed to remark that it is difficult to understand why business men persist in entering upon considerable obligations in old-fashined forms of contract which do not adequately express the true transaction. The traditional form of marine policy is perhaps past praying for; but why insurance of credits or contracts, if insurance is intended, or guarantees of the same, if guarantees are intended, should not be expressed in appropriate language, passes comprehension. It is certainly not the fault of lawyers.”
These words were echoed by Hunter J.A. in Tins Industrial Co. Ltd. v. Kono Insurance Ltd., 42 B.L.R. 110, 120, when he remarked:
“It is lamentable that an 18th century English concept should be used in this jurisdiction to confuse everybody, as we think it has confused a lot of people in this case.”
Hudson’s Building and Engineering Contracts, 11th ed., pp. 1499 – 1500, para. 17-007 refers to the almost universal practice of commercial bondsmen in clothing a very simple obligation in the jargon of an 18th century English bond. Like Lord Atkin and Hunder J.A. I find great difficulty in understanding the desire of commercial men to embody so simple an obligation in a document which is quite unnecessarily lengthy, which obfuscates its true purpose and which is likely to give rise to unnecessary arguments and litigation as to its meaning.”
On large institutional projects, the Bonds and related documents required by an Owner are a Bid Bond which will be issued in support of the tender, a Consent of Surety, a Performance Bond and a Labour and Material Payment Bond.
A Bid Bond is usually issued for 10% of the amount of the bid submitted and assures that the bid has been submitted in good faith, the contractor intends to enter into a contract at the bid price and the contractor will provide the required Performance Bond and Labour and Material Payment Bond. As it is anticipated that most tenders submitted on any particular project will fall within 10% of the estimated value of the contract, the penal sum of a bid bond is usually fixed at 10% as that penalty should be sufficient to indemnify the Obligee in the event that the contractor declines to enter into a contract after its bid is accepted and the contract must be awarded to the next highest bidder.
The Consent of Surety is a document pursuant to which the Surety that has issued the Bid Bond agrees that, if the tender of the submitting contractor is accepted, the Surety will commit to issuing a Labour and Material Payment Bond and Performance Bond, each in the amount of 50% of the agreed contract price.
The Performance Bond protects the Owner from financial loss should the contractor fail to perform the contract in accordance with its terms and conditions. This will occur where a contractor, even a well financed contractor runs into financial difficulty, often due to unanticipated conditions on one or more of the contracts in which it is involved. In spite of the fact that the contractor has been pre-qualified, had a successful history of completing contracts similar in scope and nature, occasionally circumstances will arise that are beyond the control of the contractor to foresee or overcome. In these circumstances, the Surety will invariably step in to complete the project exercising one of the options available to it under a Performance Bond.
A Labour and Material Payment Bond assures that subcontractors, labourers and material suppliers having a direct contract with the Principal will be paid in the event of a contractor default and will avoid the necessity of subcontractors filing liens on the project to secure payment. Generally where liens are filed, the Surety will arrange to have the liens discharged from title by providing alternate security in the form of lien bonds.
So What is New?
The traditional form of Performance Bond which was in standard use until sometime in 2010 was difficult to read, even more difficult to understand and was deserving of all of the criticism levelled by the House of Lords in Trafalgar House. A copy of the old bond wording that was in standard use until 2010 is attached at Appendix “A”.
“Process Enhanced” Performance Bond
Following almost three (3) years of consultation with Owners, Contractors and Consultants, in December of 2011, the Surety Association of Canada introduced what it described as a “Process Enhanced” Performance Bond that imposed relatively strict time lines for responding to claims received by Sureties under a Performance Bond and which removed much of the uncertainty that was inherent in the traditional form of Performance Bond. A specimen copy of the “Process Enhanced” Performance Bond developed by the Surety Association of Canada is attached at Appendix “B”.
Under the “Process Enhanced” form of Performance Bond, within five (5) business days of receiving the original demand, the Surety is required to acknowledge its receipt and to request the information it will need to conduct its investigation. Once the Surety receives the information and documentation it has requested, it has 21 business days to complete its investigation and report back to the owner. In the event that the Surety cannot complete its investigation within that time frame, it is required, prior to the expiration of the 21 day response time, to provide the owner with an update that sets out the status of its investigation and a firm estimate of when its investigation will be completed and its position reported to the owner. The “Process Enhanced” form of Performance Bond also provides a mechanism for undertaking the performance of emergency measures required to preserve the work while the Surety conducts its investigation and provides for pre and post-demand conferences with the Owner, Surety and Contractor which are required to be conducted on a “without prejudice” basis.
Since the introduction of the “Process Enhanced” Performance Bond, several sureties have introduced their own variations on the enhanced bond wording to provide greater comfort to the purchasers of surety bonds and in particular, to provide a mechanism to allow the construction of the project to be completed in circumstances in which a genuine dispute exists regarding the existence of a default under the contract and the Surety is not in a position to acknowledge default and proceed with the completion under one of the options that is available to it under the Performance Bond. The traditional form of Performance Bond and even the Process Enhanced Performance Bond does not provide a mechanism for completing the contract where there is a genuine dispute as between the Principal and Obligee regarding whether, or which of those parties, is in default of its obligations under the contract and the Surety is unable to make a determination on the basis of the limited time available for it to complete an investigation. One of the measures that has been introduced to address completion in these circumstances is a provision which contemplates the Surety and the Obligee entering into a Mitigation Agreement which will allow the work to continue with each of the Surety and Obligee reserving its rights pending the ultimate determination of whether there has been a default under the contract.
Practical Considerations
In the situation where the Contractor (Principal under the Bond) becomes insolvent or bankrupt and abandons the performance of the Contract, the issue of whether or not there has been a default is relatively easy to determine. The one qualification to the general rule is where a breach of the Contract by the Owner (the Obligee under the Bond) is a material cause of the default. In situations in which the Contractor is not insolvent but has been delayed in completing the work under the Contract, often by factors beyond its control or by a combination of factors, some of which are the fault of Contractor and others of which are not, the Surety’s determination of whether or not there has been a default becomes far more difficult. In these circumstances, Sureties have traditionally taken the position that there is a genuine dispute between the Owner/Obligee and the Contractor/Principal which the Surety is unable to resolve solely on the basis of the investigation that it is able to perform within a limited period of time, which often lead to a denial of the claim on the Performance Bond.
In the face of increasing competition from underwriters of other security products and increased demands from stakeholders for a prompt resolution of disputed contract claims, the emerging trend among Sureties has been to conduct a thorough investigation of any claim received on a Performance Bond and, in circumstances in which the Surety is truly unable to make a determination regarding whether or not the Principal is in default under the Contract, to engage the Owner/Obligee and the Contractor/Principal in discussions to achieve a resolution that will allow the work to continue to completion while reserving to each of the parties the right to pursue litigation over the disputed matters at a later date. The types of arrangements that may be entered into will vary depending upon the circumstances of each case but the emerging trend towards the use of some form of mitigation agreement that will allow the work to be completed on the most cost-effective and efficient basis while preserving the right to litigate disputed issues at a later date, is becoming more common and gaining wider acceptance among Sureties and Obligees.
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1 Trafalgar House Construction (Regions) Ltd. v. General Surety & Guarantee Co. Ltd. [1996] 1 A.C. 199 (H.L.)
2 Appendix “A” – old bond wording, reproduced with the consent of Intact Insurance Co.
3 Appendix “B” – Specimen copy of “Processed Enhanced Performance Bond”, reproduced with the consent of the Surety Association of Canada and Intact Insurance Co.
