Performance Bonds: Guaranteeing More Than You May Know
Performance Bonds:Guaranteeing More Than You May KnowLockton Construction Services October 2007By Jeffrey C. Carey and Joseph R. PryorWith research contribution from Laura C. PflummVery few contractorscorrectly understandthat the performancebond actuallyguarantees allprovisions of thecontract, including allwarranties. This factalone does not presenta problem; it is whenthe warranty periodextends far into thefuture that suretiesstart to lose theirnerve.In the world of surety bonding, a constanttug-of-war exists between what owners andarchitects require in construction contractsand what the surety industry and theircontractor clients are willing to provide.As surety brokers, we spend a greatdeal of time educating ourcontractors on the appetite of thesurety industry and how it affectstheir ability to bid and obtain bondedwork. One topic we constantlyaddress is long-term warranties, forwhich there exists a wide range ofperception.Many contractors believe aperformance bond only guaranteestheir performance throughcompletion of the work, while othersbelieve a bond will also cover anywarranties 12 months followingsubstantial completion. Very fewcontractors correctly understand thatthe performance bond actuallyguarantees all provisions of thecontract, including all warranties.This fact alone does not present aproblem; it is when the warrantyperiod extends far into the futurethat sureties start to lose their nerve.Many of you already understand this,and have an appreciation for itssignificance. If not, I urge you toread on and discuss it with yoursurety broker and surety companies.
Abbreviated “Bonds 101”The scope of work, geography ofthe work and credit worthiness ofthe principal are all determiningfactors in the length of warranty asurety will support.Before we dive into the topic of long-term warranties,let us first start with some bond basics used throughoutthe article. Surety bonds utilized on constructioncontracts are typically performance and paymentbonds. Performance bonds protect the obligee (owner)of a project from financial loss upon the event ofprincipal (contractor) default.The labor and materials payment bond, or simply thepayment bond, provides the obligee with assurance thatany subcontractors, laborers, or material suppliers willbe compensated to the terms described in any and allsubcontracts. While payment bonds perform a veryimportant risk-mitigating function, this article will focuson the performance bond and its maintenance/warranty aspect.For the purposes of this article, we will use the term“warranty” exclusively. However, in the surety world,the terms “maintenance” and “warranty” are usedinterchangeably, both relating back to the contractor’songoing obligation to fix defective workmanship.“Long-Term” Warranties DefinedIntroduced above was the concept of extended or longterm warranties. What does the surety world consider“long-term”? As with all things surety, the answer is,“It depends!” The scope of work, geography of thework and credit worthiness of the principal are alldetermining factors in the length of warranty a suretywill support. However, in theory, the premium you payfor performance and payment bonds includes anassumed one-year warranty obligation from the pointof substantial completion on the bonded project.Therefore, the problem sureties have with extendedwarranties with any period of time beyond one yearfrom substantial project completion or contractuallytriggered dates.Also, a distinction must be made between manufacturerwarranties and the warranty provided by the principal(contractor). To do so, one should evaluate what thecontractor is solely responsible for and what can be2
passed on to a manufacturer. Sometimes thisdistinction is very easy to make and sometimes it is not.For example, many roofing contracts require a specificbrand of shingle that provides a 25 year or longerwarranty. As long as the manufacturer supplying theshingle does not object to providing this warranty, thesurety would likely view it as a “pass-through”warranty.The same would apply for sealant applications. Manymanufacturers of urethane and silicone sealants are soconfident in their products that they have no hesitationin offering a ten- or even 20-year warranty, providingthat proper testing and documentation are completedthroughout the project. In most cases, these areintended as limited warranties (the contractor is liablefor the first few years, and the manufacturer is 100percent liable afterward). A problem arises when thesewarranties are specified as labor and materialwarranties, binding the manufacturer and thecontractor to this time period.Why Sureties Do Not LikeLong-Term WarrantiesTo understand why sureties have such a difficult timewith long-term obligations, we must first understand akey fundamental of the surety industry: surety credit isunderwritten to a 0 percent expected loss ratio. Unlikeinsurance, where a portion of premiums provide foranticipated losses, the surety premium is simply anunderwriting fee (generally passed through to theobligee) for the surety’s prequalification of thecontractor. So in theory, if the underwriting and duediligence is performed properly, the sureties will notpay any losses due to contractor default. However, thesurety industry experiences, as an annual average, lossratios between 25 and 40 percent of their direct writtenpremiums. Now, it is understandable why suretypremiums are just a theory! Add on overhead and fixedcosts upwards of 60 percent of direct written premiumsand you are left with an industry operating on very slimprofits, all the while undertaking substantial risk.3
As the amount of time under a warranty provisionincreases beyond one year, it also becomes harder todetermine whether the defects are chargeable to thecontractor, inherent to the plans and specifications orare the result of some careless or even normal usageby the owner.1Reinsurance also plays a substantial role in the suretyindustry’s ability to support extended warranties.Nearly all surety companies buy reinsurance totransfer a portion of their bonded risks. Reinsurancetreaties govern the relationship between the suretyand reinsurer, and often contain restrictions on longterm obligations. This can reduce a surety’s ability totransfer risk, and as a result, the surety is much lessinclined to support a long-term obligation.As the amount of time under awarranty provision increases beyondone year, it also becomes harder todetermine whether the defects arechargeable to the contractor,inherent to the plans andspecifications or are the result ofsome careless or even normal usageby the owner.1How the Warranty is CoveredOpen any book on the subject of contract surety andyou will find something similar to, “Performance4bond guarantees the faithful performance of a contractaccording to its terms and conditions.” This isaccomplished by referencing and incorporating thecontract on the performance bond form. For example:as the AIA A312, which is a very standard bond form,reads in Section 1, “The Contractor and the Surety,their heirs, executors, administrators, successors andassigns to the Owner for the performance of theConstruction Contract, which is incorporated herein byreference.” Thus, a performance bond binds the suretyby the same contractual terms and conditions to theobligee as the principal. Because of this, there are somekey contract provisions that must be identified before asurety will provide a performance bond to a contractor.These include, but are not limited to: scope of work,duration of the work, default provisions, damages(liquidated, actual or consequential) and the warrantyprovision.While it varies from contract to contract, manywarranty provisions require the principal to warrant:1) All materials and equipment incorporated into thework conform to the specifications, drawings andcontract documents; 2) be first-quality, new materialsfree from defect in materials and workmanship; and3) this warranty extends for a period of time that startswhen the work is considered complete. If, at somepoint during the warranty period, one of the provisionswould be triggered, the contractor is often required toremedy the defective material/workmanship at no costto the owner. This constitutes a performanceobligation to the contractor, and therefore, possibly to asurety as well through a performance bond. Dependingon the contract, this obligation can be either easy toquantify, or very vague.
When long-term warranties are passed down throughsubcontracts by the use of ambiguous language,quantifying this obligation becomes difficult. It is notuncommon for a subcontract warranty provision toread, “ contractor is bound by the same warrantyrequired in the prime contract.” In this situation, acopy of the prime contract must be obtained toaccurately determine the warranty being guaranteed bythe performance bond.Examples1) The Tudor Development Group, Inc. v.United States Fidelity & Guaranty Co. 2This case is a perfect example to highlight the scenarioof the contract prevailing over the language of thebond. The plaintiffs brought action against USF&G,alleging its contractor’s performance, under thewarranty provision in the construction contract, wasdeficient. In its motion to dismiss, USF&G argued theperformance bond did not provide coverage for breachof warranties since it was not included in the text of thebond. The district court disagreed with USF&G’sargument, pointing to the fact that the bond expresslyincorporated the construction contract. This meant thesurety’s obligations were only discharged when thecontractor had “promptly and faithfully” performedunder the contract. The motion to dismiss was denied.2) J.B. Mouton & Sons, Inc., Plaintiff v.Alumawall, Inc., and Great American InsuranceCompany, Defendant 3This case highlights the possibility of jurisdictionalstatute prevailing over the bond form. In this case,Alumawall entered into three subcontracts withMouton for glass and glazing work to be performed onthree separate buildings. Mouton required Alumawallto provide three performance bonds guaranteeing theperformance on the subcontracts. Two of the bondforms contained language limiting the time frame aclaim could be made to 12 months after completion ofthe work. However, these bonds also contained thefollowing clause, “ but if there is any maintenance orguarantee period provided in the contract for which5
said Surety is liable, and action for maintenance maybe brought within six months from the expiration ofthe maintenance period, but not afterward.” Thebond form for the third subcontract only containedthe following, “Any suit under this bond must beinstituted before expiration of two years from date onwhich final payment under the subcontract falls due.”Mouton did not file suit until five years after finalpayment was made on each subcontract. Once again,each subcontract was incorporated into the bond formby reference. Each contract’s warranty sectionreferenced, “as may be applicable by law” to providethe warranty’s duration. At the time, Louisiana lawprovided a ten-year implied warranty of fitness forbuilding construction contracts. Therefore, becausethe first two bonds expanded coverage by referencing,“ any maintenance or guarantee period provided inthe contract,” and the warranty section referenced “asmay be applicable by law,” the court ruled the bondswere valid and enforceable until six months beyondthe expiration of the ten-year statutory warrantyperiod. However, because the third bond provided aspecific and unambiguous limitation on itsenforceability, the court upheld the two-year period.3) The AIA A312 Bond FormThe AIA A312 bond form, a form widely usedthroughout the surety industry, provides anyjurisdiction’s statutes the right to prevail over thebond. Specifically, Section 11 reads:When this Bond has been furnished tocomply with a statutory or other legalrequirement in the location where theconstruction was to be performed, anyprovision in this Bond conflicting with saidstatutory or legal requirement shall bedeemed deleted herefrom and provisionsconforming to such statutory or other legalrequirement shall be deemed incorporatedherein. The intent is that this Bond shall beconstrued as a statutory bond and not as acommon law bond.46
What do these examples amplify? In determining exactlyhow the warranty is covered and also what is covered, wemust be careful on three fronts. First, we must be wellaware of the obligations within the contract. Secondly, wemust be cognoscente of how our local jurisdictions viewthese matters. And lastly, we also should be familiar withthe bond forms we are signing and how they react tocertain contractual and statutory conditions.Why All This MattersYou may be asking yourself, “Why should I care? Howdoes this impact me as a contractor?” First and foremost,the relationship between a surety and a contractor is builton trust. Sureties often do not see a copy of the contractthey have bonded until after the performance bond isexecuted and is in force. If a surety is not able to trust theaccuracy of the information provided by its client, therelationship will not last.Before any company, person or entity can obtain a bond, itmust provide an indemnity package to the surety. This isrequired because, as discussed above, the suretyunderwrites to a 0 percent loss ratio. The surety wouldlook to the indemnity package to provide loss-payingpower in any claim situation. In the construction industry,the typical indemnity package comprises of both corporateand personal indemnity.The document governing the terms and conditions of thisindemnity is known as a General Indemnity Agreement, orGIA. Each surety has its own GIA form, but by and largethey contain similar provisions. If you have ever revieweda GIA, or better yet, been asked to sign a GIA, you knowdescribing it as “onerous” may be an understatement. It isunfortunate the GIA has to be written with so many teeth,but the surety has to be able to protect itself in the worstpossible scenarios. One of the key terms standard on mostGIAs is the surety’s ability to settle claims unilaterally,meaning, the surety can investigate and settle a claim withan obligee without its client’s input. This is absolutely notthe way sureties prefer to handle claims, but they mustretain the ability to do so.7
From ownership to field crews, all parties shouldunderstand the significance of indemnity as it relates toperformance bonds. For owners personallyindemnifying, the significance is magnified. Take theJ.B. Mouton & Sons case from above; apply what younow know about indemnity, and imagine yourself inthat position. Remember, if the surety has a problem,you have a problem.the warranty they desire without taking thesureties out of their comfort zone. Forinstance, limiting the time frame of thesurety’s obligation does not remove thecontractor’s warranty responsibility.Sometimes the solution can be that simple,but until we come together as an industry onthis issue, nothing will be accomplished.”5SummarySo, how do we start to bridge the gap between thesureties and the owners/architects on the topic oflong-term warranties? The answer is two-fold. First,as an industry, waterproofers must come to theunderstanding that performance bonds, barring anylimiting factors, guarantee all warranties containedwithin bonded contracts. Second, waterproofers mustwork with owners/architects to come up with solutionsthat are amenable to all parties. Frank Halsey,President of Mid-Continental Restoration, sums it upwell:1 Remmen, Albert. The Contract Bond. Cincinnati: A National Underwriter Publication, 1977.2 Tudor Development Group, Inc., Sidney Cohen, Dorothy Cohen, Marc Cohen, t/a Green HillAssociates, Plaintiffs, v. United States Fidelity & Guaranty Company, Defendant. No.88-0758.United States District Court for the Middle District of Pennsylvania. 25 Aug. 1988.3 J.B. Mouton & Sons, Inc., Plaintiff- Appellant v. Alumawall, Inc., Defendant and GreatAmerican Insurance Company, Defendant- Appellee. No.90-191. Court of Appeal of Louisiana,Third Circuit. 16 July 1991.4 American Institute of Architects Performance Bond. Pub. L. AIA Document A312. Mar 1987.5 Halsey, J. Frank. Mid-Continental Restoration Co., Inc, President.“As waterproofers, we are the frontlinerepresentatives of our surety partners to theowners and architects pushing for longterm warranties. There are ways to provideThis article appeared in the Summer 2007 edition of the Applicator, the publication of the Sealant Waterproofing &Restoration Institute.About the AuthorsJeff C. Carey (816) 960-9360 phone (816) 783-9360 fax jcarey@lockton.comAs an Assistant Vice President with Lockton, Jeff is responsible for day-to-day surety client and surety marketrelationships. Jeff earned his Master’s in Business Administration from the University of Kansas, and since joiningLockton, he has earned his CPCU (Certified Property and Casualty Underwriter) and AFSB (Associate in Fidelity andSurety Bonding) licenses.Joseph R. Pryor (816) 960-9148 phone (816) 783-9148 fax jpryor@lockton.comAs a Construction Specialist with Lockton, Joe is responsible for day-to-day surety client and surety market relationships.He is a graduate of the University of Central Missouri with a Bachelor of Arts in Economics and a Master’s of BusinessAdministration, Finance.Laura C. PflummIs a junior at the University of Denver, and will complete her degree in Real Estate Finance in June of 2009. Lauraparticipated in the Lockton Summer Intern program with the Kansas City Surety Department.Lockton Companies, LLC, headquartered in Kansas City, Missouri, is the world’s largest privately held independentinsurance broker with more than 3,800 risk professionals in 45 offices on four continents serving more than 15,000clients. Lockton’s philosophy focuses on servicing our clients, our Associates, and our communities.
Abbreviated "Bonds 101" Before we dive into the topic of long-term warranties, let us first start with some bond basics used throughout the article. Surety bonds utilized on construction contracts are typically performance and payment bonds. Performance bonds protect the obligee (owner) of a project from financial loss upon the event of
public safety as are secured bonds. Unsecured bonds are as effective at achieving court appearance as are secured bonds. Unsecured bonds free up more jail beds than do secured bonds because: (a) more defendants with unsecured bonds post their bonds; and (b) defendants with unsecured bonds have faster release-from-jail times.
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