SURETY CLAIMS, EVOLVING TRENDS AND PRACTICAL CONSIDERATIONS
Performance Bond Claims
The Obligation
In order to trigger the Surety’s obligations under a Performance Bond four conditions must be satisfied:
(a) there must be a default by the Principal under the Construction Contract;
(b) the Obligee must declare the Principal to be in default;
- (c) the Obligee must give notice of default to the Surety; and
- (d) the Obligee must have performed its own obligations under the contract.
In the absence of notice of default to the Surety, there is no obligation to provide indemnity under the Bond.
The Surety’s Duty to Investigate
Once a notice of default has been given to the Surety, the Surety is obligated to investigate the default alleged. The case law that has considered the Surety’s obligations under the traditional form of Performance Bond have consistently held that the Surety must be given reasonable time to conduct an investigation into any claim that is received under a Performance Bond. The amount of time within which the Surety is required to complete its investigation varies depending upon the circumstances in each case. As a practical matter, there were no pre-determined time limits imposed upon the Surety within which it was required to complete an investigation and on an industry wide basis, there tended to be a significant disparity in the manner in which Sureties responded to the claims that were received under their Performance Bonds.
“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 “Process Enhanced” Performance Bond that imposed relatively strict time lines for responding to claims received by Sureties under the 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. This attachment is reproduced with the consent of the Surety Association of Canada.
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 typically 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 provides 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 work required to preserve the work while the Surety conducts its investigation and also provides for pre and post-demand conferences with the Owner, Surety and Contractor which are required to be conducted on a “without prejudice” basis.
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 a 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.
The Surety’s Options
Upon satisfying itself that the Contractor is in fact in default, the Surety has the option of discharging its obligations under the Performance Bond by:
(a) remedying the default of the Principal;
(b) completing the contract itself (normally by engaging either the Principal or another
contractor to complete the work);
(c) putting the work out to tender, arranging for the Obligee to enter into a contract with the successful low bidder and financing any deficiency between the contract price of the low bidder and the balance of the contract price under the original contract; or
(d) providing financing to the Principal in order to fund the completion of the work under the contract.
Depending upon the cost to complete and the balance remaining payable under the contract, the Surety also has the option of tendering the penal sum of the Bond in the event that the difference between the cost to complete the work and the balance remaining on the contract exceeds the penal sum of the Bond.
Another option which the Surety may explore with the Obligee is whether the Obligee is prepared to accept a specified amount in satisfaction of its claim under the Performance Bond. This process is commonly known as “buying back the bond” and is an option which the Surety may elect to pursue where the Obligee is a contractor who can complete the work itself at a lower cost than the Surety would incur by engaging another contractor to do the work.
The Defences Available
In appropriate cases, the Surety will defend the claim under a Performance Bond where:
(a) there has been no default under the contract by the Principal;
(b) the Obligee has failed to perform its own obligations under the contract – often by failing to make payments to the Principal, failing to address change order requests and claims for additional compensation arising from compensable delays in a timely manner or interference with the performance of the work;
(c) there has been a material alteration of the underlying contract without the knowledge or consent of the Surety which has prejudiced the Surety’s position;
(d) the Obligee has prejudiced the Surety’s position by overpaying the Principal as a result of which there are insufficient funds remaining payable under the contract to complete the work;
(e) the Obligee has prejudiced the Surety’s position by failing to provide prompt notice of default under the contract.
The validity of each of these defences will of course depend on the facts in each case and in particular upon the terms of the underlying contract between the Obligee and the Principal.
Labour and Material Payment Bonds
Labour and Material Payment Bonds are often required by the terms of Construction Contracts to be issued in order to secure potential claims by subcontractors and material suppliers. Labour and Material Payment Bonds are typically issued in conjunction with a Performance Bond.
Labour and Material Payment Bonds, provide security for the payment of certain claims which fall outside the scope of lien legislation including, for instance, the claims of transportation companies who deliver materials to the work site under contracts with the Principal and in some instances union dues. (Baker v. Aprok Drywall Ltd. [1990] B.C. J. No. 2583 (B.C.S.C.)).
In order to qualify as a Claimant under the most commonly used Labour and Material Payment Bond wording, a claimant must have a direct contract with the Principal. Some forms of Labour and Material Payment Bonds (notably those required under Federal Government projects) also extend to claimants contracting with a subcontractor of the Principal.
Under the more common wording, however, in order to qualify as a claimant under the Bond, a subcontractor or material supplier must prove that:
(a) it has a direct contract with the Principal;
(b) the contract is for the supply of labour, material or both reasonably required for use in the performance of the contract;
(c) it has supplied the labour, material or both contracted for to the project;
(d) it has not been paid as provided for under the terms of the contract with the Principal before the expiration of a period of ninety days after the date on which last of the claimant’s work or labour was done or performed or materials were furnished;
(e) it has given notice of its claim under the Bond to the Surety, Principal and Obligee within the time limits prescribed in the Bond.
The usual notice provisions found in Labour and Material Payment Bonds require the claimant to give written notice of its claim to each of the Principal, Surety and Obligee by registered mail stating with substantial accuracy the amount claimed:
(a) in respect of holdback funds within one hundred and twenty (120) days after the claimant should have been paid the holdback under its contract with the Principal;
(b) in respect of any other claim within one hundred and twenty (120) days after the date upon which the claimant performed the last of the work or labour or furnished the last of materials for which the claim is made.
At one time, the Courts required strict compliance with all aspects of the notice provisions of Labour and Material Payment Bonds as a pre‑condition to recovery under the Bonds. More recently, a far more flexible approach has been taken. Now a notice under a Labour and Material Payment Bond is effective if there has been “substantial compliance” with the notice provisions. Citadel General Assurance Company v. Johns‑Manville Canada Inc. et al (1983), 147 D.L.R. (3d) 593 (S.C.C.).
In a number of decisions culminating in the decision of the Supreme Court of Canada in Elance Steel Fabricating Co. v. Falk Bros. Industries Ltd. (1989), 35 CLR 225 (SCC), the Courts have held that the relief from forfeiture provisions in Provincial Insurance Legislation apply to claims under Labour and Material Payment Bonds and that the Courts may grant relief from forfeiture in appropriate cases where a claimant has failed to comply with the time limitations set out in a Labour and Material Payment Bond. The appropriate circumstances appear to extend to all situations in which the Surety is unable to establish that it has actually been prejudiced by reason of the delay in receiving notice of a claim.
In order to enforce a claim under a Labour and Material Payment Bond, an action must be commenced within the limitation period set out in the Bond, normally within one year following the date upon which the Principal ceased work on the contract, including work performed under guarantees provided for in the contract. The expiry of the limitation period is an absolute bar to the prosecution of an action under the Bond. Unlike notice provisions, the courts have no discretion to grant relief against a failure to commence an action on the Bond within one year in the absence of an enforceable waiver of the limitation period by the Surety. Make sure that you READ THE BOND to identify and comply with both the notice provisions and limitation period in THAT BOND.
The Surety’s obligations under the Bond are limited to the penal amount of the Bond and are reduced by any payments made by the Surety in good faith to other claimants. As a general rule, Sureties tend to review each of the claims received under a Bond, investigate each of the claims submitted and proceed with payment of all valid claims at a date well after the expiry of the notice period in the Bond. In the event that the Bond penalty is insufficient to honour all claims, the Surety will make a pro rata distribution to claimants on an equitable basis or pay the bond penalty into Court.
Maintenance Bond
A Maintenance Bond is a Bond pursuant to which the Principal and the Surety undertake to fulfill all of the warranty and maintenance obligations under a Contract. As in the case of the other Bonds, where a Principal fulfills all of its obligations under the Contract, the Bond is null and void. Where, however, a Principal fails to perform the maintenance obligations under a contract, the Obligee may, by written notice sent by registered mail to the Surety within ten days of learning of the default of the Principal, require the Surety to perform the necessary repairs or maintenance work within a further period of thirty days subject to the other conditions contained in the Bond. These conditions normally limit the liability under the Bond to a specified period from the date of completion and acceptance of the work. Certain types of claims falling outside of the ambit of maintenance and warranty claims are excluded and the liability of the Surety is limited to a specified amount.
Lien Bonds
A Lien Bond is a form of Bond which is created for the specific purpose of replacing the security of a Lien filed against title by a claimant under the Builders Lien Act.
A Lien Bond is signed by the Principal and the Surety and contains an unconditional undertaking to pay the amount of any judgment of the Supreme Court of British Columbia in a Lien claim action (unless an appeal is taken from the judgment of the Court in which case the obligation to pay under the Bond is postponed pending the outcome of the appeal).
As with other Bonds, the penal amount of the Bond is limited, usually to the amount of the Lien claim which it replaces.
The Surety is entitled to take advantage of the limitation of liability under the Builders Lien Act.
Indemnity Agreements
Unlike other contracts of insurance, Bonds are issued by sureties with the expectation that the Surety will be able to recover from the Principal or other indemnitors under the Indemnity Agreement all amounts which it is required to pay out under the Bonds which it has issued.
Prior to issuing any Bonds at the request of a contractor, a Surety will conduct a thorough financial investigation of the contractor and of its principals. Depending upon the financial circumstances of the contractor and its financial supporters, a Surety will normally limit the value of the contracts in respect of which it is prepared to provide Construction Bonds based upon its assessment of the financial health of the Principal and of its ability to complete projects undertaken.
Once this assessment is completed and prior to issuing any Bonds at the request of a contractor, the Surety will require the contractor and its principals (normally the officers and shareholders of the company, their spouses and any related companies) to execute and deliver a form of Indemnity Agreement.
In addition to a number of other remedies which are available to the Surety in the event of default the Indemnity Agreement will provide that the indemnitors will indemnify the Surety in respect of any liability or expenses incurred as a result of issuing Bonds at the contractor’s request including all of the costs associated with investigating, settling and paying claims under the Bonds. In addition to the right to recover any payments made or expenses incurred, the Indemnity Agreement will provide that in the event of default, the Surety has the right to:
(a) use its absolute discretion to adjust, settle or compromise any claim, demand, suit or judgment upon the Bonds with or without the consent of the Indemnitors;
(b) consent to any change in the contract or contracts, guarantee or advance loans for the purpose of the contract or complete the contract;
(c) assume all subcontracts in connection with the contract;
(d) take possession of all machinery, plant and equipment, tools and materials required to complete the contract;
(e) recover any and all sums due under the Contract;
(f) take such action as it may deem necessary in its absolute discretion to obtain its release from any and all liability under the Bonds;
- (g) demand from the indemnitors sufficient funds to meet the Surety’s obligations under the Bonds; and
- (h) register a security interest against the personal property of the contractor and indemnitors under the Personal Property Security Act.
Other Rights of a Completing Surety
In addition to the rights of the Surety arising out of the Indemnity Agreement, the Surety is entitled to recover the balance of the unearned contract price from the Obligee under the terms of the standard Performance Bond. The completing Surety’s claim to the unearned balance of the contract funds has priority over the claims of any other creditor of the Principal, (Canadian Indemnity Co. v. British Columbia Hydro & Power Authority, October 4, 1976 – Vancouver unreported, BCCA) except perhaps the Canada Revenue Agency under its super priority rights in the Income Tax Act and Excise Tax Act and claims of trust claimants under the Builders Lien Act (Commercial Union v. City of Surrey (1997), 32 CLR (2d) 1 (B.C.C.A.)), pursuant to the Surety’s subrogation rights at common law. In certain circumstances, the Surety will also have priority over other creditors of the Principal to the payment of “earned but unpaid contract funds” which were payable at the date of default. The Surety’s position relative to other creditors with respect to earned but unpaid contract funds will depend in part upon such factors as:
(a) whether the Surety holds assignments of the contract funds and/or the lien and trust claim rights of unpaid subcontractors and suppliers;
(b) the specific terms of the Indemnity Agreement, whether the Indemnity Agreement has been registered under the Personal Property Security Act (“PPSA”) and the timing of the registration under that Act;
(c) the nature of the security held by other creditors of the Principal and whether and when that security was registered under the PPSA.
In the recent decision in PCL Constructors Westcoast Inc. v. Norex Civil Contractors Inc., 2009, B.C.S.C. 95 (CanLII), the Supreme Court of British Columbia found that, in certain circumstances, the right of equitable set off may provide an owner or contractor (or a Surety exercising its subrogated rights under a Performance Bond) to assert a claim to funds either held or deposited into court in priority to the claim of the Canada Revenue Agency under the super priority created under the Income Tax Act and Excise Tax Act. In the PCL Action, PCL had entered into a contract with Norex, pursuant to which Norex was to provide construction services and PCL was to pay Norex an amount of approximately $1 million dollars plus GST. Norex defaulted in performing the Contract and PCL hired another subcontractor to complete the work left undone by Norex and incurred an expense over and above the amount remaining under the Norex Contract of $100,000.
At the time that Norex defaulted, it was indebted to two subcontractors who filed liens against title to the project totaling approximately $28,000. PCL paid the sum of $28,000.00 into court to secure the release of the lien claims and the Canada Revenue Agency asserted a claim to the funds in court in priority to the claims of the lien claimants.
In a well reasoned decision, Madam Justice E.A. Arnold-Bailey found that PCL was entitled to maintain a claim of equitable set off in respect of the additional cost of approximately $100,000 that it had incurred as a result of Norex’s default. Accordingly, PCL was never indebted to Norex and Norex itself had no right to the holdback. As Norex had no right to the holdback neither did the Canada Revenue Agency and the monies in court therefore belonged to the lien holders.
In circumstances in which a Surety under a Performance Bond steps in to complete the Contract on the default of a Principal and incurs an expense in excess of the amount remaining under the underlying Contract, it will presumably be in a position to assert a right of equitable set off over any funds that might otherwise have been payable to the Principal under the underlying Contract in priority to the claim of the Canada Revenue Agency to those funds.
In addition to its claim for the “balance of the contract price” under the Performance Bond, the Surety is entitled to obtain as a condition of payment to Labour and Material Payment Bond claimants, an assignment of all trust rights and lien rights accruing under the Builders Lien Act.
The Surety’s right to obtain these assignments arises both at common law and pursuant to the provisions of Section 34 of the Law and Equity Act which provides:
“Surety who discharges liability entitled to assignment of securities
34 (1) Every person who, being surety for the debt or duty of another or being liable with another for any debt or duty, pays the debt or performs the duty is entitled to have assigned to him or her or to a trustee for him or her every judgment, specialty or other security that is held by the creditor in respect of the debt or duty, whether the judgment, specialty or other security is or is not deemed at law to have been satisfied by the payment of the debt or performance of the duty.
(2) The person who has paid the debt or performed the duty is entitled to stand in the place of the creditor and to use all the remedies and, if necessary and on a proper indemnity, to use the name of the creditor in any action or other proceeding at law or in equity, in order to obtain from the principal debtor, or a co-surety, co-contractor or co-debtor indemnification for the advances made and loss sustained by the person, and the payment or performance made by the surety is not pleadable in bar of any action or other proceeding by him or her.
(3) A co-surety, co-contractor or co-debtor is not entitled to recover from any other co-surety, co-contractor or co-debtor, by the means referred to in subsections (1) and (2), more than the just proportion to which, as between those parties themselves, the other co-surety, co-contractor or co-debtor is justly liable”
As the assignee of trust claims under the Builders Lien Act, a Surety will normally enjoy priority over any other creditor of the Principal to the funds which would otherwise be subject to a trust in favour of the unpaid lien claimants, but subject in most circumstances to the priority of Revenue Canada Agency under the Income Tax Act and Excise Tax Act where claims have been advanced under that legislation.
Getting the Surety to Complete
Getting a Surety to complete a contract or otherwise discharge its obligations under the Performance Bond will normally be a relatively simple process provided that the Obligee has taken reasonable steps during the course of the contract:
(a) not to prejudice the Surety’s position or ability to complete the contract; and
(b) to perform its own obligations under the contract
and provided that there is an actual default under the contract and the Obligee acts promptly to notify the Surety of the default.
The factors which may lead the Surety to deny liability under a Performance Bond include the following:
(a) failure of the Obligee to pay amounts properly payable to the Principal under the contract which impairs the Principal’s ability to do the work and produces a default under the contract;
(b) overpayment of the Principal such that the Surety is prejudiced in its ability to complete the work in the event of default because there are insufficient funds available to complete the work under the contract;
(c) the Obligee consenting to or orchestrating a material alteration of the underlying contract which adversely prejudices the Surety such as:
(i) materially changing the scope of the contract to include work well beyond that contemplated by the original contract;
(ii) giving up other security which has been provided for the performance by the Principal of its obligations without the consent of the Surety;
(iii) substantially delaying the time for performance of the contract; or
(d) failing to give prompt notice of a default to the Surety in sufficient time to enable the Surety to correct the default or take other steps to mitigate any loss.
Assuming that the Obligee has done nothing during the performance of the contract to prejudice the Surety’s position, there is genuine default by the Principal under the Construction Contract and the Obligee gives prompt notice of the default to the Surety, the Surety will perform its obligations.
Practice Points
Generally speaking, giving formal notice of default to a Surety under a Construction Contract is a significant event. Often Obligees are reluctant to give formal notice to the Surety in the absence of a clearly defined default by the contractor/Principal.
While formal notice of default ought not to be given in the absence of an actual default by the Principal in the performance of the contract, it is often advisable to notify the Surety of a potential problem informally at the first indication that the contractor is encountering difficulty in performing its obligations, either to prosecute the work with reasonable dispatch or in dealing with subcontractors and suppliers. Indications of potential problems will include the filing of liens, a request by the contractor for advances on future draws and receipt of complaints from unpaid subcontractors and material suppliers.
While none of these events in and of themselves will necessarily lead to a default under the contract, they are indications of problems which, if known to the Surety at an early stage will enable the Surety to conduct some preliminary investigations respecting the contractor’s ability to complete the work and will better enable the Surety to promptly deal with the contract in the event of an actual default. This process is specifically contemplated in the “Pre-Demand Conference” provision of the “Process Enhanced” Performance Bond developed by the Surety Association of Canada.
Claims Against the Surety
Where a claimant, whether an Obligee under a Bid, Performance or Maintenance Bond or a claimant under a Labour and Material Payment Bond has a claim against the Surety, notice of the claim should be given to theSurety promptly. In the event of a claim by an Obligee under a Bid Bond, Performance Bond or Maintenance Bond, notice of the claim should be given to the Surety immediately upon occurrence of the default by the Principal and within the time limits prescribed in the Bonds themselves.
In the case of a claim by a claimant under a Labour and Material Payment Bond, notice of the claim should be given as soon as possible after the claimant is in a position to state with substantial accuracy the amount of the claim and in any event within the notice periods provided for in the Labour and Material Payment Bond.
While recent decisions of the Courts have substantially relaxed the earlier requirements for strict compliance with the notice provisions, claimants under a Labour and Material Payment Bond are likely to be far more successful in advancing their claims if they:
(a) present their claims with substantial accuracy as soon as reasonably possible;
(b) comply strictly with the notice provisions including delivering the notice by registered mail to each of the Principal, the Surety and the Obligee;
(c) comply strictly with the time limits for presenting the claim both in respect of claims for the recovery of holdback and other claims arising under the contract;
(d) comply promptly with any reasonable request for supporting documentation received from the Surety; and
(e) proceed with action well within the limitation period for bringing an action set out in the Bond.
A Surety will honour any valid claim falling within the provisions of the Bonds which it has issued provided that the conditions of the Bond are satisfied and the claim presented is valid. Normally, the cases which proceedto litigation are cases in which there is a dispute between the claimant on the one hand and the Principal on the other respecting the validity or amount of the claim which the claimant is entitled to recover under the Bond. In those cases which proceed to litigation, the Principal and Surety will raise and will rely upon any valid defence which may be available to them including a failure to comply with the notice and limitation provisions under the Bond or other factors which may have jeopardized the Surety’s position.
A claimant who has taken reasonable steps not to prejudice the Surety’s position, has dealt fairly and honestly with the Principal and has complied with all of the conditions of the Bond has a far greater chance of successfully recovering on the Bond either on a negotiated settlement or at trial.
