A surety on a performance bond guarantees to the project owner that the construction contractor will perform the contract fully, in accordance with its terms and conditions.
The nature and scope of what the surety is securing, the performance of the contract, is not set forth in the performance bond form.
The performance bond form is a relatively simple document that is typically one or two pages long. The underlying obligation being secured, the construction contract, usually is incorporated by reference. For example, paragraph 1 of the A312 Performance Bond promulgated by the American Institute of Architects states, "The Contractor and Surety, jointly and severally, bind themselves ... to the Owner for the performance of the Construction Contract, which is incorporated herein by reference."
Thus, in order to determine its exposure under the performance bond, the surety must review the construction contract. A surety analyzes certain key contract terms to assess the level of risk under the performance bond. Use of construction industry standard form agreements by construction owners offers a convenient and ready contractual framework that facilitates the underwriting process and is well-regarded by surety underwriters.
Key Contract Terms
Contract review is an essential element in the underwriting process and the surety's determination of whether to issue the bond. Key contract terms that are important to a surety underwriter's risk assessment are:
- Payment terms
- Time for performance
- Liquidated damages provisions
- Termination for default provisions
- Warranty obligations[i]
Payment Terms
A surety reviews the contract terms to determine whether the contract will provide sufficient cash flow to fund the project. Construction contracts typically provide for monthly payments by the owner in accordance with the contractor's progress on the work (a progress payment). Typically, the payment provision in the contract requires the contractor to submit an application for payment by a certain day of the month for work performed in the prior month. The surety reviews this provision to ensure that the contractor is not required to fund the work out of its own capital for an extended period of time. Monthly progress payments generally provide sufficient cash flow to cover costs and overhead incurred throughout the project.[ii] A more infrequent progress payment schedule raises the risk that the contractor's cash flow may become strained.
Another element of the payment provision is the retainage clause. Under the terms of the contract, the owner typically retains a percentage of the progress payment (e.g., 10 percent). The owner then releases the retainage upon substantial completion of the project. A surety generally favors a retainage provision because it provides financial incentive to the contractor to complete the punch-list items of the contract. At the same time, however, the retainage should be a reasonable amount that does not significantly hamper cash flow on the project.
Two payment clauses that are of interest to the surety when reviewing a contract between a general contractor and subcontractor are a "pay when paid" clause and a "pay if paid" clause. A "pay when paid" clause generally suspends the general contractor's obligation to pay the subcontractor for a reasonable time while the general contractor attempts to collect payment from the owner.[iii] However, nonpayment from the owner generally is not an absolute defense against the general contractor's obligation to pay the subcontractor. A "pay if paid" clause establishes the payment by the owner to the general contractor as a condition precedent to the general contractor's obligation to pay the subcontractor. (A number of states have determined the "pay if paid" clause void and against public policy.)[iv] A "pay if paid" clause puts the cash flow to the subcontractor at risk and would be a concern to the surety on a subcontract performance bond.
Time for Performance
In writing a performance bond, the surety is making a determination of the contractor's operational and financial viability throughout the term of the project. The longer the term of the project, the further into the
