Should a Subcontractor provide bonds to a GC who is not himself bonded? (Bonding Agent Perspective)

Guest Post Friday is back, and for this week, Construction Law Musings welcomes Steve Moore. Steve has been the Construction & Surety Manager for Towne Insurance Agency-Invincia, in Chesterfield, VA since 2010. Steve’s experience in the Virginia surety bonding marketplace started in 1985 with USF&G. His underwriting travels took him from USF&G to starting National Grange Mutual’s mid-Atlantic bond department over Virginia, Maryland, Delaware, North & South Carolina, to being Reliance Surety’s “Firemark” bond manager in Virginia. Reliance was purchased by Travelers, where Steve continued to grow the surety book of business and build expertise and relationships. Experience with Travelers and Zurich had Steve handling surety bonds for some of Virginia’s largest and best-of-class contractors. Recently, he was contracted by the Commonwealth’s Attorney’s office to serve as a contract surety expert witness on behalf of the state. He is a 1985 graduate of Virginia Tech with double-major B.S. degrees in Finance and Marketing.

Today, Steve has business and relationships with Travelers, The Hartford, Westfield, CNA, CBIC, Selective, Liberty Mutual, Ohio Casualty, Cincinnati, and many other companies. Steve’s strong foundation of insurance knowledge and in bonding principles and practices allow him to serve as a great resource for his clients.

An old Aesop fable comes to mind when I am asked whether a Sub should bond to an unbonded GC:

A woodsman entered the forest and asked the trees to give him a handle made of the best wood. After giving the woodsman a stave of hickory, the forest watched the woodsman fashion an axe onto the handle. In a flash, the woodsman began to chop down the various oaks and maples in the forest. The oak then said to a pine, “It serves us right, since we gave our adversary the very thing that contributes to our doom…”

When a subcontractor client of mine asks about bonding to an un-bonded general contractor, a number of questions immediately come to mind. Why isn’t the GC bonded? What is the existing relationship between the GC and Sub? How well is the job financed? While wanting to help my subcontractor procure work, and surely enjoying the commissions from writing a bond, I also want to help my sub client manage unforeseen risk. What are the risks to a sub, when posting a bond to an unbonded GC?

I will assume that the GC in question is financially stable, and able to bond, and that his credit is not in question. Even so, we should always consider the risk inherent with the owner being worked for and whether the contract is fully funded.

First, it helps to recognize that risks may come from different directions: Upstream, Downstream, and Sideways. If you’re in construction, risks can seemingly come from all directions.

Typically, construction bonding carries two different bonds-within-a-bond: The performance bond (which generally protects those ‘upstream’- the owner, and GC); and the payment bond (as a “downstream” protection, is primarily for guaranteeing payment to suppliers, first tier subs, and second tier sub-subs).

A third very important realm of risk the inquiring subcontractor should keep in mind arises from his side agreement with the Surety, the Agreement of Indemnity (sometimes called a “General Agreement of Indemnity). While there is risk inherent in construction contracts between GCs and Subs, there are also obligations arising for the Sub towards his Surety Company as a result of the Agreement of Indemnity.

The Indemnity Agreement is usually very one-sided in protecting the Sub’s surety company’s rights, and is the basis under which the surety is made comfortable to back the subcontractor’s bonding requests. It is important to note that while surety companies are almost always insurance companies, there are radical differences between suretyship and insurance. An insurance company is usually happy to write a check for a proven claim, and consider it an expense of doing business. Contrast this with a surety company writing a claim check. The surety will always turn to its customer, the subcontractor, for reimbursement of any checks written, as well as costs incurred settling the claim. This can mean legal fees. A liability insurance policy will provide defense for the subcontractor facing an insurance claim; a bond company may tender defense for a subcontractor facing a bond claim, but will likely ask to be reimbursed. Remember, while insurance is for your own protection, .the bond isn’t there for you, the principal, it is there for the other parties’ protections (the GC, and subs-subs/suppliers).

Adding to the gravity of the Agreement of Indemnity is that the Surety usually requires the owners of the bonded Subcontractor to indemnify personally, jointly and severally. This means the Subcontractor’s owners are on the hook for the obligations to the surety that may arise in payment disputes. The GC’s owners are not so obligated to their surety, if they do not post a bond on the job in question.

A General Contractor posting Performance and Payment bonds is protecting the owner on the job for his performance, but also his first tier Subcontractors and second tier Subcontractors for payment. A second tier sub can file a claim against a bonded GC. In a case where the GC is not bonded, and a first tier subcontractor is, a second tier sub has recourse against the bond held by the first tier sub immediately above him, but not the GC’s bond, because there isn’t one. Shouldn’t the GC share that risk with his first tier sub?

An unbonded GC will give a first-tier Subcontractor a subcontract, and the subcontract usually has “flow down” terms and conditions, meaning that the first-tier Sub is agreeing to include terms of the GC’s contract with owner in his subcontract agreement with the GC. In essence, the bonded Subcontractor becomes a guarantor of the GC’s contract, while the GC avoids such a level of assurance. The sub’s surety company is guaranteeing on behalf of the GC that which the GC’s own surety is not.

The effect of change orders to the GC’s contract with the owner often flow down to the GC-Subcontractor’s subcontract. There may be guarantees being made by the sub’s bond that the sub and sub’s surety had not intended when the subcontract was originally being entered into. Again, the sub is making a guarantee through suretyship that the GC is not, and yet, the sub is not in control of what that new guarantee may be.

In Virginia, Pay-if-Paid clauses have been found enforceable. In a situation where the GC has a Pay-if-Paid clause in his subcontracts, and he has not paid his bonded Sub, but the bonded Sub has a payment obligation to either a supplier or second tier sub, and that supplier files a claim against the first tier Sub’s payment bond, what will the surety do? If the surety determines that the payment to the supplier should be made, the surety can both pay the sum, and turn to his Subcontractor principal for reimbursement, or, the Surety may use the Indemnity Agreement to force the Subcontractor to pay the supplier.

Pay-when-paid clauses can have a similar risk against a bonded subcontractor, if the provision states that the sub will accept the same proportional payment as the GC accepts from the owner. Again, the suppliers and subs to the Subcontractor may not be bound by such a ‘proportional’ limitation. If the bond company determines that a full payment is owed to the supplier, they may pay it, and demand reimbursement from the bonded subcontractor for their payout. Even if the sub had not yet received full payment for that material from the GC.

In these two cases, the bonded Subcontractor has risk that comes from both upstream, and sideways from his indemnity agreement with his surety.

When a contractor and his surety enter a dispute, they may not always agree on what is “right”. The surety will certainly look after its own interests first. This includes protecting its future rights on other bonded contracts, precedent-setting, and whether the surety is concerned that non-payment of a claim could open it up to independent bad faith litigation.

Simply put, the bonded Subcontractor, under an unbonded GC, is giving other parties an axe with which to chop wood which he himself does not have. He is giving extra protections to the GC, but not receiving the same. I won’t say “never” do this, but only do so after carefully weighing your risks, knowing that Murphy is lurking about.

As Chris Hill always says, consult an experienced construction attorney. I might also add that you should consult your professional bond agent for any questions about your surety relationship, and the indemnity agreement.

As always, Steve and I welcome your comments below. Please subscribe to keep up with this and other Construction Law Musings.

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