Legally Speaking: Understanding the Value of a Payment Bond
Payment bonds are a common issue that contractors face in today's large construction projects. Simply stated, payment bonds are payment guarantees for subcontractors. They are contracts between general contractors and insurance companies, usually for a predetermined amount, to guarantee payment on work performed by the subcontractors who provide labor, materials, supplies and equipment on a project. The existence of a payment bond becomes critical when the general contractor or a subcontractor goes out of business, files for bankruptcy, or otherwise fails to pay its subcontractor.
While different states have different laws and regulations pertaining to payment bonds, there are several common facets of this area of the law that apply. Similarly, surety and insurance companies include varying provisions in their contracts, yet there are certain elements that will always exist.
Why Have a Payment Bond?A payment bond is not only beneficial to unpaid subcontractors, it also protects the owner. Upon default, the payment bond generally requires the surety to pay unpaid subcontractors and suppliers. This provides an owner with a means by which to avoid lien claims and to secure continued performance from unpaid subcontractors and suppliers in the face of payment disputes.
Notice is the KeyAn integral provision of a payment bond as it applies to subcontractors is the notice provision. To make a claim on a bond, a claimant must provide notice to either the insurance company or the owner on a project. The means of the notice vary depending on the category of the contractor. There are two general categories of subcontractors: the subcontractor and the sub-subcontractor, or "second-tier subcontractor." The obvious distinction arises from the fact that a subcontractor has a direct contractual relationship with the general, whereas the second-tier subcontractor does not.
First, both first- and second-tier subcontractors must provide the owner notice of furnishing work or supplies on the project. Next, to make a claim, a subcontractor need only provide the owner with notice that the general contractor has failed to make a payment and the amount of the claim on the bond. A claim by a second-tier subcontractor usually requires that the "notice of last furnishing" be made within a certain time period after the last furnished labor, materials or equipment have been provided on a project. Additionally, the second-tier subcontractor must have received a rejection or no response to their claim by the contractor before making a claim on the bond.
The contractual provisions regarding notice are strictly interpreted and vigorously litigated. Additionally, contractors and their attorneys must be aware that state laws may impose notice requirements that are similar, though not necessarily identical, to those of the contract. The failure or success of providing proper notice will frequently be the reason why a subcontractor gets paid on a project or will be forced to walk away empty-handed.
Public or Private Project?As most contractors are aware, public construction projects frequently introduce issues that would not otherwise be seen on a private project. This holds true for the payment bond arena. State and federal law does not allow for lien rights on public projects. Breach of contract actions against general contractors and claims on payment bonds are usually a subcontractor's only remedy. Therefore, nearly all states have passed laws mandating that a payment bond be issued on a public construction project. Key issues that contractors must consider regarding these laws are: 1) does the state impose a requirement as to the amount of the bond, and 2) who is responsible if the bond amount does not attain the statutory minimum?
Though a lower amount is typical, the law may require the general contractor to cover as much as 100 percent of the contract amount by the bond. Since the general contractor pays the premiums for the payment bond, there is no incentive for it to obtain a greater bond than the absolute minimum required by the governmental entity. The next question, therefore, is: Where do the subcontractors turn when the payment bond does not cover the amounts to which they are entitled?
Usually, the answer is: nowhere. In addition to the immunity from tort actions, governmental units are usually immune from actions brought by subcontractors when there are insufficient funds in the bond. This can occur if the amounts owed exceed the statutory minimum or if the general contractor fails to meet the minimum or obtain the bond altogether. An exception can occur, however, if the contract between the governmental unit and the general contractor specifically sets forth a bond amount that is not obtained.
Protecting the General ContractorThe concept of bonding is not relegated to merely subcontractor protection. Frequently, a general contractor may require that its major bidding subcontractors obtain a bond for a particular project. If a major subcontractor defaults, the second-tier subcontractors will look to the general for payment. By requiring its subcontractors to obtain payment bonds, the general will be protecting its interests by shifting some of the risk to some of the other contractors on the project.
Payment bonds - and their frequent partners, performance bonds (which protect the owner against a general contractor's inability to complete the project) - are becoming an increasingly common requirement of construction projects. Although the premiums to the insurance company are an added cost that eventually must be borne in some measure by all of the parties, they provide confidence to all parties involved. Contractors should always demand a copy of the bond at the outset of each project and be aware of the notice issues. Careful attention to the notice requirements imposed by the bond and as required by state law will ensure entitlement to a bond claim if a general contractor fails to pay.