Payment bonds are one of the key arrows in the metaphorical quiver of tools that can help ensure a successful construction project. Traditionally, they have only been available on public projects, but the use of payment bonds is becoming more prevalent on private work due to changes in mechanic’s lien laws and evolving views of project owners.
A third-party guarantee of payment that is becoming more popular, but has a cost
By definition, a payment bond is a legal contract by which the surety company promises to pay for the work if the bonded party fails to do so. Importantly, a payment bond is not the same thing as general liability insurance. While contractor default insurance is conceptually similar, bonds work a little differently. The payment bond is a third-party guarantee. The promise to pay, however, does not come free of charge. The principal on the payment bond—which is the party the guarantee backs up—is required to sign a general indemnity agreement that usually requires some form of a personal guarantee and accompanying collateral.
Contractors and subcontractors also like bonds because they cover a defined dollar amount and are easier to collect on if the claim is determined as valid.
On the positive side, payment bonds benefit owners because they provide a built-in vetting of the economic standing of the general contractor given the financial review required to obtain a bond. The same is true for general contractors as it relates to subcontractors. In many jurisdictions, requiring a payment bond also eliminates the possibility of a mechanic’s lien claim being filed. Contractors and subcontractors also like bonds because they cover a defined dollar amount and are easier to collect on if the claim is determined as valid. In short, there is some security against assetless owners or contractors, as the case may be, and the unpredictability of selling real estate to collect on an unpaid contract balance is eliminated.
Like mechanic’s lien claims, however, there is a process that must be followed to make a valid bond claim. The timing mechanisms of the public prompt pay acts apply on public projects. While the same restrictions technically don’t apply to private project bonds, sureties tend to use the same time horizons. The typical time to give notice is 90 days after the last date worked, but this can differ depending on the jurisdiction. The payment bond will provide the time frames, so read it carefully. If you are still unsure, consult a construction lawyer you trust to evaluate it further.
The claims process on a payment bond is usually efficient and completed in a relatively short period (up to the time when suit is filed) in comparison to other legal mechanisms. Once the claim is submitted to the surety, an investigation of the claim is undertaken. The surety speaks with the principal on the bond (the party who allegedly has not paid) and evaluates documents to determine the reasons payment was not submitted. The claimant is asked to submit a proof of claim with supporting documents to demonstrate its claim. Once the investigation is complete, the surety decides whether to pay the claim and seek reimbursement from the principal or deny the claim in whole or in part. The claimant then has the option to file suit in the event of a denial. Most bonds allow 12 months to bring suit.
Payment bonds are a useful project tool for a variety of reasons. They provide stability for everyone concerned by giving assurances that payment is guaranteed. Owners can worry less about liens that might impact financing; and contractors can work knowing there is a third party, with liquidity, that can pay for the work if the party with whom it contracted fails to do so. It also results in an evaluation of the financial conditions of key project parties and provides for third party review of claims for payment. On the negative side, payment bonds require the payment of premium and can price out certain contractors or erectors who cannot get a bond despite being reliable and financially sound.
In the end, payment bonds are often an afterthought when planning projects, and the last thing unpaid contractors consider when they need to pursue a claim. They are enormously important tools on any construction project though. Make sure you understand how they work and add inquiring about payment bonds to the standard list of questions you ask at the front and back end of every project.
Josh Quinter is a commercial litigation attorney, with a focus on construction law. He is also a member of the board of directors and a department chair at his law firm, Offit Kurman. Active in a number of construction trade and business organizations, he presently serves as the president of the Mid-Atlantic Chapter of the Metal Building Contractors & Erectors Association (MBCEA), serves on the MBCEA national board and is the organization’s general counsel. Contact him at email@example.com, or for more information, go to www.offitkurman.com/attorney/joshua-quinter.