a guide to construction surety bonds

Transcription

1 Standard construction document CCDC a guide to construction surety bonds Canadian Construction Documents Committee

2 TABLE OF CONTENTS INTRODUCTION 1. WHAT IS SURETYSHIP? 1.1 HISTORY 1.2 WHAT IS A SURETY BOND 1.3 TYPES OF CONSTRUCTION SURETY BONDS 1.4 DEFINITIONS 1.5 HOW SURETY BONDS DIFFER FROM OTHER FORMS OF SECURITY? 2. HOW SURETYSHIP WORKS 2.1 THE THREE Cs OF SURETYSHIP 2.2 INDEMNITY AGREEMENTS 2.3 HOW TO GET THE BOND? 2.4 WHAT DOES THE BOND COST? 2.5 VALUE ADDED TAXES 3. BOND FORMS 3.1 CCDC 220 BID BOND 3.2 CCDC 221 PERFORMANCE BOND 3.3 CCDC 222 LABOUR AND MATERIAL PAYMENT BOND

3 The Canadian Construction Documents Committee is a joint committee composed of owners and representatives appointed by: The Association of Consulting Engineers of Canada The Canadian Construction Association Construction Specifications Canada The Royal Architectural Institute of Canada Committee policy and procedures are directed and approved by the constituent organizations. This document has been endorsed by each of the above organizations and the Surety Association of Canada. Enquiries should be directed to: The Secretary Canadian Construction Documents Committee Suite Albert Street Ottawa, Ontario K1P 5E7 Tel: (613) Fax: (613) or The President Surety Association of Canada 6299 Airport Road Suite 709 Mississauga, Ontario L4V 1N3 Tel; (905) Fax; (905) CCDC guides are products of a consensus-building process aimed at balancing the interests of all parties on the construction project. They reflect recommended industry practices. Readers are cautioned that the guides do not deal with any specific fact situation or circumstance. CCDC guides do not constitute legal or other professional advice. The CCDC and its constituent member organizations do not accept any responsibility or liability for loss or damage which may be suffered as a result of their use and interpretation. CCDC Copyright 2002 Must not be copied in whole or in part without the written permission of the CCDC.

4 Standard Construction Document 2002 INTRODUCTION The purpose of this guide is to help the construction and business communities in Canada better understand surety bonds and the suretyship process. This guide was prepared by the Surety Sub- Committee of the Canadian Construction Documents Committee (CCDC) and is endorsed by the constituent organizations of the CCDC and the Surety Association of Canada. Surety bonds are by far the most common means of securing contractual obligations in the construction industry today. Bonds are unique in that they are the only contract security specifically designed to be used with construction contracts. Despite their extensive use, however, such bonds and the suretyship process are not well understood. Those who use bonds as an integral part of their business (i.e., contractors, construction purchasers, subcontractors, suppliers, design professionals and even surety companies themselves) often have divergent ideas about and expectations of surety bonds and the suretyship process. Too often bonds are perceived as an obstacle another document to obtain before the bid is submitted or the contract is signed. This Guide attempts to fill the information gap and assist all sectors of the construction industry in using surety bonds to their advantage. The following pages describe the suretyship process and clear up some commonly held misconceptions. The guide is divided into three parts. Part 1 reviews suretyship, what a bond is and how it differs from other risk management tools. Part 2 discusses how suretyship works in practice, how bonds are obtained, the requirements of a surety company, and how the company proceeds through the prequalification process. Part 3 examines the various forms of bonds with a view to understanding the purpose of each bond and the claims process. CCDC

5 1. WHAT IS SURETYSHIP? 1.1 HISTORY Although North America s first corporate surety bond was written in Canada in 1872, it wasn t until the Post-World War II that suretyship was used extensively by public construction purchasers and became the preferred method to provide third-party assurance that a contractor s contractual obligations would be met. More recently, the Canadian surety industry s commercial results have proven to be extremely volatile. During the 1990s, the industry showed tremendous growth and profitability, but then came a downturn of unprecedented proportions. The formation in 1992 of the Surety Association of Canada signalled the industry s determination to ensure that the product and process keep pace with the business realities of the construction community and the demands of the construction purchaser. 1.2 WHAT IS A SURETY BOND? A surety bond is a contract by which a third party ( the Surety ) guarantees that one party ( the Principal, usually a contractor or subcontractor), fulfills its obligation to a second party ( the Obligee, usually an owner or general contractor). More simply, a surety bond is a third-party guarantee of the Principal s performance. All bonds are structurally the same, and share a number of common features. A bond is a financial instrument. The first paragraph of any bond, including bid, performance and payment bonds, is identical: it is a promise on the part of the Principal and Surety to pay up to the bond amount to the Obligee. Other paragraphs define the conditions that trigger liability under the bond. The conditions of the various types of surety bonds are different. In a performance bond, for example, the condition is the performance of the obligations set out in the underlying contract. If the contract is performed, the obligation of the Surety, as set out in the first paragraph, is no longer an issue. There is one aspect that sets a surety bond apart from other forms of contract security. Under surety bonds, the obligation of the bonding company is secondary. The Obligee cannot claim under a bond until the Principal is in default under the contract. That said, however, the obligation itself is joint and several in that both the Principal and the Surety are obligated to perform under the terms of the bond. In other words, if the Principal is unable to perform, the obligation to perform is owed by the Surety. The on default nature of a surety bond raises a question often asked of surety companies: What constitutes a default under a construction contract? That question is not easy to answer and the existence of default is determined largely by the terms of the contract and the particular circumstances and problems of the job at hand. 2 CCDC

6 While there is no one size fits all definition, there may be some guidance that can be given. Perhaps a good rule of thumb in deciding when to declare default is to look carefully at the issues raised and assess their effect on the overall performance of the contract. A bonding company should be called in when the non-performance of a contractual obligation is so significant in its impact that it becomes difficult or impossible to continue with the work. Some examples would be: - Insolvency of the Principal - Abandonment of the site by the work forces of the Principal (provided this was not the result of a breach on the part of the Obligee) - Extensive delays and scheduling problems on the part of the Principal. 1.3 TYPES OF CONSTRUCTION SURETY BONDS In response to the needs for contract security in the construction industry, the CCDC endorses three forms of surety bonds: Bid Bonds provide financial protection (as described in the bond) to the Obligee in the event that the Principal fails or refuses to enter into a formal contract after its bid has been accepted in accordance with the bid documents. Performance Bonds provide an owner or contractor (the Obligee) with protection (as described in the bond) ensuring completion of the contract in the event of default of the Principal. Labour and Material Payment Bonds ensure that the Principal s outstanding payables for labour and materials, supplied under the bonded contract, are paid as described in the bond, thereby reducing the likelihood of liens and construction schedule delays. 1.4 DEFINITIONS While terms are defined in each bond, for the purposes of this guide the following general meanings will be assumed: Bond Amount the maximum amount for which the Surety will be liable under the bond. Principal the contractor or subcontractor whose performance is guaranteed by the Surety and who has entered into a written construction contract with the Obligee. Obligee the owner or contractor who holds the bond and who has entered into a written construction contract with the Principal. It is the Obligee alone who is entitled to make a demand under a bid bond and a performance bond. Surety the surety company that prequalifies the Principal, and issues and (with the Principal) executes the bond. Contract the written agreement between the Principal and the Obligee. CCDC

7 1.5 HOW SURETY BONDS DIFFER FROM OTHER FORMS OF SECURITY? In an effort to better understand suretyship, it is instructive to compare bonds to other instruments and forms of contract security. Surety vs Insurance Surety bonds are often confused with insurance policies. This confusion is understandable because bonds are not only written by major insurance companies, they also share the same distribution network and, in the marketplace, a common jargon. For example, fees for both surety bonds and insurance policies are referred to as premiums and payouts are referred to as claims. Despite these similarities, surety bonds are distinct from their insurance counterparts. For example, surety bonds involve three parties, while insurance instruments are two-party agreements whereby one party (the Insurer) agrees to indemnify another (the Insured) for a defined loss or set of losses. Insurance is based on the risk-spreading principle of underwriting. Premiums are collected from a large population of insureds, and premium levels are determined by actuarial analysis, which takes into account demographic and other factors. It is accepted that losses will be incurred; however, under the principle of risk-spreading, the losses of a few are covered by the premiums of many. Surety bonds, by contrast, are effectively credit instruments, and are underwritten much like a banker assesses a loan application. In this case, no losses are anticipated and if the underwriter believes a contractor may not be able to perform his or her contractual obligations, no bond will be issued. Premiums for bonds do not pay for losses; rather, they are a service fee for extending the required credit. The Surety also has the right to recover any losses from its Principal should it be forced to pay out under a bond. Principals seeking surety bonds are invariably required to sign an indemnity agreement under which they specifically agree to those terms. Surety vs Letters of Credit Occasionally, an owner will prefer a cash deposit or Letter of Credit to bonds. There are a number of reasons for this decision. Letters of Credit offer an owner the promise of cash on demand. They are first demand instruments under which the issuer (usually a bank) must pay cash to the holder immediately upon a demand. There is no need to prove that the contractor is in default although a certificate to that effect is usually required. Additionally, a Letter of Credit or other liquid security allows the owner to fully control the default rectification process and eliminates the need to deal with the bonding company. 4 CCDC

8 While these liquid security alternatives hold advantages for the construction purchaser, the quick cash solution is not without problems. Control of the default rectification process can be a double-edged sword. For example, while the owner may have control of the default rectification process, he or she must now complete the defaulted job and shoulder all the associated administrative burden and costs. More importantly, the requirement to post cash or Letters of Credit can have a negative impact on a contractor s cash reserves and/or borrowing power. It has been suggested that a Letter of Credit can cause the very problem it seeks to protect against by restricting a contractor s access to cash that may be required to address a problem on a job. The performance bond is in force for 2 years following Substantial Performance of the Work. Contractors posting cash or Letters of Credit press hard to have the security returned or considerably reduced following completion of the project but long before the expiration of the warranty period. This has caused stress for owners and hardship for contractor s cash flow. Restricted access to cash can also create further problems. Liquid security requires that a contractor s cash reserves or borrowing capacity be the same as the amount posted; therefore, the available security is limited by the contractor s access to cash. Due to this restriction, Letters of Credit are typically for a smaller percentage (10-15%) of the contract value than performance bonds (50% or 100%). These smaller amounts have proven inadequate to cover the shortfall in a majority of defaulted contracts. Finally, Letters of Credit or cash deposits do not address the problems of unpaid subcontractors and suppliers, who would be protected under a Labour and Material Payment Bond. Unlike Letters of Credit, bonds are not liquid security: Letters of Credit provide cash on demand while surety bonds guarantee performance on default. Bonds do not necessarily provide the construction purchaser with the funds necessary to rectify the problem; instead they solve the problem by guaranteeing performance. A bonding company may arrange for the completion of the defaulted contract. In addition, a bond is not intrusive in the sense that it does not restrict a contractor s cash resources or borrowing power. By allowing access to all available cash, the potential for cash flow problems, as discussed above for a Letter of Credit, is reduced. As contractor s on default instruments, performance and payment bonds are available in amounts up to 100% of the contract price. Also, unlike Letters of Credit, bonds do not respond on demand. It must first be established that the Principal is in fact in default of the contractual obligations; simple declaration of default will not suffice. CCDC

9 2. HOW SURETYSHIP WORKS Construction surety bonds are marketed through the insurance industry, and usually by insurance brokers and insurance companies which specialize in construction suretyship. A Principal must establish a surety relationship well in advance of bidding bonded projects. Surety companies that provide construction surety bonds have varying underwriting guidelines and often prefer certain types of contractors and sizes of contract. A specialized surety broker can best match a construction firm with an appropriate surety company. It is important for the surety company to understand the contractor s business plans; the surety broker s role is to ensure that the surety company underwriter understands and supports the contractor s business objectives. 2.1 THE THREE Cs OF SURETYSHIP As part of the underwriting process, a surety company will assess a number of factors to determine whether the contractor is likely to succeed in meeting its contractual obligations. In other words, a contractor must qualify for a bonding program. If a contractor does not qualify, no bonds will be available. Each surety company has its own assessment criteria. However, all companies look at the basic three Cs of suretyship character, capacity and capital. As a starting point, most surety companies require the following confidential information: - Background about the company, including ownership, related companies, type and size of projects previously completed, previous suppliers and subcontractors, and architects/engineers/general contractors for whom the applicant has previously done work; - Details about the contractor s line of credit including a reference letter from the bank outlining the amount of the line of credit, the amount currently in use and how it is secured; - Details about the current work program (work on hand schedule) including the contract price, billings and costs to date, and estimated costs to complete; - Financial statements of the company (and any related companies) for the last three years and any interim financial statements prepared since year end; and - Personal financial statements of the company owners. 6 CCDC

10 Character The underwriter will assess the individuals who run the firm executives, estimating and office staff, site superintendents, etc. as to their honesty and approach to business. Generally, resumes of key personnel will be requested and references checked. The underwriter must determine the reliability and integrity of the owners of the construction firm. In the event of a problem, will the owners do the right thing when managing the business under pressure? Capacity An underwriter will investigate the capacity of the construction firm to perform its contracts. Is the equipment in place to perform the work? Do the administrative and construction personnel have the requisite skills and experience to successfully undertake the current project? Are qualified people available for the contract? Where a different technique or new equipment is being employed, are the people and equipment in place to ensure success? Capital An underwriter will need assurance that the company has the financial resources to meet not only its current commitments, but also to withstand the problems inherent in the construction industry unresolved disputes, unpaid receivables, varying site conditions, holdback provisions, tight operating margins to name a few. There will be particular attention paid to the working capital, equity, and ongoing profitability of the business. An underwriter will require regular updates of financial statements, aged listings of accounts payable and receivable, work on hand schedules, and details of the contractor s bank line of credit. Other financial information may be requested depending on the surety company s underwriting requirements. 2.2 INDEMNITY AGREEMENTS When a surety company completes its investigation and agrees to a surety program, the contractor must execute (i.e., sign and seal) an indemnity agreement. In the event of a loss, the Obligee looks to the Surety to make it whole in accordance with the terms and conditions of the bond. The surety company, in turn, looks to the parties who executed the indemnity agreement to make it whole. The criteria for indemnity vary from one surety company to another; however, most will ask for the indemnity of the construction firm, its owners and their spouses, and any related companies (including holding companies). Once the indemnity agreement is in place, the contractor can request bonds from the surety company. The contractor must continue to inform the surety company about any changes within the firm, and also any changes in the financial position and ongoing work of the firm. This information is usually relayed through the contractor s surety broker. CCDC

11 2.3 SECURING THE BOND When bidding or commencing a project that requires a bond, the contractor contacts its surety broker with the project details. While the information required varies by surety company, contractor, and type of work, the following basic information is usually required: - Full legal name of the Obligee; - Description of the work, including type of work and location; - Estimated contract value should the Principal seek to submit a bid and require a bid bond; - The actual contract price (and other bidders and their prices, if known) if the Principal is seeking a Performance and/or Labour and Material Payment Bond; - Confirmation that there is an engineer and/or architect on the job; - Bid or contract date; - Payment terms; - Maintenance or warranty period; - Penalties for delay; - Estimated or actual completion time; - Amount and type of work to be sublet (the surety company may request that some of the subcontractors provide bonds); and - Amounts and types of bonds required. A fourth C of surety, Conditions, is often discussed at this stage. The Surety may request specific details about the project (including the terms and conditions of the contract) prior to giving the surety broker approval to issue the bond. Some surety companies give specialty surety brokers Powers of Attorney enabling them to issue bonds in their offices. All bonds are executed under corporate seal by the attorney-in-fact of the surety company and must also be similarly executed by the Principal (i.e., the contractor). Bonds are legal documents and must be issued accurately with the proper legal names of the parties to the bond, as well as a clear description of the work to be undertaken. Bonds must be signed, sealed and delivered to the Obligee to be operative. 8 CCDC

12 2.4 BOND COSTS Surety companies generally do not charge clients for the bonds necessary to bid on a project; however, most companies charge an annual administration fee to cover some of the costs of issuing these documents. Surety companies receive remuneration when a contractor is awarded a project and a Performance Bond (and perhaps a Labour and Material Payment Bond) is issued. The surety company s fee is calculated per $1,000 of the contract price. Standard rates are charged annually. Long-term rates may be available for projects where the construction schedule exceeds 24 months. Both standard and long-term rates include warranty protection for up to one year. Rates vary by surety company and are based on the financial position of the construction firm. In addition to the requirement of a Bid Bond, a contractor is occasionally asked to provide what may be referred to as an Agreement to Bond, Consent of Surety, Bid Letter, etc. These can be in the form of a letter or an undertaking signed by the Surety under which the Surety agrees to provide a Performance Bond and, if required, a Labour and Material Payment Bond on behalf of the contractor. When the project is awarded to that contractor, the Obligee may choose to waive the requirement for performance and payment bonds. Although the owner has used the services of the surety industry to prequalify the contractor, the surety company receives no remuneration for its prequalification efforts. In these circumstances, most surety companies will charge a prequalification fee. 2.5 VALUE ADDED TAXES Surety companies do not receive the benefit of input tax credits and therefore may be exposed to Value Added Taxes (e.g. the Goods and Services Tax, the Quebec Sales Tax and the Harmonized Sales Tax) costs in the event of a claim. As a result, they may include the Value Added Taxes in the bond amount and compute the premium on a Value Added Taxes inclusive basis. Clarification on the effect of Value Added Taxes on surety bonds may be required for individual circumstances. CCDC

13 3. BOND FORMS Contract surety bonds are distinctive among methods of contract security they are the only instruments designed to respond to the unique needs of the construction industry. CCDC endorses three forms of contract surety bonds: CCDC 220, Bid Bond; CCDC 221, Performance Bond; and CCDC 222, Labour and Material Payment Bond. 3.1 CCDC 220 BID BOND Bid bonds provide construction purchasers with assurance that the contractor submitting the bid has been examined by the surety company and has been found qualified to perform the work. Specifically, this bond offers an Obligee financial protection should a successful bidder not enter into a formal written contract, or not provide the specified security. This protection is limited to the lesser of the bond amount (usually 10% of the bid) and the difference in price between the Principal s bid and the next lowest compliant bid. This is the primary prequalification instrument issued by a surety company to ensure that construction purchasers receive a bid from a qualified contractor. Condition of the Bond The bidding process, which defines the obligation under a Bid Bond, is usually described in the Invitation to Bid. Provided a bid is submitted in accordance with the Invitation to Bid and is capable of acceptance, the proper acceptance of the bid creates an obligation on the part of the Principal to enter into a formal contract as specified in the Invitation and, often, to provide contract security (usually a Performance Bond and a Labour and Material Payment Bond). The condition of the form 220 Bid Bond is that if the Principal satisfies the obligation to enter into a formal contract and, if required, provides the specified contract security, the bond is then null and void. If the Principal defaults in this obligation, the bond remains enforceable, subject to its conditions. The Claims Process Surety Investigation When a demand is made by the Obligee under a Bid Bond, the Surety will investigate the circumstances surrounding the demand. The investigation will focus on several questions: - Has the bidding process created an obligation for the Principal to enter into a formal contract and to provide certain contract security? - If such an obligation has been created, is the Principal in default of the obligation? - If the Surety is liable under the bid bond, what amount should be paid under the bond? 10 CCDC

14 Making a Demand A demand should be made promptly in writing to the Surety. The form of a demand is not specified in the bond, but it will assist the Surety investigation and response if the demand includes: - notice that the Principal has an obligation to enter into the formal contract and/or provide security, and a brief description of the circumstances giving rise to the obligation (i.e., the submission and acceptance of a bid, and the proper award and delivery for execution of a formal written contract in accordance with the bid); - notice that the Principal has defaulted on the obligation, and that demand is being made on the Surety under the Bid Bond; and - confirmation that a written notice of the default has been provided to the Principal and that no satisfactory response has been received. Copies of the following documents, provided with or shortly after the demand; will also assist the Surety s investigation: - Invitation to Bid (or similar document to which the bid responded); - Principal s bid as submitted; - documented proof of the acceptance and contract award in accordance with the Invitation to Bid; - the formal written contract as presented to the Principal for execution; - any documents showing evidence that the Principal has refused or failed to honour the obligation; - the list of bid results; - any formal or written bid analysis on the basis of which the Principal s bid was accepted; - the next lowest compliant bid ; and - the signed contract that the Obligee has entered into with another party to perform the work. Common Problems to Avoid - Accepting an informal or non-compliant bid; - Accepting a mistaken bid; CCDC

15 - Failing to follow the prescribed bid process, or failing to properly accept or award the contract; - Presenting for execution by the Principal a contract that is materially different from the submitted bid; - Postponing acceptance beyond the period stipulated in the Invitation to Bid, or beyond the period specified in the bond; - Failing to institute legal action to enforce the bond within seven (7) months of the date of the bond (not from the date of the bid closing, award, or Principal s default); - Entering with another party into a contract that is in a different form or that includes an obligation(s) that differs from the original contract; - Failing to mitigate damages. The Bidding Process: An Obligee s Bid Bond Checklist Pre-bid - Include specific reference in the bid documents to the CCDC 220 Bid Bond as there are many non-standard forms in the marketplace. - Ensure the bid documents clearly define the bidding process, including time limits for review and acceptance of bids, the document or act that constitutes acceptance of a bid, when a formal contract must be signed, and what constitutes entering into a formal contract, including the form of the contract (e.g. CCDC 2, 3 or 4). Before extending the acceptance period of a bid, keep in mind the Bid Bond is not enforceable after seven months from the date of the bond. After Bid Closing - Ensure that the bid bond received was accurately drawn and executed. - The formal contract presented by the Obligee to the Principal must be essentially the same contract that was bid in order for the Obligee to rely on the Bid Bond. The Principal and the Surety are not bound to pay under the Bid Bond if the formal contract, which the Principal fails or refuses to enter into, is materially different from the contractual terms and conditions set out in the bid documents. - Payment under the Bid Bond requires that the Obligee actually enters into a contract with another contractor. 12 CCDC

16 3.2 CCDC 221 PERFORMANCE BOND The Performance Bond guarantees that the Principal will perform the contract in accordance with its terms and conditions. This bond protects the Obligee financially from the excess costs of completion of a bonded contract should the Principal fail to perform. Usually the Surety will participate actively in arranging for completion of the defaulted contract and in resolving any resultant issues. For example, instead of simply funding a cost over-run, the Surety may remedy a default, complete the contract, or re-bid the remaining work under a new contract. Without a Performance Bond, the construction purchaser would have to finance the additional costs to complete a defaulted contract, and bear the risk and expense of recovering the costs from the defaulted Principal. Under the Performance Bond, the Surety essentially finances the additional cost of completing a defaulted contract up the bond amount, and assumes the risk and expense of recovery. The Bond Condition The condition that the Principal must be in default is the fundamental characteristic of a surety bond, one that clearly distinguishes it from other forms of contract security. If the Principal performs, the bond is null and void. If the Principal defaults, the undertaking to pay the bond amount or elect one of the alternative settlements described in the bond remains in full force and effect. The construction contract between the Principal and the Obligee establishes the obligations of the Principal. Assuming the performance bond is properly drawn, and has been signed, sealed, and delivered to the Obligee and is, therefore, operative, the Surety will be liable if: - the Principal has been declared to be in default pursuant to the terms of the contract; - the Principal is, in fact, in default under the contract (i.e., the declaration of default is justified and proper given the circumstances); and - the Obligee has honoured its obligations under the contract. Surety Options If the Principal has defaulted in the performance of the contract, and if the Surety is liable under the bond, the Surety can satisfy its obligation in a number of ways as described below. The Surety has the discretion to select the settlement option, but will often consult with the Obligee and consider the unique circumstances of the default when making its decision. It is in the best interest of the Surety and the Obligee to act expeditiously to mitigate the cost of completing the contract. CCDC

17 Remedy the Default The Surety may elect to remedy the default by providing assistance to the defaulted Principal. This may involve financing a cash-strapped Principal through to the completion of the bonded project. Complete the Contract The Surety may elect to complete the contract. Although under this option it may appear that the Surety has simply replaced the defaulted Principal and is acting as the contractor or subcontractor under the contract, it is important to note that the Surety is not a party to the contract and will be acting in its capacity as Surety under the bond. The Surety will complete the defaulted contract using the unpaid balance of the contract price, which it is entitled to receive from the Obligee, and seek recovery from the Principal any additional costs or expenses arising from the default. There are several ways by which the Surety can complete the contract. For example, the Surety can hire one or more general or subcontractors, project or construction managers, or suppliers to provide the required services. Under this option the Surety makes financial and payment commitments directly to the parties retained. The Obligee must be informed of the arrangements and commitment for the unpaid contract balance to be made available to the Surety, subject to any statutory requirements or obligations imposed upon the Obligee (e.g., lien holdback). Re-bid Under this option, the Surety may seek bid(s) for completion of the contract and arrange for a new contract between the successful bidder and the Obligee. Usually, the terms of the completion contract, including scope of work, payment terms and bonding requirements, are the same as in the defaulted contract. However, agreement about the scope of the remaining work, as well as provision for approved and pending changes to the work, will be required. The Obligee administers the new completion contract and makes payments directly to the new contractor. If the amount payable to the completion contractor exceeds the amount the Obligee would have otherwise been required to pay to the defaulted Principal had there been no default, the Surety pays this additional amount to the Obligee under the bond as the work progresses, subject to the bond amount. Pay the Bond Amount The Surety, when it accepts liability under the bond, is entitled to pay the bond amount to the Obligee in full satisfaction of its obligation under the bond. A Surety would consider this option, for example, when satisfied that the Obligee s completion costs, which the Surety would be liable for under the bond, exceeded the bond amount. Where the completion costs for which the Surety is liable are less than the bond amount, the Surety may satisfy its obligation under the bond by tendering payment of the lesser amount to the Obligee. 14 CCDC

18 Disputed Default Occasionally, when presented with a demand under a Performance Bond and following its investigation, the Surety will be unable to determine whether there has been a default. The contract between the Obligee and the Principal sometimes gives rise to genuine disputes which cannot be resolved or determined by the Surety, and which require resolution by some alternative means or, ultimately, by the courts. In this situation, the Performance Bond continues to provide the same degree of financial protection to the Obligee. If a determination is ultimately made in favour of the Obligee, and assuming the Obligee has given proper notice to the Surety and preserved its rights under the bond, the Surety will be liable to the same extent as if the default had been clear at the outset. In a disputed default, the parties often agree to put aside the dispute in the interests of completing the job as expeditiously and economically as possible. In these circumstances, a Surety might propose or accept an arrangement whereby the work is completed and funded by the parties while preserving their respective rights under the contract and the bond. This approach focuses the parties energies on promptly completing the work, mitigating the costs, and avoiding additional disputes about the costs of completion. The Construction Process - An Obligee s Performance Bond Checklist Pre-construction - Include specific reference in the bid documents to CCDC 221 as there are many nonstandard bond forms in the marketplace. - Ensure that the fully executed bond is accurately drawn and in the possession of the Obligee. In the event the bond is not delivered to the Obligee, it cannot become operative. During Construction - Notify the Surety of material changes in the contract, and obtain the Surety s consent to remain bound under the bond. Since the performance of the contract referred to by the Principal in the bond is the condition of the bond, a material change in the contract without the Surety s consent releases the Surety. Understandably there is often confusion among Obligees, Principals and consultants as to when a change to a contract is material. Regrettably, there are no absolute criteria to define material change and indeed a change which may be material in one contract can be insignificant in another. CCDC

19 Some owners have attempted to address this issue by establishing a percentage change threshold (e.g. 25%) in the contract and/or bond. They deal with this issue by defining a material change as any change which increases the contract price by an amount greater than that percentage. Unfortunately a material change may not have any effect on the contract value and this approach, however well intentioned is probably misguided. The good news is that even though there are no hard and fast rules there are some indicators. Significant extensions of time or increases or decreases in the contract price, changes in the payment terms (e.g., advance payments), major changes in the scope or nature of the work (e.g., the addition of design responsibility) are examples of changes which, in specific circumstances, can be material to the Surety s risk. Probably the best advice to an Obligee is to take the cautious approach. If you think there s a chance that a change to a contract may be material it is best to inform the bonding company as described above. Default If a default occurs for which the Obligee intends to look to the Surety, the Obligee or its consultant should ensure that the default is first properly declared to the Principal in accordance with the terms of the contract. The Surety should be provided with a clear and unequivocal written demand under the bond, advising that the Principal is in default under the contract (naming the specific provision(s) of the contract that may have been breached), and that the Obligee requires the Surety to meet its obligations under the bond. Keep in mind that the Surety will not likely take any action until the time allowed under the contract for the Principal to remedy the default has expired. Notice must be given to the Surety so that it has an opportunity to consider its options under the bond. If notice is not given, the Surety is discharged. Investigation by the Surety The Surety will investigate the circumstances surrounding the declaration of a default and the demand on the bond, and will attempt to answer the following questions: Is the Surety liable under the bond and, in the event of liability, what arrangements should be made to complete the contract and settle the Surety s financial obligation to the Obligee? Keep in mind that it may take some time and, indeed, may not be possible to determine whether the Surety is liable under the bond. Contractual disputes are often complex because they have evolved over a period of time. The Obligee should assist the Surety in its investigation by providing: - copies of contract documents, including general, special, and supplementary conditions, specifications, drawings, latest approved schedule, approved and pending change orders, minutes of meetings and other correspondence or documents relevant to the default; 16 CCDC

20 - a full accounting of the contract price, including reconciliation of the price or unit values specified in the contract at the time of award with the current contract value, including a record of all payments, credits or backcharges, holdback or other amounts retained, and copies of payment certificates; - reasonable access to the work-site and assistance in determining the status and condition of the work; - information about any special or urgent circumstances necessary to the Surety s investigation. Should it be necessary to preserve or protect the work while the Surety is investigating, seek the Surety s agreement that the Obligee undertake reasonable and economical action, with the resultant expenses treated as costs to complete the contract. Verify that project insurance remains in force and, if necessary, notify the Surety of any pending lapse and seek agreement that the Obligee pay any premium for interim coverage, which should be treated as a cost to complete the contract. Completion and Settlement When considering a Surety s proposal to complete the contract and satisfy its financial obligation, it is important to keep the following in mind: - The settlement option proposed by the Surety often involves arranging for or even directly performing some of the work called for under the contract. However, the Surety does not replace the Principal. In fact, after having satisfied its obligations under the bond, the Surety will usually attempt to recover from the Principal the excess cost to complete the job, just as the Obligee would have had there been no bond. Additional costs of completing the bonded contract are, in essence, financed by the Surety, but ultimately paid by the Principal. - When electing to remedy the default or complete the contract, the Surety may ask the Obligee to acknowledge that the Surety is acting in its capacity as Surety under the bond, and is subject, therefore, to the terms and limitations of the bond. This acknowledgement can avoid confusion and expense where it appears that the Surety is acting as the Principal contractor. - If the Surety proposes to complete the contract, it will require a clear commitment by the Obligee to pay to the Surety the contract balance as defined in the bond, subject to any statutory requirements or obligations imposed on the Obligee (e.g., lien holdback). It is typically part of the completion agreement between Obligee and Surety that the Obligee will pay these amounts as the work progresses, in the same manner as they would have had the original contractor not defaulted. - The Surety s financial responsibility is limited to the bond amount. CCDC

21 It is important to record the date on which the Principal s default or abandonment occurred. Should completion of the contract or financial settlement with the Surety extend over a long period, steps should be taken to preserve the right to recover under the bond. It is a good practice to evaluate the status of the work immediately after the default in order to have an accurate record of the work performed and any deficiencies observed. Any suit against the Surety under the bond must commence within two years from the earlier of: 1) the date of substantial performance of the contract as defined in the lien legislation where the work is taking place or, if no such definition exists, the date when the work is ready for use or is being used for its intended purpose; or 2) the date on which the Principal is declared in default by the Obligee. 3.3 CCDC 222 LABOUR AND MATERIAL PAYMENT BOND This bond provides financial protection to subcontractors who have a direct subcontract with the defaulted Principal to provide labour and materials for the project covered by the bond. Labour and Material Payment Bonds are usually available only together with Performance Bonds. Under the bond provisions, should the Principal pay the claimants for all labour and material used in the performance of the contract, the obligation of the Surety would then be null and void. That is, if the Principal fulfills its obligations to the claimants, the Surety has no liability under the bond. While some non-standard or Government of Canada Labour and Material Payment Bonds provide limited coverage to second tier subcontractors and suppliers, this is not the case with CCDC 222. It is important for claimants to realize that coverage under this bond is limited to labour and/or material supplied to the specific project described in the bond. While it is not uncommon for a supplier to maintain a running account with the general contractor, and to simply apply payments to the oldest outstanding invoices, this can pose problems for both general contractors and subcontractors in relation to this bond. Potential claimants should, during the performance of their agreement with the Principal, identify the project for which they are supplying materials, general contractors should identify which invoices are being paid at any one time. Where a supplier sells materials in bulk, it maybe unable to recover unpaid debt under a labour and material payment bond because it is not possible to prove the ultimate destination of the supplies. Bond Conditions Potential claimants should understand the terms and conditions of the Labour and Material Payment Bond, especially the following: - Claimants cannot sue under the bond until 90 days after the date on which they last supplied labour and/or materials to a project. 18 CCDC

22 - Under their contract with the Principal, claimants must provide notice of their claim (other than for holdbacks), indicating the exact amount or their claim, within 120 days after the date on which the claimant did or performed the last of the work or labour, or last furnished materials for which the claim is being made. - With respect to statutory or other holdbacks (e.g., maintenance holdback), claims must be submitted within 120 days after the claimant should have been paid in full under the claimant s contract with the Principal. - No suit or action shall be commenced by any claimant under this bond after one year following the date on which the Principal ceased work on the contract, including work performed under the guarantees provided in the contract and provided the claimant has complied with the conditions of the bond. This condition simply limits a suit and does not serve to extend the notification period within which a claim must be made. - Claimants should note that written notice of their claim must be sent to each of the Principal, Surety, and Obligee by registered mail. Proving the Claim While the requirements for proving the claim may vary, the following documentation is normally required: - Copy of the complete contract or purchase order with the Principal; - Copies of all change orders and change directives concerning the contract; - Copies of all invoices and/or progress billings submitted to the Principal; - Copies of all statements of account rendered to the Principal; - A summary of all payments, including the date and amount of each payment; - Evidence of the last date upon which labour and/or material was supplied to the project; - Signed delivery tickets and/or time sheets; - Evidence and documentation to support other amounts being claimed and which may not have been agreed to or authorized in writing under the contract or within a change order or change directive; and - Proof of acceptance of the work by the owner or consultant. CCDC

23 Benefits of Labour and Material Payment Bonds While Labour and Material Payment Bonds clearly benefit subcontractors and suppliers, they also benefit Obligees who may appear to be nothing more than trustees for the claimants and not direct beneficiaries. The benefits to Obligees include the following: - In the event of a default by a Principal, construction purchasers and/or their representatives will have to deal with subcontractors and suppliers who, in turn, may feel that the construction purchaser has a direct obligation to them. This can become a significant administrative burden to an owner who is deluged with phone calls from angry, frustrated and confused subtrades and suppliers. Furthermore, an owner has a statutory obligation to retain and properly distribute any holdback monies for those parties who may have registered liens against the property in question. With a Labour and Material Payment Bond in place, the surety company deals with these claimants and, upon payment, will be subrogated to their claims. - Owners who do not require Labour and Material Payment Bonds, may do so to their own detriment. Many subcontractors and suppliers are reluctant to enter into a contract on a project where there is no Labour and Material Payment Bond, because of the inherent credit risk, and may, consequently, increase their prices to reflect the additional risk. - A Surety s obligation under a Performance Bond is limited to the balance of the work to be completed under the contract. There is no obligation on the part of the Surety to deal with unpaid labour or material suppliers to the Principal. These unpaid parties typically refuse to return to a project until paid for the work already completed; since the Surety has no obligation towards them, the Surety would likely contract with replacement contractors for the balance of the work. This would then require additional time to complete the contract in that replacement contractors must familiarize themselves with the work in place. With a Labour and Material Payment Bond in place, the Surety is in a position to bring the sub-trades up-to-date financially, to obtain their co-operation to complete the contract, and to maintain the integrity of the warranties. Obviously, any unpaid sub-trade has no obligation to maintain or honour a warranty. 20 CCDC