Knowledge Corner

Depending on the type of construction project, the General Contractor may be required to provide both General Liability (GL) coverage along with Performance & Payment Bonds. In that situation—if a claim were to arise dealing with a construction defect—a common question is who will cover the loss?   

Sometimes installation of defective work may result in property damage, which is often covered by the Contractor’s GL Policy. However, there are times where the default by the Contractor is covered under the Performance Bond. In that specific situation, the Surety has the opportunity to exercise its options as permitted by the Performance Bond language or the project’s jurisdiction bond statute.

A big difference between the GL Policy and the Performance & Payment Bond is the parties in the agreement. The GL Policy is a two-party agreement between the insured and the insurance carrier. Where the Performance & Payment Bond is a three-party agreement between the project Owner (Obligee), the General Contractor (Principal), and the General Contractor’s Surety (Surety).

How does a Performance Bond claim work?

Under a Performance Bond claim, one option is to have the Surety exercise a takeover and completion of the project. That means:

1. The Surety would secure bids from potential completing Contractor and tender the lowest bidder to the Obligee.
   
   
2. The Obligee would then enter into a direct contract with the Contractor.
   
   
3. The Surety would then enter into a completion agreement with the Contractor (if necessary). 
   
   
4. The Surety is responsible to pay the difference between the completing Contractor’s bid price, the cost to complete the project, and the remaining contract balance. 
   
   
5. The Surety would enter into a completion agreement directly with the Obligee.
   
   
6. May enter into a straight financial settlement with the Obligee.
   
   
7. The Surety would pay the Obligee a stipulated cost to complete the project minus the remaining contract balance.
   
   
8. The Surety is entitled to use of the unearned funds held by the Obligee, which would have otherwise been paid to the Principal absent its default and its subsequent contract termination.
   
   
9. In most cases, the Surety would require Surety Bonds from the completing contractor in the case of a default by the completing contractor. These bonds are then released by the Obligee after the project is completed and accepted. 

The principal and their indemnitors are responsible for incurred losses

It is important to remember that any loss incurred by the Surety is the ultimate responsibility of its Principal and their Indemnitors. The Surety then turns its attention to recouping its loss from other parties, including the liability carrier of its Principal. If the claim involves an occurrence of property damage and is not subject to an exclusion under the GL Policy, the Surety may seek recovery as an assignee of the insured contractor, or simply under a theory of equitable subrogation.

Equitable subrogation is the legal theory where the Surety is entitled to “step into the shoes” of its Principal and enforce its rights to be reimbursed for the losses it paid out due to the Principal’s default and termination.

The Surety has the right to use whatever monies are left in the contract, which the Obligee did not pay at the time of the Principal’s default and contract termination. The Surety may use these funds to fulfill its Surety Bond obligation—whether they are a completing surety, tendering a completion contractor, or entering into a financial settlement with the Obligee. 

Join us next week, as we explore how the courts have ruled regarding this situation. If you have any additional questions, contact TSIB today!

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