A Construction Project Owner’s Guide To

Surety Bond Claims

It’s Friday and, as the afternoon creeps into the weekend, you, the project owner, are
dissatisfied with the progress of Quality Constructors. It’s obvious, with the lack of
performance this week, there is no way the project is going to be completed on time!
At 3:00 p.m. the phone rings. E-Z Mechanical, the mechanical subcontractor, angrily
threatens to walk off the job. Quality Constructors hasn’t paid them and they intend to
take legal action to file a lien on the project if something isn’t done. That’s going to go over
great with the lenders!
There is no choice; it’s time to declare Quality in default and call the surety! After all,
didn’t the surety promise a completed project, free of liens?

You are about to experience a surety bond claim.

I NTRODUCTION
The purpose of A Construction Project Owner’s Guide to Surety Bond Claims is
to provide an understanding of the claims process for those who have or are
about to become involved in a bonded construction project. Although we
always hope our projects will be perfect, sometimes things go wrong. That is
one of the reasons owners bond their projects to have someone to turn to when
the contractor gets into trouble1. The other reason is to have an independent
third party, a surety, verify that the contractor is, in fact, qualified to perform
the job. This is called prequalification of the contractor. In its underwriting
process, the surety evaluates the capital, capacity, and character of the pro-
spective contractor to assure the project owner that the contractor is able to
complete the project before the surety commits to provide the bonds.
The corporate surety backs its judgement with its own financial resources.
When the surety errs in its prequalification, it pays for its mistake. With $450
billion of construction performed annually in both the public and private
sectors, the prequalification services of the corporate surety are essential to
The purpose of
assure that the contractor is qualified and capable of performing the contract.
[this booklet] is to
More than 80,000 contractor failed during 1990-1997, leaving a trail of unfin-
provide an
ished private and public construction projects with liabilities exceeding $21.8
understanding of
billion.
the claims
Usually, by the time a claim on the bond is considered something has gone
process.
terribly wrong with the project. Prequalification failed, and the owner and
contractor are at odds. The atmosphere is charged and tempers are short on
every side.
Surety Information Office www.sio.org
 By using examples, A Construction Project Owner’s Guide to Surety Bond Claims
will help you understand the process, the participants, and the complexities that
are a part of every bond claim and why things happen during the course of a
surety claim.

D EFINITIONS
The following definitions are presented to provide an understanding of
certain terms commonly used in the surety industry.
In the language of the construction industry, the three parties to a perfor-
mance bond are usually the contractor (principal), the owner (obligee), and the
surety.
Claimant: A party who has a right to make a bond claim.
Obligee: The construction project owner or the party to whom the con-
tractor (principal) is bound under a contract.
Payment Bond: A written instrument, generally issued in tandem with a
performance bond, whereby the surety is bound to pay certain parties, such as
subcontractors or material suppliers, furnishing labor or material to the contrac-
tor for use in performance of the bonded contract to the extent provided by the
bond or any applicable statute.
Performance Bond: A written instrument whereby a surety has under-
taken to guarantee that a named principal shall perform in accordance with the
terms and conditions of an underlying agreement with the obligee. In essence,
the performance bond protects the owner from financial loss should the con-
tractor fail to perform the contract.
Principal: The contractor or subcontractor whose performance under a
contract is guaranteed to the owner or obligee.
Surety: A corporation licensed to provide guarantees to third parties of the
performance of its contractor (principal) in discharging the contractor’s respon-
sibilities to the owner (obligee).
The three parties to
P ERFORMANCE B OND C LAIM a performance bond
The contractor and the surety, jointly and severally, bind themselves, their heirs, are usually the
executors, administrators, and successors and assigns to the owner for the performance of the contractor
construction contract, which is incorporated herein by reference. (principal), the
If the contractor performs the construction contract, the surety and the contractor shall owner (obligee),
have no obligation under this bond...2 and the surety.
This standard language establishes the obligation of the surety to the
owner under the performance bond. In order to understand the obligation of a
surety to the owner, you must look at the underlying agreement, the contract,
along with approved modifications and authorized changes.
Surety Information Office www.sio.org
 Since a contract is an agreement binding two parties to accomplish a
common goal, there are obligations assumed by each party to the other. As a
result, either party may be in breach or default of its obligations to the other.
While the corporate surety guarantees the performance of the contractor,
in accordance with the terms and condition of the contract, it also stands in
the shoes of the contractor with respect to the obligations that the owner has
to the contractor. As an example, the most basic of these contractual rights is
the expectation of timely payment from the owner, in accordance with the
terms of the contract, for work performed.

T HE C LAIMS I NVESTIGATION
The claims investigation is the surety’s first action once it has either been
placed on notice of an alleged default or learned of a pending action that may
place the contractor into default under the contract. The surety’s investigation
usually will include the following steps:
Contract Review: The surety will undertake an extensive review of the
contract documents to determine the full extent of the responsibility of all
parties to each other.
Contract Progress: The surety, with the cooperation of both the contrac-
tor and the owner, will try to determine what has transpired between those
parties. Have both parties operated in accordance with the terms and condi-
tions of the contract and what are the responsibilities, as well as the defenses,
of the contractor and surety?
Legal Position: Using its own professional legal staff and/or outside
counsel specializing in construction and surety law, the surety will evaluate its
obligations to both the owner and the contractor. The claims investi-
Owner: The duty of the surety to the owner is spelled out in the bond and gation is the
contract. If its principal has been properly terminated for default according to surety’s first action
the terms of the contract, the surety usually is obligated to pay the cost to once it has either
complete the work less the contract funds still in the owner’s hands, but been placed on
subject to the limit of the bond penalty. notice of an al-
Contractor: Since the surety may avail itself of the rights and defenses of leged default or
the contractor in determining its legal responsibilities to the owner, the surety learned of a pend-
will take care to avoid any action that would serve to dilute or prejudice any ing action that
right the contractor may have against the owner. Also, since the surety is may place the
guaranteeing the performance of the contractor, the contractor remains liable contractor into
to the surety for any losses caused by the contractor’s failure. Thus, the surety default under the
must be sure not to take action to perform the work unless the contractor contract.
actually is in default.

Surety Information Office www.sio.org

 It’s in the surety’s best interest to take prompt action to complete the
investigation as soon as possible. Benefits of quick action include:
• It keeps the project moving; Suggested References
• It will likely save the surety money in the long run; Additional information on
• It may prevent contractor default; and contract surety bonds is
available from:
• It’s good customer service.
Let’s go back to the opening scenario that has brought about the declara- Surety Information
tion of default of Quality Constructors: Office
After conducting its investigation, the surety learned that Quality Constructors was not
paying E-Z Mechanical and other subcontractors, even though you, the owner, had made
payments to Quality for the work performed to date. Quality’s president had suffered a www.sio.org
severe illness and the interim management team was unable to manage the firm’s backlog of • The Importance of
work. Quality was experiencing serious financial problems due to severe losses on another Surety Bonds in
un-bonded project and had several hundred thousand dollars in liabilities. Construction
• 10 Things You Need to
After meeting with you, the owner, and Quality Constructors, the surety agreed that Know About Surety
your declaration of default was correct and began working to find another contractor to Bonding
complete the job. The surety also paid E-Z Mechanical and other subcontractors under the • Why Do Contractors

payment bond in order to minimize disruption as the project headed toward completion. Fail?
• Alternative Financial
There are several key points in this oversimplified analysis: Security: A Bad Deal for
1. Although surety bonds are provided by the insurance industry, bonds are a Owners
unique type of insurance product. Bonds are a guarantee of one party’s • Surety Bonds Versus

performance or payment obligations by a third party, the surety. Most Bank Letters of Credit
• Protect Your
insurance is a two-party contract between the insurance company and the Construction Lending
insured. Capital with a Surety
2. Bonds are contracts. A contract, by its nature, will establish the responsi- Bond
• Surety Bonds at Work
bilities of the parties, in this case the owner and the contractor, to each
other. Both parties are compelled to operate within the framework of the
contract.
3. If the contractor materially breaches the contract, the surety has an obliga-
tion to the owner to complete the work or pay for resulting damages.
4. The surety also has an obligation to consider the contractor’s position if
the contractor asserts it has not breached the contract.
5. The surety has a right and duty to promptly conduct a reasonable investi-
gation of the owner’s allegation that the contractor is in default under the
contract.
The process of making a bond claim is governed by the entire body of
construction law and precedence associated with the construction industry.
The surety must respond to an owner upon notice of default without jeopardiz-
ing the rights and defenses of the contractor as it conducts its investigation.

Surety Information Office www.sio.org

 By the time the surety becomes involved in a claims investigation, both
the contractor and the owner generally are disenchanted with each other.
Suggested References
Positions are either polarized, or headed in that direction, and each party has its Additional information on
own opinion of the circumstances surrounding the dispute! This is the environ- contract surety bonds is
ment in which the surety claims representative must make decisions. available from:
Accordingly, one key to the prompt and orderly conduct of A Construction
Project Owner’s Guide to Surety Bond Claims is to provide adequate documentation
and assistance to the surety claim representative as quickly as possible. A
surety cannot definitively respond to a claim until it has investigated the facts National Association of
associated with the alleged default of the contractor. Surety Bond Producers
www.nasbp.org
If there is no owner default, the surety’s obligation under this bond shall arise
• Bonds on Public Works
after...The owner has declared a contractor default and formally terminated the contractor’s • Guidelines for
right to complete the contract.3 Evaluating
This standard provision establishes a very important condition precedent Contract Bond Forms and
Contract Documents
in order for the surety to respond to claims presented under the performance
• The Basic Bond Book
bond. The surety’s obligations mature after the contractor has, in fact, de-
faulted and been declared by the owner to be in default. In the event of a
voluntary default, the contractor will inform the owner and the surety that it
can no longer perform its obligations under the contract and will ask the surety
to respond to the owner. Surety Association of
It’s important to keep in mind that: America
www.surety.org
1. The surety is not a judge or referee of disputes between the owner and the • Glossary of Fidelity &
contractor. Until such time as the contractor has been properly declared in Surety
default of the contract, the surety’s obligations to the owner have not • Bond Authenticity
matured. Program Obligee’s Guide
with user information,
2. If the contractor is, and is declared by the owner to be, in default under instruction, model inquiry
the contract, the surety will take action. form, and list of surety
3. There are three basic forms of default: companies
a) default via a breach of a material contractual term or condition related
to the work such as failure to make satisfactory progress;
b) financial default such as failure to pay suppliers or subcontractors for
work properly performed; and
c) voluntary default.

P AYMENT B OND C LAIM

But what if the surety had discovered an entirely different problem in
which its contractor was not responsible for the delays? Here’s yet another
scenario:

Surety Information Office www.sio.org

 Through its investigation, the surety learned that you, the owner, had issued 28 change
orders to the contract. These change orders had included the extension of the completion time
by 45 calendar days, and Quality Constructors had a schedule prepared indicating that the
revised completion date could be met, with only one major exception. E-Z Mechanical, the
subcontractor that had filed the notice for non-payment, ordered the wrong equipment for
installation, was behind schedule, and would undoubtedly be required to work overtime to
achieve the revised completion date. Under the terms of the subcontract, Quality Construc-
tors had the right to withhold funds due to the failure of E-Z Mechanical to perform. The
surety concludes, therefore, that its principal, Quality Constructors, is not in default under
the contract and notifies the owner.
After learning this from the surety, you get a phone call from your attorney, whom you
contacted as soon as you heard E-Z Mechanical wanted to place a lien on the project.
“You are not going to believe this, but I was just at the courthouse and learned that E-
Z Mechanical filed for Chapter 11 Bankruptcy. They missed last week’s payroll, and their
vendors are lining up to file claims. I expect that we will have liens filed against us by the
end of today. Did you hear anything from the bonding company?”
“Yes, the bonding company said they had received our notice of claim, but that their
preliminary investigation found that Quality is not in default of the contract.”
But, what about the 25 E-Z Mechanical workers who had their paychecks bounce last
Friday and the six vendors and a representative from the Department of Revenue who are
all looking to you for financial recovery?
Since this claim involves a failure to make payments to subcontractors, you
look to the payment bond provided by Quality Constructors for some answers.
With respect to claimants, this obligation shall be null and void if the contractor
promptly makes payment, directly or indirectly, for all sums due. The surety shall have no
Suggested References
obligation to claimants under this bond until...[a notice of claim is made]4
Additional information on
In our example, it’s E-Z Mechanical who is now insolvent, but the bond in contract documents is
hand is from Quality Constructors. Have you bonded the wrong contractor? available from:
The answer is no. The bonds provided by Quality Constructors will protect
American Institute of
your project from unpaid bills and liens because of the subcontractor’s default.
Architects
You know that you have paid Quality Constructors every month, on time. www.aiaonline.com
There is no question you’ve held up your end of the agreement!
What else does the payment bond say? Associated General
Contractors
Claimant: An individual or entity having a direct contact with the contractor or with a
www.agc.org
subcontractor of the contractor to furnish labor, materials, or equipment for use in the
performance of the contract...5 General Services
Administration
This definition presents an interesting twist. As an owner of the project www.gsa.gov/forms/
you are named as the obligee on the payment bond, however you do not fit the forms.html.
definition of a claimant! How do you make a claim on this payment bond? The
answer is that in most circumstances you do not need to because the claimants
Surety Information Office www.sio.org
can pursue payment directly from the contractor and surety. In fact, the payment
bond will explicitly provide that the claimant has a direct right of action against
the surety.
Since the first order of business was to protect the integrity of the project
from liens or encumbrances, you are pleased to learn that the persons who
worked for E-Z Mechanical, and who are threatening to file a lien against the
property, can take their claim to Quality Constructors and its surety for satisfac-
tion under Quality’s payment bond.
But, of all these people and companies, how will the surety know who has a
valid claim? Once again, the importance of a thorough claims investigation
becomes clear. The contractor and surety have the responsibility to conduct this
investigation and to validate the claims. Remember, their commitment to you is
to assure you that the project will be completed and delivered free of liens or
other encumbrances as provided for in the contract. Your responsibility is to be
certain that the claimants who come forward are appropriately directed to the
contractor and the surety to investigate and pay valid claims. All the calls from
potential claimants can be directed to Quality Constructors and/or All American
Surety, who have been advised of the situation and are prepared to work with
you to resolve these claims.
For the moment your problem is solved. E-Z Mechanical’s workers and suppliers will be
paid, and at least they are off your back.
But then you learn that All-American Surety is trying to reach you. They want to discuss
the results of their investigation, and have some requests to make of you regarding the referral
of claimants to their office.
All-American has been working hard over the weekend. Because of your claim notice
they met with Quality Constructors and learned of the dispute between Quality and E-Z
Mechanical. They also learned that E-Z Mechanical was bonded to Quality Constructors by
Old Faithful Insurance. There was a performance bond and a payment bond in place, and one
of the events of default under the subcontract agreement was failure to pay for labor or
material. Another was declaration of bankruptcy or insolvency. All American had already
Special thanks to
contacted Old Faithful, and Old Faithful was expecting calls from the claimants.
James Pateidl,
Confused? Here’s what has happened.
Executive Vice Presi-
1. When you obtained a performance bond and a payment bond in support of
dent, Lockton Insur-
your contract, you received the irrevocable commitment of the surety that
ance Agency, Kansas
the contractor will complete the project, and pay for labor and material, or, in
City, MO for his
the event of a default on the part of the contractor, the surety will perform
contributions to this
under the bonds. As part of the guarantee, the surety agreed that it would be
publication.
responsible for conducting the process of validating the claimants’ rights to
payment.

Surety Information Office www.sio.org

 The claims investigation now becomes a valuable service to you! Because
Quality Constructors and its surety have the responsibility of payment, it
only makes sense that they will conduct the validation process. To be
successful in the investigation they must have the claimants referred to
them, removing the claimants from your responsibility. You now have
References
“partners” in the form of a contractor and surety who are investigating the 1
The Miller Act of 1935 is a
claims. federal law mandating surety
2. During the investigation, the surety has learned that there were other con- bonds on federal public
works projects. The Miller
tractual agreements that bear on the outcome of the problems with your Act requires performance
project. The fact that the contractor had required his or her subcontractors and payment bonds for all
public work contracts in
to provide a bond was a very important piece of information.
excess of $100,000. Also,
In this scenario, you referred the unpaid workers and suppliers of E-Z each of the 50 states,
Mechanical to your contractor, Quality, and its surety, All-American. Since it has District of Columbia, Puerto
Rico, and almost all local
been established that E-Z Mechanical had provided subcontract bonds to jurisdictions have enacted
Quality, however, Quality and its surety will, in turn, refer these claimants to E- legislation requiring surety
Z’s surety, Old Faithful. bonds on public works
(generally referred to as
Under the payment bond from E-Z Mechanical, and because E-Z Mechani- “Little Miller Acts”).
cal was clearly in default of its subcontract, Old Faithful Insurance has an
2
AIA A312 Performance
ultimate responsibility to Quality Constructors regarding the actions they must
Bond, December 1984
take to resolve the claim and mitigate their loss. edition
There are two very important practices in the surety industry: 3
AIA A312 Performance
1. A surety will respond to claimants, under either a performance bond or a Bond, December 1984
payment bond, and begin an investigation as a result of receiving a notice of edition
a claim. 4
AIA A312 Performance
2. With a performance bond or payment bond, the surety must be satisfied that Bond, December 1984
its contractor owes a debt before it will pay it. edition
5
AIA A312 Performance
C ONCLUSION Bond, December 1984
While the scenarios presented in A Construction Project Owner’s Guide to Surety edition
Bond Claims are quite simplified, they are not meant to oversimplify the surety 6
For further information,
claims process, which can be quite complex, or even to suggest that the resolu- contact the Surety
tions to the problems represent what you should expect when you are faced with Association of America
(SAA) at 202-463-0600 or
a claim. Rather, they are presented to explain how and why the process works as the National Association of
it does. Surety Bond Producers
Keep in mind that the entire matter of surety claims is predicated on the (NASBP) at 202-686-3700.

legal interpretation of a contractual relationship, as developed through our legal

system, including statutes and legal precedents.
When there is a proper default, the surety has the obligation to respond to
the owner and perform in accordance with the terms of the contract, subject to
the limitations and understandings contained in the performance bond. In
Surety Information Office www.sio.org
addition to this obligation of the surety, the proper declaration of default
For more information about
allows the surety to exercise its option to proceed in discharging its bond contract surety bonds contact:
liability, if any, without risking a claim by the contractor for interference with
the contract.
Surety Information Office
These are easy statements to make, and generally describe the principles 5225 Wisconsin Ave., NW #600
that are involved in a surety claim. However, anyone familiar with commerce Washington, DC 20015-2014
(202) 686-7463
and our legal system can appreciate the fact that there are exceptions to every Fax: (202) 686-3656
rule. www.sio.org • [email protected]

What should you do? The information source on contract

surety bonds. SIO is supported by SAA
First, be fair in your contract and in dealings with the contractor. and NASBP.
When entering a contract, you do so for the end goal of completing the
project to fulfill a defined need. If you require your contractor to bond the
The Surety Association of
project, you are taking the extra step and expense to use a prequalified contrac- America
tor to perform the work. What remains is to manage the construction process 1101 Connecticut Ave., NW #800
Washington, DC 20036
and to comply with your part of the contract. (202) 463-0600
Fax: (202) 463-0606
Second, be prudent in managing the construction process. www.surety.org
Name one body of law that has more case law than that surrounding the [email protected]

construction industry. It is hard to do! SAA is a voluntary, non-profit,

unincorporated association of companies
Third, know and understand the traditions of the construction engaged in the busienss of suretyship.
If presently has approximately 600
industry and your contract, including your responsibilities under it. member surety companies, which
Fourth, document the progress of your project. collectively underwrite the overwhelming
majority of surety and fidelity bonds in
Remember that the surety promises to fulfill the contract when the “prin- the US, and 7 foreign affiliates. SAA
is licensed as a rating or advisory
cipal is in default of the contract and has been declared to be in default by the organization in all states, DC, and
Puerto Rico, and has been designated by
obligee.” Well-documented project files go a long way towards assisting the all state insurance departments except
Texas as a statistical agent for the
claims representative in his or her investigation, and ultimately help you reporting of fidelity and surety
experience.
substantiate the default if the matter goes to court.
Fifth, seek legal assistance in pursuing your claim.
If you are involved in a surety claim, something has gone wrong in the
contractual relationship between you and your contractor. Given the multitude National Association of Surety
of jurisdictions, and the thousands of interpretations surrounding the case law Bond Producers
5225 Wisconsin Ave., NW #600
governing the construction industry, you should not rely on a layperson’s Washington, DC 20015-2014
interpretation of a contract, nor should you rely on a surety to make those (202) 686-3700
Fax: (202) 686-3656
interpretations for you. Seek legal counsel to assist you with this contractual www.nasbp.org • [email protected]
problem, and in doing so, seek counsel who is familiar with the construction NASBP is the international organiza-
industry. This is a specialized field of law. Proper counsel can save time, tion of professional surety bond
producers and brokers. NASBP
money, frustration, and frequently, unnecessary litigation. represents over 5,000 personnel who
specialize in surety bonding, provide
Finally, we have emphasized that the claims investigation is required once performance and payment bonds for the
construction industry, and issue other
a default or complaint is made. Find out who is in charge of the surety claims types of surety bonds for guaranteeing
performance, such as license and permit
operations from the contractor or surety bond producer, and be certain to bonds. NASBP's mission is to
strengthen professionalism, expertise,
follow instructions for proper notification, in writing, to that party.6 Getting and innovation in surety and to advocate
its use worldwide.
the process underway correctly is vital to prompt and effective claims service.

Surety Information Office www.sio.org