Bonding companies are, in effect, insurance companies that provide to owners and various claimants on a job site an alternative source of possible relief in the event that the bonded party fails to perform certain specified duties on the project. In certain types of construction projects, such as many projects for the Federal government, bonds are the sole source of effective relief for many claimants.
The reader is advised to read our basic article on Mechanics Liens and Stop Notices on Construction Projects before reading further. The rest of this article shall assume that the reader is already familiar with the contents of that article as well as our basic articles on Contracts and Breach of Contracts under American law.
Quite often a bond on a construction project is an additional source of remedies available to a claimant which may be pursued in addition to the Mechanics Lien, Stop Notice and breach of contract causes of action against a party in violation of their duties in a construction setting. However, for disputes concerning the larger Federal projects the only secured legal claim is under a Miller Bond Action. In such situations, a suit on the bond is often the sole practical remedy available for subcontractors or material men who find themselves unpaid by a defaulting contractor or seeking relief from a subcontractor who is without funds that could pay a judgment.
It is important to differentiate between the different types of bonds often found on construction projects.
There is first of all the “performance bond” which is an insurance policy taken out by someone performing duties on a construction project which has the insurance company obligating itself to make good on the failure of performance either in work or in payment to third. Typically, the bonding company insures the owner of the project that the bonded party will finish the job correctly. This bond is vitally important for owners including the State and Federal authorities who retain contractors to work on a project. Often the bonds require the bonding company to arrange for the completion of a project abandoned by a contractor or subcontractor on a job site.
There is, secondly, a “payment bond” which is an insurance policy taken out by someone performing duties on the construction project which has the insurance company obligating itself to make good on the failure of that entity to pay subcontractors or material men on the project. (Note this bond is for the benefit both of the owner of the project who might otherwise face a stop notice or lien action and in favor of the subcontractors or material men who are unpaid.)
Thirdly, there is the bond that a stop notice claimant is required to post should it seek relief on a private stop notice cause of action, as more fully discussed in the article on Mechanics Liens and Stop Notices on Construction Projects.
Additionally, certain States require their contractors to post a bond that is available for paying claimants if the contractor fails to perform and is unable to make the payment itself. This
contractor’s license bond is, unfortunately, usually quite small and is available to mostly assist consumers in making claim in home improvement situations. It can, at times, act as incentive for a contractor to pay since the State bonding authorities often require a cleared bonding record for legal additional work. Each State varies in the size and regulations concerning their bonding of contractors.
This article shall only discuss the performance and payment bond requirements, strategy and tactics that a party making a claim on such a bond should be familiar with before commencing any sizable construction project. While directed at claims filed in California, many of the recommendations apply to claims in other states.
CALIFORNIA BOND CLAIMS
As stated in the Mechanics Lien article on our web, a claimant who is unpaid by a contractor, subcontractor or owner on the job, or a contractor unpaid by the owner, has a right to seek to seize any sums unpaid by the lender on the job site by filing a requisite claim on undistributed sums (stop notice claim) . Note that if the claimant is not in direct contract with the owner (in “privity of contract”) it is usually necessary to file a twenty day preliminary notice on the owner, parties and lender. Further, strict time limits as described in the above article (and which should be discussed with experienced counsel) apply to each such claim and the wise claimant moves quickly if payment is not made.
Such claims for stop notice usually require the claimant to post a bond before the stop notice is valid. (This is true for private jobs. On public stop notice claims, the claimant is usually not required to post a bond.)
The bonds being discussed in this article, however, are those posted by the owner and, more often, the contractor or certain subcontractors, ensuring payment to third parties, usually subcontractors and material men, for work performed or materials used on the project. The claim is usually brought in a legal action against the bonding company, the nonpaying party (owner, contractor or subcontractor) and requires as a condition precedent the filing of a Ninety Day Notice to all the parties, including the bonding company, of the materials or labors delivered and the possibility of the claim. Again, competent legal advice is needed to adhere to the notice requirements, both in terms of timing and content. Failure to make the notice correctly can defeat the right to seek relief under the bond.
Unlike State and Federal jobs, there is seldom a legal requirement that the owner require contractors or subcontractors to post a bond. These are discretionary requirements often imposed upon bidders by the larger private entities owning or financing the project (and recommended by their professionals advisors in most instances.) Since bonds are expensive at times and often increase the cost of the entire job, many owners decline to insist upon bonds, relying instead on joint checks or waivers of lien and stop notice rights before payment to protect themselves. A wise subcontractor or material man will inquire as to whether a bond has been required of the buildings on the project by the owner since the existence of a bond is one more indication of security available for unpaid claimants.
Often material men will offer special prices and terms if they are made aware that a project is bonded since the sale is that much more secure.
If a subcontractor or contractor fails to pay, the claimant will normally file suit to collect predicated on multiple causes of action, since a claimant is not required to elect only one path of relief. A typical construction claimant’s claim will involve a suit for breach of contract (against the contractor or subcontractor) a suit to foreclose a mechanics lien; a suit to enforce a stop notice; and a suit to require payment under the bond. Note that of all these claims, the bond is usually the most secure since an insurance company is pledged to make payment. The contractor may be defunct, thus not having sufficient sums to pay. The property may not have sufficient equity to make full payment on all liens. The stop notice may have been too late to seize lender’s funds before they were disbursed. But the bond is normally available with an insurance company obligated to make payment.
But be aware that if the bond claims exceed the total amount bonded, the bonding company is only required to pay out pro rata to the validated claimants the amount bonded.
How does that occur? Often a poorly performing subcontractor will order too much material or will use material for one job and install it in another. Often the claimants seek payment for materials not actually incorporated into the job and most bonding contracts require proof of incorporation of materials and labor before payment is due. A subcontractor, low on credit, and realizing that a bonded job will create additional credit availability, will at times misrepresent the destination of goods being purchased and actually install them in a non-bonded job.
In that case, when the “bonded” claimant makes claim on the sums due, the bonding company can seek to demonstrate by reference to the plans and specifications that far too many of a particular type of material were delivered to a job site in which case either the bonding company allows the contenting parties to argue as to which material went in or argues to the court that it is up to the claimant to demonstrate that its actual goods were incorporated into the job.
An equally typical problem for the claimant is that the bonding company will argue that the defaulting builder had many open accounts, including many unbonded. The bonding company will claim that the claimant wrongfully insists they all went to the bonded job or should have been applied to the bonded job when, in reality, much of the material was properly allocated to unbonded jobs.
Recall it is the burden of proof of the claimant to show that the goods went to a particular bonded job and that payments received on various jobs were not wrongfully allocated to unbonded jobs. In such circumstances, the claimant will have to either prove that its materials must have gone into the job (since no other entity supplied them) or prove nonpayment by demonstrating that various payments received were directed by the contractor to a specified account or applied in a normal appropriate business method (e.g. oldest outstanding accounts) to the unbonded accounts. Note this will not work if a joint check method was required by the bonded owner or specific instructions received from the contractor to apply it to the bonded account.
Thus, a good rule for a claimant to keep in mind when selling to various jobs of a questionable contractor is to ensure that the bookkeeping department is aware of the proper allocation of payments and that goods sold for the bonded job be separated (and credit decisions be accordingly made) from goods sold on the unbonded jobs.
From the above it is clear that incorporation of materials is usually required to recover on a bond claim, just as with a mechanics lien or stop notice cause of action.
Bonding company attorneys and adjusters are normally specialists and fully aware of the steps they are required to take to ascertain the validity of a claim. While they should be given opportunity to investigate a claim and determine the number of claimants on a job, it is important to note that each month that goes by without payment is to their benefit since they are using the bonding funds otherwise due the claimant, thus if payment is not made within thirty to sixty days of filling out their typical bonding claim demand form, it is time to consider legal action and obtain legal advice.
Some bonds award attorneys fees to the prevailing party thus the threat of a suit from an attorney can be a powerful inducement to a rapid settlement should the bonding company be oddly reluctant to make payment as required under the bond.
PUBLIC WORK: STATE JOB BONDING
Mechanics liens can not apply against governmental property so, in addition to stop notices in State jobs, the overwhelming majority of state owned jobs require the contractor to post payment and performance bonds.
As with the private bonding claims, incorporation of materials must be proven and the issues involving proper allocation of payments to accounts must be proven. The major difference is that with no mechanics lien available the bond becomes even more important for the claimant and that it is typically appropriate when filing the twenty day preliminary notice (see our articles on Mechanic’s Lien) to concurrently notify the bonding company (in addition to the standard ninety day notice) so to notify the entity of the likely claim. It is not necessarily legally required but often a good method to involve the bonding company in planning for payments out if the job fails.
FEDERAL WORK: FEDERAL BOND JOB (MILLER BOND)
There are neither mechanics liens nor stop notices allowed on federally owned projects. With the paucity of security available to material men and others on such jobs, the requirements for enforcement of bonds is relaxed. Incorporation of materials need not be proven. Indeed, if materials are ordered for a project legally and are lost in transit, the claim for materials must still be honored under a Miller Bond claim.
The same issues as to allocation of payments and filing of requisite timely notice must be met.
TACTICAL CONSIDERATIONS IN THE BOND CLAIM
It is a little known fact that unlike most insurance companies which set aside loss payee funds for anticipated claims, bonding companies seldom do, relying instead on rigorous bonding criteria to weed out builders who are unqualified or under funded. Any contractor can attest to the difficulty of convincing a bonding company that the contractor is qualified for a particular level of bonding and it is often said that the size of contractors in the industry is often determined by the level of bonding that the companies will provide on the larger projects.
Thus, when a claim is made on a bond it is both an unusual event for the bonding company and already a situation in which the bonding company is considering the event as a failure on its part to qualify the contractor correctly. Unlike insurance companies, one does not often find an adjuster who is convinced that some sums must be paid out since that is what insurance is for: their “client,” e.g. the company who paid the bond, is usually bankrupt and defunct and there is no desire to please that client to maintain future business. All that is left is the need to pay out claimants and, occasionally, to pay out additional sums to finish up the job. As one bonding company executive once told the author, “All there is for us when a job fails is bad news and worse news.”
As with any claim, there is seldom a feeling of the need of alacrity to pay out these sums. Often the job is halted in mid completion and the bonding company has no idea what additional claims may arise or what materials were actually incorporated. An adjuster is normally assigned who will insist upon full documentation of incorporation, allocation of payments, etc, and, while not declining the claim, will be remarkably slow in most instances to agree to a pay out.
It is vital to keep in mind that rigid time limits exist for when the clam is made-and when litigation must be commenced to perfect rights on the claim. Competent legal counsel must be quickly retained so deadlines are not lost and pressure is maintained for a full and appropriate payment.
If payment is not achieved within sixty days of when the claim is first made, most claimants would be well advised to commence legal action, for if the adjuster later determines to make payment, the suit can always be dismissed.
Many bonds (most state and federal) require the bonding company to pay the reasonable attorneys fees incurred by a claimant forced to litigate a valid claim. Thus, once litigation arises there is remarkable pressure on the bonding company to make appropriate payment before the attorneys fees get very high since, absent a victory, the bonding company will face the unpleasant prospect of having to pay both its own and the claimant’s attorneys fees and costs.
It is vitally necessary to make sure that the documentation presented to the bonding company is both accurate and does not produce irrelevant evidence that can be used against the claim. Just giving the entire file to the bonding company can lead to even more delay or even a successful defense, thus counsel should be retained even before making the verified claim to the adjuster.
An example can perhaps illustrate the dangers faced. One client of ours, before retaining our office, simply copied and forwarded to the bonding company their entire credit and ledger concerning a project. Written in the margin were the words of the credit manager, “They say to apply the payment to the non-bonded jobs since they may be in trouble.” The bonding company seized on that note in the margin to claim that misallocation of payments were made and it took months of discovery before we could convince them of the truth-that the owner of the company had not followed that direction and had properly allocated accounts. The bonding company had not even asked for the credit notes, only the ledger of the account, thus this sloppiness in providing irrelevant information to avoid a careful preliminary review of the file by counsel only cost the client tens of thousands of dollars more.
Most litigators in the construction field would rather advance a bond claim than any other type such as mechanic’s liens or stop notices. Not only are the issues often easier to confront and prove, but the fact that attorneys fees are often paid to the claimant make the attorney’s job that much easier.
Any entity in construction is well advised to learn the basics of bond claims, keep accurate records of incorporation and allocation of accounts, move quickly, and get good legal advice. In the majority of bond claims, recovery is relatively rapid with a high degree of probability of success.