Two Bonds, Two Independent Obligations

A surety may prevail on a performance bond claim arising on a construction project yet still be hit with substantial damages if the surety fails to resolve valid payment bond claims in a timely way.

August 9, 2017

The Robins Kaplan Insurance Insight Newsletter

A surety may prevail on a performance bond claim arising on a construction project yet still be hit with substantial damages if the surety fails to resolve valid payment bond claims in a timely way.1 A surety has separate and distinct obligations under the performance bond and payment bond issued on a construction project. Based upon the discrete obligations, a surety that prevails on a performance bond claim may nevertheless suffer significant damages if there is a determination that the surety breached the obligations it undertook under its payment bond.2 

Surety professionals are often faced with competing claims and positions between the bond obligee and the bond principal. A typical situation involves the principal claiming that the obligee is in default or has breached the contract secured by the performance bond. If the surety elects to support the position of the principal, it is critical for the surety to remain cognizant that it still has an independent obligation to quickly and thoroughly investigate, evaluate, and resolve claims that may be asserted against the corresponding payment bond. Stated otherwise, a dispute between the obligee and the principal does not necessarily provide a legitimate basis for the surety to deny valid payment bond claims. Failure to properly address all payment bond claims can expose a surety to greater loss.

California’s Works of Improvement Law (Civil Code § 8000 et seq.) imposes limitations on the defenses a surety may raise on a claim against a bond issued pursuant to its provisions. California Civil Code § 8154 provides that a surety will not be released from liability to those for whose benefit a bond has been given as a result of a breach of the bonded contract or as a result of the obligee’s breach. Additionally, Civil Code § 8152 precludes the release of a payment bond surety as a result of: (i) a change, alteration, or modification to a contract, plans, specifications, or agreement for a work of improvement or for work provided for a work of improvement; (ii) a change or modification to the terms of payment or an extension of the time for payment for a work of improvement; (iii) a rescission or attempted rescission of a contract, agreement, or bond; (iv) a condition precedent or subsequent in the bond purporting to limit the right of recovery of a claimant otherwise entitled to recover pursuant to a contract, agreement, or bond; and (v) in the case of a bond given for the benefit of claimants, the fraud of a person other than the claimant seeking to recover on the bond. These tenets make clear that a surety owes separate and distinct obligations under its performance bond and its payment bond.

By way of illustration, a dispute arises between the principal and obligee, where the major point of contention is additional compensation claimed by the principal due to delays and other problems caused by the obligee. The principal does not satisfy its payment obligations to its subcontractors, resulting in the recording of mechanic’s liens against the obligee’s property.3 The obligee makes demand upon the principal and surety to pay the subcontractors and secure a discharge of the liens against its property.  Claiming a right to withhold payment to the subcontractors because of its dispute with the obligee, the principal refuses payment to the subcontractors. The surety, asserting the same defense, also refuses payment to the subcontractors under the payment bond.  Upon legal action by the unpaid subcontractors against the obligee, the obligee pays $1.1 million, leaving only the disputes between the obligee, the principal, and the surety. Held: The surety is not entitled to rely upon the principal’s unresolved claim against the obligee as a basis for refusing to pay the principal’s subcontractors. The obligee is awarded $1.1 million dollars it paid to the subcontractors, plus $200,000 in prejudgment interest and $8,000 in costs, based upon a finding that the obligee was the prevailing party against the surety.

The illustration demonstrates that the rights of payment bond claimants may be unaffected by the disputes between the principal and obligee. Without an additional valid basis to dispute the payment bond claim, a dispute between the principal and the obligee about a payment obligation to the principal will have no bearing on sums that may be due from the principal to its subcontractors, material suppliers, and laborers. A surety cannot withhold payment to payment bond claimants simply because of the principal’s dispute with the obligee under the bonded contract and, depending upon the terms of the payment bond and particular facts at play, the surety may be held liable to both the owner of the project and/or the subcontractors and material suppliers retained by the principal. 

On the other hand, certain disputes between a bond obligee and bond principal may afford a surety viable defenses to a payment bond claim notwithstanding the precepts of Civil Code § 8152 and § 8154. For example, if there is a dispute between the obligee and principal over the fulfillment of a scope of work or the quality of work furnished by the principal through a subcontractor, this may provide the surety a defense against a payment bond claim by that subcontractor. The foregoing is substantively different than a basic failure of an obligee to fulfill its contractual obligations to the principal, because the dispute goes to the merits of the claim by the subcontractor against the payment bond. 

A clear understanding of the different obligations undertaken by the surety pursuant to the two types of bonds, as amplified by applicable law, is critical to the proper handling of bond claims. A performance bond creates duties owed by the surety directly to the owner obligee; a payment bond creates duties owed by the surety directly to the subcontractors, material suppliers, and laborers. Given the different liabilities and potential defenses, when evaluating a principal’s defenses to a payment bond claim the elementary rule is to evaluate the genesis of the defenses. Are the defenses premised upon the principal’s independent disputes with the owner, or the quality and quantity of the work or materials furnished by the principal, or the conformity of the work with the plans and specifications? If limited to the independent dispute between the principal and owner, then California Civil Code § 8152 and § 8154 preclude reliance upon such a dispute to deny a payment bond claim. Failure to adhere to this rule could expose a surety to significant damages beyond the principal amount of the claim, particularly if its principal and indemnitors no longer have the financial ability to indemnify the surety.

1 Bonding companies, also known as sureties, issue bonds that are financial guarantees whereby the surety agrees to be secondarily responsible for the primary obligations of another. In the construction context, the contractor procures performance and payment bonds from a surety, thereby becoming the bond principal. The surety guarantees the principal’s contractual obligations to the owner of the project, designated as the obligee on the bond. The performance bond secures the completion of the project, while the payment bond secures payment to subcontractors, material suppliers, and laborers retained by the contractor or its subcontractors. 
2 Although this article relies upon California law, the principles discussed are generally applicable in other states, with the caveat that, in evaluating liability under a surety bond, one should always read and become familiar with all applicable law. 
3 A mechanic’s lien is a lien against the property afforded by statute to those who perform work or furnish material in the improvement of that property. In California, mechanic’s liens are governed by Civil Code § 8400 – § 8494.

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