This article’s analysis begins with a maxim that is the very essence of suretyship – the surety is not liable unless its principal is liable on the underlying obligation. As such, a surety is entitled to assert its principal’s defenses against a claim for labor or material furnished to the bonded project. This general rule is true even if the principal does not assert the defenses itself or is barred from doing so by an unrelated legal disability. The surety may not, however, maintain a defense that has already been waived by the principal nor may the surety assert the “personal” defenses of its principal, such as bankruptcy, infancy, insanity, or duress. Further, the surety’s ability to assert its principal’s defenses may be impacted when dealing with second-tier claimants.
Additionally, a surety may also assert defenses that are unique to itself as a surety. However, a surety’s defenses to a performance bond claim, such as owner/obligee default, will not likely defeat an unpaid subcontractor or supplier’s payment bond rights because a payment bond claimant has distinct rights under the payment bond that are defined by its own contract and conduct. With all of this being said, it is important that the surety conduct an independent and objective investigation to determine whether it has the factual, contractual and legal authority to assert such defenses. Below is a general overview of only some of the defenses that may be available to a payment bond surety.
A claimant’s material breach of its contract may serve as a complete defense to a payment bond claim. A material breach may occur if the claimant unjustifiably abandons the project, fails to reach substantial completion, or fails to perform its work in accordance with the contract documents. However, this defense may fail if the claimant’s performance under its contract is executed by the principal’s own prior material breach, i.e., nonpayment, wrongful termination, etc.
Recoupment Or Setoff
Generally speaking, a surety may setoff against a first-tier claimant any costs incurred by its principal to complete or remediate claimant’s work and any costs incurred as a result of the claimant’s delay. But, authorities differ on a surety’s setoff rights against a second-tier claimant. Some courts have found that the principal is not barred by the lack of privity from recouping its corrective expenses because the second-tier claimant may only recover for “sums justly due.” See United Structures of America v. G.R.G. Eng’g, 9 F.3d 996 (1st Cir. 1993). However, other courts have found that a surety may not charge correction and delay damages against a second-tier claimant because of the lack of privity between the principal and the second-tier claimant. United States ex rel. Martin Steel Constructors v. Avanti Constructors, 750 F.2d 759 (9th Cir. 1984).
Payment may also serve as a defense to a payment bond claim. However, this defense will only hold up if actual payment is made and received. In other words, a promissory note or bounced check will not discharge the surety of its bonded obligations.
Contingent Payment Clauses
Sureties may also assert contingent payment clauses as a defense of their principals in order to shift the risk of non-payment by project owners to subcontractors. Contingent payment clauses generally fall into two categories: Pay-When-Paid clauses and Pay-If-Paid clauses.
Pay-When-Paid clauses provide that a contractor will pay its subcontractor within a certain amount of time after receiving payment from the owner. Pay-When-Paid clauses serve as a timing mechanism that postpone a contractor’s payment obligations to its subcontractors, but do not shift the entire risk of owner non-payment to subcontractors.
On the other hand, Pay-If-Paid clauses make payment by an owner to a contractor a condition precedent to a contractor’s payment to its subcontractor, thereby shifting the risk of non-payment entirely to a subcontractor. Pay-If-Paid clauses will generally be enforced only if the language in the contract makes it expressly and unequivocally clear that the parties intended the contract to include the Pay-If-Paid condition precedent. Additionally, some states have enacted statutes that prohibit the enforcement of Pay-If-Paid clauses as void against public policy.
Contingent payment clauses will not be enforced or considered as a valid defense where a principal is the cause for the non-payment or delay in payment from the owner. Notably, some jurisdictions have also found that sureties may not raise contingent payment clauses as a defense unless they expressly incorporate the terms of their principal’s subcontractors into the terms of the bond.
No-Damages-for-Delay clauses prevent a subcontractor from recovering delay damages against a contractor. Delays in construction are not uncommon and therefore, these provisions serve as a tool for allocating the costs for delays between the parties. However, courts across the majority of jurisdictions have recognized the following exceptions to the enforceability of No-Damages-for-Delay clauses: (i) bad faith or other misconduct by the contractor; (ii) active interference (an affirmative or willful act) interfering with a subcontractor’s work; (iii) a delay that is so unreasonable that the delayed party could have abandoned the project; (iv) a delay not contemplated by the parties at the time of their agreement and which lies beyond the contractor’s intended scope; and (v) a delay caused by the contractor’s gross negligence. This is a non-exhaustive list of exceptions, as they are highly fact specific and vary on a cases-by-case basis and by jurisdiction.
Waiver, Estoppel And Other Related Defenses
Another set of defenses available to sureties are those in which the claimant surrenders rights that were previously available to the claimant either through novation, a wavier or equitable estoppel.
For the defense of novation, the parties agree to replace the terms of the original agreement with a second agreement, which ultimately extinguishes the obligations under the original agreement. Typically, to effectuate novation of a binding agreement, there must be: (i) a previously valid contract; (ii) an agreement between the parties to cancel the previous contract; (iii) a new valid and binding contract; and (iv) an agreement between the parties that the new agreement will replace and extinguish the old agreement. The assent to the second agreement would then release the parties from any liability under the previous agreement. Consequently, a new agreement between a contractor and a subcontractor will also release the surety from its obligations or liabilities under the former agreement.
A second method by which a claimant may forgo previously held rights is through the execution of a waiver. A claimant can waive its payment bond rights by entering into a written agreement with the parties to the payment bond. The Miller Act considers a waiver of a civil action on payment bond to be valid so long as the waiver is: (i) in writing; (ii) signed by the person whose rights are waived; and (iii) executed after the person whose rights are waived has furnished labor or material outlined in the construction contract. Thus, a claimant cannot waive its payment bond rights prior to supplying labor or materials. For this reason, some jurisdictions find that waiver provisions contained in construction contracts are unenforceable.
Finally, a claimant may lose its payment bond rights due to its own actions. Under the doctrine of equitable estoppel, if a claimant conceals facts or makes false misrepresentations to the principal or its surety, and knows the other party will rely on such statements, then the claimant’s assertion for damages against the principal and its surety may be barred. In order for a surety to assert estoppel, the following elements must be met: (i) the claimant actually or constructively knew the material facts the other party relied upon; (ii) the claimant intended for the other party to rely on the concealed facts or misrepresentation; (iii) the contractor or surety did not know or have means to know the material facts; and (iv) the contractor or surety acted to its detriment on the claimant’s misrepresentation.
When a payment bond claimant makes a timely and proper payment bond claim, the surety must conduct an independent and objective investigation to determine whether such demanded monies are truly owed to the claimant. The surety’s investigation should include a thorough review of the underlying contract, the payment applications, invoices, schedules, project correspondence, meeting minutes, etc. The surety should also seek an understanding of the nature of the project and the claimant’s work on the project, because if the claimant caused delays or if its work is defective, it may be a partial or total defense to the bond claim. The surety’s investigation must not be hasty and may require the assistance and advice of counsel or a consultant to ensure that the surety’s analysis of the claimant’s payment bond claim is comprehensive. So, to pay or not to pay, the results of the surety’s investigation should answer that question.