Despite well-laid plans and best intentions, the complexity of construction projects can overwhelm even experienced contractors. When this occurs, owners face the risk of unfinished projects, and contractors face the risk of unpaid invoices. Construction bonds play a critical role in mitigating these risks by providing financial security where contractors default on their obligations to complete the work or pay those who have supplied labour and materials.
For those confronted with a defaulting contractor and the need to make a bond claim, the process can appear daunting. Even identifying the correct bond against which to claim can create confusion. As a starting point, it is essential to understand the distinction between performance bonds and labour and material payment bonds.
A performance bond is a promise by a surety—typically an insurance company that issues bonds—to step in when the contractor defaults. Depending on the circumstances, the Surety may be required to remedy the contractor’s default, to undertake completion of the work by directly engaging a replacement contractor, or to otherwise assume the financial responsibility for the cost of completion, up to the limit of the bond. By contrast, a labour and material payment bond protects subcontractors and suppliers by guaranteeing payment for labour and materials properly supplied to the project where the contractor has failed to pay.
Once the correct bond has been identified, understanding its terms and conditions presents a further challenge. While most construction bonds use standard form wording, they are often drafted in dense and antiquated language, with layered conditions that can be difficult to interpret. As a result, claimants may struggle to determine what steps are required to preserve and advance a valid bond claim.
Because bond wording and requirements vary, it is not possible to provide one-size-fits-all guidance. However, there are several common pitfalls that can compromise or complicate a bond claim. Keeping these issues in mind will assist in navigating the claims process.
Complying with the Underlying Contract
Bond claims do not exist in a vacuum – they are contingent upon compliance with the underlying construction contract. For the bond to be triggered, there must be a failure to pay in accordance with the contract’s terms, which in turn depends on strict compliance with its often onerous payment provisions.
Common pitfalls include failing to properly follow the payment application process, neglecting to have payment certificates issued by the contractually designated “Consultant,” and failing to provide required supporting documentation, such as statutory declarations or workers’ compensation clearance letters. All too often, contractors ignore the payment provisions of their contracts and instead send standard form invoices without regard to the contract’s payment terms. Such missteps can create uncertainty around entitlement to payment and, in turn, complicate or even derail a bond claim.
Keeping thorough records of applications for payment, obtaining proper payment certificates from the designated party, and documenting approvals of completed work go a long way toward substantiating a claim when the surety requests supporting documentation. If the paperwork does not align with the contract, the claim may be on shaky ground.
Meeting the Notice Requirements of the Bond
Performance bonds and labour and material payment bonds impose their own strict notice obligations. This usually requires written notice, in the prescribed form, to the principal, the surety, and the obligee within the specified notice period. Critically, the governing deadline is set by the bond itself—not the underlying contract or lien legislation—which may impose separate notice requirements based on different triggering events. Notice must be timely and include all information required to fully substantiate the claim.
Recognizing the Limits of the Bond
Performance bonds and labour and material payment bonds are subject to monetary limits, which are often less than the full value of the underlying contract they secure. For example, a labour and material payment bond may be issued in the amount of 50% of the contract price.
Because contractor defaults frequently arise where the cost to complete the work exceeds the original contract price, the bond limit may be significantly less than the total value of resulting claims. Claimants should also bear in mind that even where their individual claim falls well within the bond’s limit, there may be multiple competing claimants. In such circumstances, the aggregate value of claims may exhaust the bond, leaving claimants with a significant shortfall.
Appreciating the Potential for Delays
Contractors often must demonstrate financial stability to secure new projects. For such contractors, payment delayed may be akin to payment denied. Unfortunately, a valid bond claim does not necessarily mean a prompt payout by the surety.
The surety will typically defer to the defaulting contractor when assessing the validity of claims and determining its payment obligations. If the defaulting contractor alleges that the bond claimant’s work was defective or delayed the project, litigation may be required before the surety pays the claim. Even where the claim itself is uncontroversial, if competing claims exceed the bond’s limit, total entitlement may remain uncertain until other disputes are resolved.
In assessing the likelihood of underlying disputes, it should be remembered that once a surety pays out under a bond, it will typically pursue recovery under personal guarantees signed by the directors of the defaulting contractor. With their personal assets potentially at stake, directors have a strong incentive to challenge claims and reduce the amount of any payout under the bond.
Given the potential for ongoing disputes and delayed payouts, bond claimants must ensure they understand any applicable limitation periods for commencing an action against the surety, the defaulting contractor, and the owner.
Final Thoughts
Bonds play a critical role in mitigating risk on construction projects. However, their effectiveness depends on the claimant’s compliance with the payment terms of the contract and the terms and conditions of the bond, including notice requirements. Appreciating the monetary limits of the bond and the potential for delays and disputes—some of which may require litigation—is also key to managing a defaulting project.
Bonds are but one tool in the toolbox for mitigating risk; they are not a substitute for a well-drafted construction agreement, appropriate holdback provisions, and the preservation of builder’s lien rights. Used together, these tools can help contractors and owners move beyond a defaulting contractor, recover losses, and complete the project.
Please contact a member of our Construction + Engineering Group if you have any questions regarding the above.
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