PERFORMANCE BONDS AND LABOUR AND MATERIAL PAYMENT BONDS: WHAT THE CONSTRUCTION INDUSTRY SHOULD KNOW

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1 PERFORMANCE BONDS AND LABOUR AND MATERIAL PAYMENT BONDS: WHAT THE CONSTRUCTION INDUSTRY SHOULD KNOW Deborah E. Palter, B.A., LL.B., J.D. What is a Bond? A bond is a three party written agreement. The three parties to a bond are most often: (1) the general contractor (called a principal under the bond); (2) the owner (called the obligee under the bond); and (3) the bonding company (called the surety under the bond). Under a surety bond, there is a principal who has a contract to perform for the obligee. If the principal defaults in performing his obligations under the contract, the surety is bound to make good the default, which the principal was or should be liable to pay. The surety may then seek reimbursement from the principal. A bond is not the same thing as a policy of insurance. There are two principal differences between a bond and a policy of insurance. First, a bond is a three party agreement. A policy of insurance is a two party agreement between the insurance company and the policy holder. Second, a loss on a surety bond is ultimately the principal s loss. The surety is entitled to reimbursement from the principal for any loss it suffers as a result of the principal s default. Since the surety will be seeking reimbursement from its principal under the bond, an obligee must realize that: (1) the surety will want to be satisfied as to the quantum of the obligee s claim and the principal s liability before the surety will pay; and (2) the surety may decide to litigate the claim so that a court can decide the surety s liability. An action on a surety bond is an action for damages for breach of the promises contained in the bond. The obligee is obligated to mitigate its damages. In other words, the obligee is required to take all reasonable steps to lessen the damage it has suffered as a result of the principal s default. The bonding company will draft the bond. If there is any ambiguity in the wording of a bond, the wording will be interpreted in the way least favourable to the bonding company. This is called the contra proferentum rule. If there is no ambiguity in the wording, then the words will be given their plain meaning. The following discussion on Performance Bonds and Labour and Material Payment Bonds is based on the standard wording most often

2 Willson Lewis LLP 2 contained in these types of bonds. In order to determine your precise rights and obligations in a particular case, it is essential that you carefully read the terms of the bond to which you are a party. Performance Bonds A condition of a performance bond is that the principal will properly perform the contract, and if it does not, the surety will make good the default, provided that the obligee has performed its obligations under the contract. Pursuant to the terms of the bond, the surety may insert a penalty amount and thereby limit its liability to a certain amount. A Performance Bond is not intended to cover payment of labour and material claims. Owners and contractors are advised to purchase a Labour and Material Payment Bond if they desire this type of coverage. Labour and Material Payment Bonds are discussed in more detail below: The standard Performance Bond provides that whenever the principal is in default under the contract, and the obligee has performed its obligations under the contract, the surety has three main options: (1) to remedy the default; (2) to complete the contract; or (3) to submit a bid for completion to the obligee. When a surety receives notice of default, it will normally investigate to see if there is a defence available to the allegation by the obligee that a default has occurred. If the surety decides that there is no defence to the default, the surety must choose one of the options available to it under the wording of the Performance Bond. In practice, the surety, the principal and obligee rarely agree on each other s obligations. The obligee expects that its notice of the principal s default should be accepted without question and responded to instantly. This expectation may be accompanied by a threat of dire consequences if the surety does not respond accordingly. The principal, on the other hand, expects the surety to accept its word that it is not in default and that it can handle the situation. The surety is caught in the middle with a duty to both sides to act with fairness and speed to bring about a resolution of the dispute and completion of the project. Surety s Option to Remedy the Default When the surety is satisfied that the principal is in default, the surety s first option is to remedy the default. This option is available when the principal is solvent and some dispute has arisen between the principal and the obligee concerning the performance of the contact. Sometimes the surety can bring the principal and the obligee together so that the default may be remedied and the principal may continue

3 Willson Lewis LLP 3 its work under the contract. Surety s Option to Complete the Contract The surety s second option is to complete the contract. Obligees most often view this as a mandatory requirement for the surety, rather than just one of several options. From a surety s perspective, this option may be risky. If a surety decides to complete the contract itself, the argument can be made that the surety is obligated to complete the contract, regardless of what it costs, and the limit on the surety s liability under the bond no longer applies. In addition, a surety is not usually in the contracting business. There are often legal obligations on a contractor that a surety must meet if it decides to complete the contract. For example, it may be required to comply with workers compensation legislation and suffer penalties if it does not. On the face of it, the parties to a bond may believe it would be cheaper for the surety to complete the project if it acts as the contractor. This may not be the case. Surety s Option to Obtain Bids The surety s third option is to obtain bids for the completion of the contract and submit the bids to the obligee. The bidding procedure may take a variety of forms, including the possibility of a public tender. However, because there is usually some urgency involved, several contractors may be asked to bid privately. In the normal course, the obligee enters into a contract with the lowest tender and the surety consents. A new Performance Bond is usually required for the completion contract. Labour and Material Payment Bonds Labour and Material Payment Bonds provide that the surety must pay labour and material suppliers on the project who are owed money by the principal. A standard Labour and Material Payment Bond provides that notice must be given and an action commenced with specified time periods. Labour and material payment bonds are often required by public bodies such as municipal corporations and the Federal and Provincial Governments. The federal form of a Labour and Material Payment Bond is different from a provincial or private bond form. Federal Government Form of Labour and Material Payment Bond The Federal Government form of a Labour and Material Payment Bond is fundamentally the same as the form of Labour and Material Payment Bonds used in private industry. However, the federal form of a Labour and Material Payment Bond is unique in extending the

4 Willson Lewis LLP 4 surety s liability to second tier claimants. In the case of provincial and private bond forms, the surety is liable only to those claimants who have contracted directly with the principal. However, in the case of the federal bond form, the surety is also liable to those claimants who contracted with the subcontractors who contracted with the principal. Claimant Requirements In order to qualify for coverage under a Labour and Material Payment Bond, a party is required to do the following: (1) bring itself within the definition of claimant found in the Labour and Material Payment Bond; (2) provide appropriate notice of its claim to the surety; and (3) commence an action against the surety to enforce its claim within one year of the date that the principal ceased work on its contract with the obligee. It is essential that potential claimants familiarize themselves with the terms, conditions and limitation of the Labour and Material Payment Bond to which they are a party. Particular attention should be paid to the time limitations for providing notice of a claim and commencing an action. Generally, the claimant must deliver written notice of its claim to the surety by registered mail within 120 days from the date that the claimant last supplied work, labour or materials to the project. The notice should describe the nature of the claim with as much particularity as possible. At a minimum, the notice of claim should contain the following: (1) the amount of the claim; (2) a description of the project; (3) the name of the principal; (4) a description of the bond, including the bond number; (5) the nature of the materials and/or services provided; and (6) the last date of supply of the materials and/or services. Failure to deliver a written notice of claim within the time prescribed can be fatal to a claimant s ability to obtain coverage pursuant to the terms of the Labour and Material Payment Bond. However, in the event a written notice of claim is not delivered within the time prescribed, two possible remedies exist.

5 Willson Lewis LLP 5 First, the Construction Lien Act allows any person having a lien to demand a copy of any Labour and Material Payment Bond. If a claimant requests a copy of the Labour and Material Payment Bond, and the recipient (usually the owner) does not answer that request in a timely fashion, the owner may be liable to the trade in damages equivalent to the benefit the trade would have obtained if a timely notice of claim on the Labour and Material Payment Bond had been made. Second, failure to give notice within the strict time limits may be relieved if the claimant can show that the surety did not suffer actual prejudice as a result. In the decision Citadel General Assurance Co. v. Johns-Manville Canada Inc., [1983] 1 S.C.R. 513, the claimant supplied pipe to the principal of an Ontario government construction project. The principal defaulted in paying the claimant for the pipe supplied. The Labour and Material Payment Bond provided that every claimant had a right to sue under the bond for payment of monies owed by the principal under the claimant s contract with the principal. The claimant commenced an action under the bond, and gave notice to the surety in accordance with the bond requirements. However, the claimant did not comply strictly with the bond terms in giving notice to the principal and the Ministry. The claimant delivered its notice of claim to the Ministry by regular mail, instead of registered mail, as required by the terms of the bond. The claimant did not deliver any written notice at all to the principal, but kept the principal informed of the proceedings. At issue were whether or not strict compliance with the bond provisions were prerequisite to the action. The Supreme Court of Canada held that the surety cannot escape liability found in the bond merely because of a trivial failure to meet the bond s conditions. In this case, the object of the notice provisions in the bond was fully achieved within the time limit imposed and the surety suffered no prejudice. This case stands for the proposition that a surety may still be held liable in accordance with the terms of a Labour and Material Payment Bond, even where the claimant does not strictly comply with the notice provisions of the bond, so long as the claimant can prove that the surety has not suffered any prejudice. Conclusion Whether you are dealing with a Performance Bond or a Labour and Material Payment Bond as a principal or as a claimant, it is important to remember the following: (1) If you intend to lien a project, deliver a written demand in writing to the principal requiring a copy of any Performance Bond or Labour and Material Payment Bond. If you are a principal, be certain to respond promptly to such a request. (2) If you are a claimant, be certain to deliver a notice and commence an action within the time prescribed. (3) The form and content of bonds may vary. It is therefore extremely important that you read the bond until you are certain you understand your obligations under the bond to which you are a party and the extent of your coverage.

6 Willson Lewis LLP 6 Bonds are intended to provide some security to claimants whose principal is unwilling or unable to perform its obligations pursuant to a contract. Only those claimants who understand the nature of the Bond and their obligations under a Bond can fully benefit from the existence of this security.