Introduction

The use of surety bonds is widespread in public and large private construction projects. General contractors who work on such projects regularly post such bonds either pursuant to applicable laws on public projects, such as the Miller Act, or the requirements of owners.

The use of surety bonds goes back centuries. As the Surety Information Office explains on its website:

Suretyship was addressed in the first known written legal code, the Code of Hammurabi, around 1792–1750 BC. A Babylonian contract of financial guarantee from 670 BC is the oldest surviving written surety contract. The Roman Empire developed laws of surety around 150 AD that exist in the principles of suretyship today.

Today, surety bonds are used to shift the risk that a project will not be completed from the owner to the general contractor. General contractors then pass some of that risk down to lower tier contractors and their surety companies. The need for contractors and owners to use instruments like surety bonds is underscored by the fact that the construction industry has one the highest failure rates of any business sector.

However, not all brokers and companies that issue surety bonds are equal. There have been numerous cases in recent years of fraudulent bonds being issued. For example, Engineering News & Record reported in 2013 that:

In a coast-to-coast internet-and-telephone crime spree, alleged forgers who had websites that made them appear to be individual sureties have spread fake Chubb completion bonds across the U.S.

Twenty-two contractors in nine states have lost a total of more than $3 million paid to two men with addresses in Georgia, Florida and Louisiana in the last 18 months. Acting as brokers, the two allegedly forged signatures of a former Chubb executive on bonds made to appear to be from Chubb subsidiaries Pacific Indemnity Co. and Federal Insurance Co.

Given the importance of surety bonds, contractors need to be careful when purchasing surety bonds, and when accepting them from lower tier contractors.

A Case Study

Given how frequently surety bonds are used in the construction industry, it is almost inevitable that most contractors will eventually become involved in litigation concerning a bond. Consider the following scenario, which is based on a case litigated by Watt, Tieder, Hoffar & Fitzgerald.

A general contractor is awarded a project by a federal agency to construct a multi-million dollar building. Under the Miller Act, payment and performance bonds protecting the owner are required, and the general contractor procures them. As a condition to issuing the bonds, however, the general contractor’s surety requires that all subcontracts worth at least $100,000 contain provisions requiring the subcontractor to post payment and performance bonds protecting the general contractor to reduce the general contractor’s and its surety’s ultimate liability.

The project is located in a state in which the general contractor does not have an office. The general contract contains mandatory Disadvantaged Business Enterprise (“DBE”) requirements which are difficult to fulfill given the small number of qualified DBE contractors in the region where the project is located. Eventually, the general contractor is able to locate a sufficient number of DBE subcontractors. However, one of the DBE subcontractors, whose subcontract will be for well over a million dollars, has never had a contract of this magnitude, and as such, has never purchased payment and performance bonds with limits approaching the amount of the subcontract. As a result, the subcontractor has significant difficulties finding a surety company willing to provide the required bonds.

Although the subcontract requires subcontractors to provide bonds prior to beginning work, due to an aggressive schedule and to avoid falling behind, the general contractor reluctantly allows the subcontractor to begin work with the agreement that the subcontractor will obtain bonds as soon as possible.

The subcontractor eventually finds a bonding company located offshore, and operating out of a different state than the project, to issue the bonds. One requirement imposed by the bonding company is that the subcontractor utilize a “funds control” company which will receive all payments due to the subcontractor, pay lower tier subcontractors and suppliers, take its fee, and remit the balance to the subcontractor. During work the owner issues a series of change orders to the prime contract that increase the size of the project. As a result, the value of the subcontract rises to more than $2 million. As required, the subcontractor’s surety raises the penal sum of the bonds to match each of the change orders.

Unfortunately, the subcontractor falls behind schedule, and despite the involvement of the funds control company, the general contractor begins to receive notices of non-payment from the subcontractor’s suppliers. The general contractor then issues a notice of default, which the subcontractor fails to cure.

Ultimately, the general contractor terminates the subcontractor for default. Upon doing so, the general contractor demands that the subcontractor’s surety step in and complete the work. The surety refuses to investigate, much less complete the work, and instead claims the termination was wrongful.

The general contractor immediately commences a full investigation. They determine that not only was the subcontractor behind schedule, but also failed to pay suppliers, billed for materials that were never delivered to or removed from the job site, and performed defective work that needs to be removed and corrected. Due to the fact that the job is now behind schedule, the general contractor is forced to immediately hire a replacement subcontractor. It insists on a much higher contract price to assume the risk for work that it did not perform, and to pay significant overtime and other acceleration costs in an attempt to recover the lost time. The owner predictably refuses to pay either to correct defective work or for acceleration costs. Ultimately, the general contractor pays well over $1 million in additional costs to complete the work.

As the project nears completion, the general contractor and its bonding company face lawsuits from unpaid suppliers, but have essentially no defense as the suppliers were easily able to prove that they provided the materials at issue and were not paid. The general contractor then brings claims against the defaulted subcontractor, who does not have sufficient assets to pay a potential judgment, its bonding company, the bonding company’s majority shareholder, nor the funds control company that had agreed to pay lower tier subcontractors and suppliers. All of those parties deny liability, claiming that the termination was wrongful.

As discovery progresses, the general contractor makes several startling discoveries. First, it learns that the majority shareholder of the subcontractor’s bonding company also owned the funds control company, which was run by a relative with a different last name. Second, the bonding company is not on the Department of the Treasury’s Listing of Certified Companies authorized to issue bonds on federal construction projects. Further, the bonding company is not licensed to sell insurance products in the state where the project is located, nor in the state in which it operated. Third, the majority shareholder has been banned by several state insurance commissioners from selling insurance products of any kind as a result of having sold fraudulent surety bonds while using multiple names. Worse, and perhaps most problematic, the surety does not have sufficient reserves to pay the entire claim, and appears to have never had enough assets.

The subcontractor’s surety, the funds control company, and the shareholder who controlled both of them, then engage in delay tactics by ignoring court ordered deadlines, refusing to produce documents, hiring and firing multiple law firms, and otherwise delaying the litigation in any way possible. Approximately five years after the litigation begins, the court finally enters a default judgment against all of the defendants for discovery abuses in amounts ranging between $2 million and $5 million.

Creatively Address Problems As Quickly As Possible

In the unfortunate event a contractor finds itself in such a position, the first thing to do is immediately contact counsel and discuss options for recovering losses and recovering attorneys’ fees. Also critical is quickly obtaining leverage to use when attempting to negotiate a settlement. Fortunately, a number of potential avenues of damage control exist.

First, consider bringing a direct claim against officers, directors, and owners of such entities under the responsible corporate officer doctrine. Under this doctrine, if an individual with the power to manage corporate affairs participates in wrongful conduct or knows of and approves of wrongful conduct, the officer is personally liable along with the corporation for damages suffered. This claim was first recognized by the United States Supreme Court in the 1943 decision United States v. Dotterweich, 320 U.S. 277 (1943), and has been successfully used in the construction arena.

A claim under the federal Racketeer Influenced and Corrupt Organizations Act, commonly referred to as RICO, should also be evaluated. Although the RICO Act was originally created as a tool against organized crime, it has other applications as well. In fact, large construction projects, which frequently involve bonds and checks mailed across state lines, wire transfers made across state lines, and other similar actions can be well suited for racketeering claims. The benefits of such claims can include the right to recover attorneys’ fees against all defendants (which can be important where claims are advanced against parties with whom a contractor has no contract and as a result, no contractual attorneys’ fees provision), as well as the right to multiply damage awards by up to three times. Thirty-three states have adopted similar laws, which should also be kept in mind, particularly since some carry lower burdens of proof. Similarly, state consumer protection acts may also provide enhanced damages and the right to recover attorneys’ fees.

Also potentially relevant are various state insurance licensing regulations. Many such statutes allow injured parties – for example, those who are supposed to be protected by bonds – to recover damages and attorneys’ fees against entities that sell or issue bonds and other insurance products without required licenses.

A final strategy to consider is the possibility of asking the court to freeze the surety’s assets at the outset of the lawsuit. When available, such orders can help bring a party to the negotiating table much sooner, and ensure that at least some assets can be seized to help satisfy a judgment.

Plan Ahead: Develop A Bond Evaluation Program

To minimize the chance of litigation, contractors should seriously consider adopting a bond evaluation protocol that is strictly followed on all projects. The following is a list of potential steps that could be included:

  • Include a provision in all contracts with lower tier contractors providing that a bond is a condition precedent to allowing a contractor to begin work. Ensure that project managers, superintendents, and all people with any decision-making authority on every project understand and enforce this requirement.
  • Insert a clause in all contracts with lower tier contractors giving you the power to unilaterally determine whether bonds are acceptable, and to reject any you deem unacceptable. Resist any attempts to add language to the clause that requires you to act in good faith while evaluating such bonds.
  • When each bond is received, put someone in charge of checking to see if the company issuing the bond is listed on the Department of the Treasury’s Listing of Certified Companies to issue bonds on federal projects, which is available at http://www.fiscal.treasury.gov/fsreports/ref/suretyBnd/c570. This is critically important if the owner of the project is a federal agency, but the lack of a listing can be a red flag on other public and private jobs as well.
  • Require proof that all bonds are issued by companies which have all required licenses to issue bonds both from the state in which the bonding company issues the bond, as well as the state in which the project is located.
  • Insist on receiving contact information for the surety issuing the bond and have someone verify that the issuing company, even if highly reputable, actually issued the bond.
  • Consider requiring that all bonding companies prove that they have at least a minimum rating from AM Best. As examples, a rating of C+ indicates that in AM Best’s opinion a company has “a marginal ability to meet their ongoing insurance obligations” while a rating of A means that in AM Best’s opinion a surety has an “excellent ability to meet their ongoing insurance obligations.”
  • Be wary of purchasing or accepting a bond from a surety that is not incorporated and based in the United States, particularly one from a country that is known as a tax haven such as Jersey, Guernsey, the Isle of Man, the Seychelles, or The Commonwealth of The Northern Marianas Islands. Such jurisdictions typically have no or much laxer requirements for insurance and surety products.
  • Have counsel run a check to see if the bonding company is being or has recently been sued for fraud, racketeering, or other similar causes of action.

Conclusion

Bonds are important tools that should protect contractors from the kinds of issues that inevitably plague problem construction projects. With advance planning, contractors can significantly reduce any chance that bonds are worthless and fraudulent, and fail to provide such protections.