by Mark H. McCallum and Robert J. Duke
November 2, 2011

A contractor needs to understand the meaning and implications of a surety bond's terms.

A surety bond is a three-party agreement in which one party secures a second party's performance to a third party. Contract surety bonds typically secure the performance of construction contracts. More specifically, a performance bond secures, for the benefit of the project owner, the contractor's performance of the contract, and the payment bond secures, for the benefit of subcontractors and suppliers, the contractor's obligation to pay its subcontractors and suppliers.

If there is a default of the underlying obligation (the construction contract), the surety steps in to remedy that default. In our article in the July 2008 edition of Construction Business Owner, we noted that a performance bond usually incorporates the underlying construction contract. (Go to www.constructionbusinessowner.com and search for "Surety Bonds: The Best Way to Prevent Subcontractor Default" to read the article.) Thus, an important part of the surety underwriting process is to know and understand the terms of the construction contract.

In addition,a performance bond and a payment bond have terms and conditions that are included in the form itself. Along with the terms of the construction contract, the terms included in the bond form determine the risk undertaken by the surety and contractor. (Remember, a contractor signs the bond as well. In addition, the surety has a right to recoup losses incurred under a bond from the contractor through indemnification. The contractor bears the ultimate financial risk.)

The contractor also must be aware of onerous terms that increase the risk for the surety and contractor beyond reasonable levels. Awareness of the bond terms is especially critical, considering that the form is not prescribed by the contractor or surety but by the project owner. The forms have some, but very little, room for negotiation. Thus, the surety and contractor must be fully knowledgeable of the risk.

Inclusion of one-sided terms and language that shift risk inappropriately and unbalance the rights and responsibilities among the parties is in no party's best interest. Experienced construction project participants know that onerous terms encourage parties to pass on contracts that include such terms, thereby lowering the competition for those projects, or, alternatively, to incorporate significant cost contingencies, thereby increasing the overall price of those projects.

Further, the presence of onerous language likely will have an overall negative impact on the project; it sets a "win-lose" environment for the parties' relationship from the "get go," which, in turn, may lead to adversarial posturing and contentious relations throughout the life of the project. Acceptance of an onerous contract or bond ultimately may mean assuming risks that, when realized, eliminate profits on the project or, if severe losses occur, the insolvency of one's construction business.

Anatomy of a Bond Form

A bond form has three main parts. The first part is the "binding paragraph." It identifies the three parties to the bond and states that the surety and principal (the contractor) are jointly and severally bound to the obligee (the project owner). This paragraph also establishes a financial limit to the obligation owed to the project owner. This limit is called the "penal sum."

The second part of a bond form is usually quite short, and much of the substance of the obligation is included in the construction contract. Thus, the construction contract is included in the bond form by reference. For example:

The conditions of this obligation are such that whereas the Principal entered into a certain contract, hereto attached, and made a part hereof, with the State of Texas, acting by and through the Board of Regents of The University of Texas System for and on behalf of _____________________________________________________, _______________, dated ________________, _______, for ____________________________________ (Project No. _______).

The next paragraph includes the condition and coverage of the bond. It usually states that the condition of the obligation under the bond is that the contractor will perform the contract. If the contractor so performs, then the bond is "null and void." If the contractor does not perform, the bond remains "in full force and effect" and the surety's obligations are triggered. For example:

NOW THEREFORE, the condition of this obligation is such that, if the Principal shall faithfully perform the said Contract in accordance with the Plans and Specifications and Contract Documents, and shall fully indemnify and save harmless the State of Texas from all cost and damage which the State of Texas may suffer by reason of Principal's default or failure so to do and shall fully reimburse and repay the State of Texas all outlay and expense which the State of Texas may incur in making good any such default, then this obligation shall be null and void, otherwise it shall remain in full force and effect.

This is the key paragraph under which the project owner seeks coverage under the bond. The surety's obligations are conditional, and they are triggered by the contractor's failure to perform. The bond is "in effect" if the contractor defaults.

Essentially, a bond form needs only these three parts: a binding paragraph, a reference to or description of the underlying obligation and the bond condition. However, the need for greater specificity or the desire to expand the scope of the surety's obligations has caused the addition of other provisions. These provisions address such issues as the claims process after the contractor is in default, waivers of certain rights of the surety and the duration of the surety's obligation. These additional provisions are the provisions where onerous language can be found that increase the both the surety's and contractor's risk.

Problematic Bond Language

Below are examples of some common modifications to bond form language that are problematic from the surety's perspective.

Language that makes it easier to trigger the surety's liability

Sometimes, a bond obligee will insert language which, in effect, acts as a "hair trigger" to invoke the surety's liability. For example, language may be inserted in a performance bond that "any breach," regardless of the materiality or significance of the