Bound to the bond

As you know, payment bonds assure subcontractors and suppliers that payment will be made for the labor and materials they provide to a project. This protection especially is important on public projects where payment bonds serve as substitutes for the lien rights a subcontractor or supplier would otherwise have if the project was not being performed for a public owner.

However, you may not be aware of the legal relationships created through a payment bond, the various types of payment bonds, the scope of protection provided under a payment bond or the process you will be required to follow to recover under a payment bond.

Terminology and obligations

It is important to realize payment bonds are not insurance policies. They are contracts that essentially obligate the surety and principal to pay for labor performed on and materials provided to a construction project. The contractor who executes the bond will be the principal on the bond. The party to whom the principal is bound under its contract will be the obligee. When a prime contractor provides a payment bond, the obligee will be the project owner. When a subcontractor provides a payment bond, the obligee is likely to be the general contractor. Those supplying labor or materials to the project often are referred to as claimants or beneficiaries.

If a valid claimant is not paid for labor or materials and the claimant makes a claim under the bond, the surety and principal are required to satisfy the claim. This is true even when the principal already has paid its downstream subcontractor for the labor or materials and the subcontractor failed to pass along the payment to the claimant.

If a claim is satisfied, neither the principal nor surety will be liable under the payment bond. However, if the principal and surety fail to pay the claim, both will be liable for the claim up to the penal sum of the bond, which is the amount listed on the bond. The penal sum typically is set at the amount of the principal's contract for the project.

Generally speaking, when a subcontractor or supplier has made a valid claim on a payment bond and that claim is not paid, the subcontractor or supplier may file a lawsuit against the principal and/or the surety because either can be individually liable for the full amount owed under the bond. The specific procedural requirements that must be followed by a claimant to recover under a particular payment bond usually are set out in the bond's language or, in the case of "statutory" payment bonds that are required by law to be provided for certain projects, may be found in applicable federal or state statutes.

Types of payment bonds

There are two primary types of payment bonds: those required by federal or state statute for public construction projects (which often are referred to as statutory payment bonds) and those that are not (which often are referred to as common law payment bonds).

The parties' duties and obligations under a statutory payment bond are created and construed in accordance with the governing statute and the bond's language, which often will mirror the statute. If not expressly established in the bond, the rules applicable to a statutory payment bond are implied and read into the bond. Whether a statutory payment bond is required for a particular public project depends on the project's size and complexity as measured by the dollar amount of the project's prime contract.

Common law payment bonds are private contracts between the surety and principal that are enforceable in accordance with their express terms. No outside conditions or requirements are implied into or applied to the bond.

Common law payment bonds typically are used in private construction projects, but they also may be required on public projects when the prime contract price does not exceed the statutory minimum for when a statutory payment bond is required. A subcontractor on a public project also may be asked to provide a common law payment bond for a project already covered by a statutory payment bond if the prime contractor wants to protect itself from claims related to the default of the subcontractor to pay its sub-subcontractors or materialmen.

Statutory payment bonds

Statutory payment bonds for public projects find their source in either the federal Miller Act (40 U.S.C. § 3131, et seq.) or "little" Miller Acts, which are states' equivalent to the federal act.

The federal Miller Act requires any prime contractor on a federal project where the prime contract exceeds $100,000 to provide a payment bond for the protection of certain subcontractors or suppliers providing labor and/or materials. These payment bonds only cover first- and second-tier claimants, meaning a supplier or subcontractor who has a direct contract with the prime contractor (a first-tier claimant) or a supplier or sub-subcontractor who has a direct contract with a subcontractor (a second-tier claimant) can make a claim under the bond. Any party further down the contractual chain is considered too remote and cannot assert a claim.

All 50 states, as well as the District of Columbia, have their own little Miller Acts for state-funded public projects that require prime contractors to obtain payment bonds. Many of these statutes mirror the federal Miller Act. However, the circumstances in which a little Miller Act payment bond is required differ greatly among states.

For instance, under California's little Miller Act, a prime contractor must provide a payment bond for any project in which the prime contractor's contract with the public owner is more than $25,000. Alaska, Florida, Georgia and Kansas mirror the Miller Act, requiring payment bonds on public projects where the prime contract price exceeds $100,000. Effective July 1, 2011, a new Virginia law only requires a contractor to provide a payment bond on a public project unrelated to transportation when the contract exceeds $500,000, provided the contractor has been prequalified by the state public body for which the project is being performed.

The coverage provided by little Miller Act payment bonds also varies. Some states, including Connecticut and Utah, follow the Miller Act by only allowing first- or second-tier claimants to make claims. Other states, such as Maryland, extend the payment bond's protection to third-tier claimants (those supplying labor or materials to a sub-subcontractor). A number of states, including Colorado and Illinois, generally allow any party providing labor or materials to a state public project, no matter how remote, to make a claim and seek payment under a little Miller Act payment bond.

Common law payment bonds

Because there is no required format or specific statutory requirements governing common law payment bonds, there is significant diversity among these bonds. Depending on the specific payment bond form used, these potential variations include but are not limited to: what costs are recoverable under the bond; who may make a claim; what notice requirements and other procedural steps must be followed to make a claim; and how long a claimant has to file suit against the principal and surety to enforce a claim.

Many sureties and general contractors have drafted their own common law payment bond forms. There also are a number of standard common law payment bond forms promulgated by various industry groups, including The American Institute of Architects (AIA). AIA's A312 payment bond form, which originally was published in 1984, is one of the most commonly used payment bond forms. In 2007, the Association of General Contractors led a coalition of industry stakeholders to publish the ConsensusDOCS family of construction documents. They include a number of standard payment bonds (ConsensusDOCS 261, 472, 473 and 707) for use in various situations.

Enforcing rights

Generally, the process for recovering payment under a payment bond will involve three steps: obtaining a copy of the payment bond and determining whether a claim can be made under the bond; providing all required notices; and, if necessary, filing suit on the payment bond to recover money owed.

Obtaining a copy

Ideally, you should obtain and review copies of all applicable payment bonds early in a project or even before commencing work. This may be done by submitting a simple written request to the owner, general contractor or prime contractor for a copy of the bond. For public projects, there typically is a statutory requirement that obligates the public owner and/or prime contractor to provide a potential claimant a copy of the payment bond upon request.

For instance, the Miller Act requires a federal agency and/or owner to provide a certified copy of the payment bond to any person who submits an affidavit stating he or she has supplied labor or material to a public project and that payment for the labor or material has not been made. Many states have similar requirements. If there is no specific procedure for obtaining a copy of the payment bond applicable to a state public project, consider making a formal request under your state's Freedom of Information Act or Open Records Act.

After obtaining a copy of the applicable payment bond, you will need to determine whether you qualify as a proper claimant under the bond. The bond's language often will designate who may make a claim under the bond. If there is no applicable language in the bond, consult legal counsel to determine whether the payment bond's protection extends to cover your claim.

Notice requirements

When and how notice must be given to preserve and make a claim under a payment bond will depend on the type of payment bond issued, the bond language, any relevant statutes that apply to the bond and your position in the contractual chain. Regardless of the specific requirements that apply, ensure all notice obligations are satisfied in a timely manner to preserve your claim.

Notice under statutory bonds

The notice requirements applicable to statutory Miller Act and little Miller Act bonds are set out in the federal and state statutes governing these bonds, but they also may be included in a bond's language.

For federal projects covered by the Miller Act, first-tier subcontractors and suppliers who have a direct contract with the prime contractor are not required to provide notice of a claim before filing a lawsuit to recover on the bond. It is presumed the prime contractor is aware the supplier or subcontractor is providing labor and/or materials to the project and the supplier or subcontractor has not been paid. Because this may not be the case with more remote subcontractors and suppliers, a second-tier claimant must provide the prime contractor with written notice of its claim within 90 days from the date when the claimant last provided the labor or materials for which the claim is being made.

The notice provided by a second-tier claimant must state with "substantial accuracy" the amount claimed to be owed and the name of the party to or for whom the labor or material was furnished and must indicate the claimant is looking to the prime contractor for payment. Simply notifying the prime contractor that payment has not been made generally is not sufficient to constitute appropriate notice.

A Miller Act notice must be delivered by any means that provides written verification of delivery or by any means through which the U.S. Marshal of the district in which the project is located may serve a lawsuit. In most situations, notice by FedEx, UPS or certified U.S. mail with return receipt requested will be adequate unless the 90-day time limit for providing the notice will run out before delivery.

Generally, the Miller Act and its requirements are liberally construed. However, if the 90-day notice requirement for second-tier claimants is not adhered to strictly, a claimant will lose its right to payment under the payment bond.

For example, in the 1992 case Pepper Burns Insulation Inc. v. Artco Corporation, Artco Corp., the prime contractor on a federal project, subcontracted a portion of its work to Pyramid Contracting Ltd., which sub-subcontracted portions of its work to Pepper Burns Insulation. Pepper Burns Insulation completed its work July 27, 1989, and submitted invoices to Pyramid Contracting for payment. Full payment was not made by Pyramid Contracting, so Pepper Burns Insulation, as a second-tier claimant, provided the 90-day notice to Artco. The notice was mailed Oct. 20, 1989, less than 90 days after Pepper Burns Insulation completed its work. However, Artco did not receive the notice until Oct. 31, 1989, more than 90 days after Pepper Burns Insulation completed its work.

Pepper Burns Insulation ultimately filed a lawsuit against Artco and was awarded the money it claimed was owed. However, on appeal, the court reversed the trial court's ruling and ordered the dismissal of Pepper Burns Insulation's lawsuit against Artco.

According to the appeals court, the written notice to the prime contractor that is required under the Miller Act must be received by the prime contractor within 90 days of a second-tier claimant's last day of work. The day the claimant mailed the notice to the prime contractor is irrelevant.

The notice requirements applicable to little Miller Act payment bonds differ among states. In certain states, such as New Jersey and Utah, written notice must be given by a second-tier claimant to the prime contractor at the commencement of the claimant's work to preserve the right to make a payment bond claim later if the claimant does not get paid.

Given that a prime contractor may not be aware of a remote subcontractor or supplier, virtually every state requires notice by lower-tier subcontractors or suppliers after work has been performed.

For example, in New York, a second-tier claimant cannot enforce its rights under a payment bond unless it has provided the prime contractor with written notice of its claim within 120 days of last providing labor or materials to the project.

Notice under common law bonds

Common law bonds also include important notice requirements. Similar to the Miller Act, the notice requirements found in the AIA A312 and ConsensusDOCs 261 bond forms differ depending on whether a claimant has a direct contract with the principal on the bond.

For A312, if a claimant has a direct contract with the principal, the claimant is not required to provide notice during construction of the project because the principal is presumed to have knowledge of the claimant and the fact that the claimant has not been paid. However, the claimant is required to provide notice of a claim to the payment bond surety and project owner. There are no specific timing requirements for providing this notice.

If the claimant has not contracted directly with the principal on the payment bond, the claimant must provide notice of its claim within 90 days after its last day of work at the project. If payment is not made within 30 days following the date of the notice, the claimant must provide notice to the surety.

Filing suit

If the principal or surety fails to make payment on a valid claim, the last and final step involves filing a lawsuit against the principal and/or surety. You must be aware of the time period within which this lawsuit must be filed (which often is much shorter than the time period applicable to other types of claims).

On federal projects covered by Miller Act payment bonds, a claimant must wait 90 days after the day on which the last of the labor or materials was supplied to file a lawsuit against the principal and/or surety. This allows time for the money being paid by the owner to the prime contractor to make its way to those down the contractual chain. Many states have similar waiting requirements for the same reason. After any initial waiting period has lapsed, the claimant may file its lawsuit against the surety and/or principal.

A claimant under a Miller Act payment bond must file its lawsuit within one year of the day on which the claimant last provided labor or materials to the project. The same time limit applies to AIA A312 and ConsensusDOCS 261 payment bonds. State laws specifying the time within which a lawsuit on a little Miller Act bond must be filed vary, but most states allow the claimant either one year from the project's completion or one year from the claimant's last day of work at the project to file its lawsuit.

Last day of work

The period for giving written notice of a claim on a payment bond and the statute of limitations for filing a lawsuit on a payment bond generally begin to run the day a claimant last provided labor or materials to the project. Because these requirements must be strictly followed for a claimant to recover payment, the issue often arises as to what type of work can be used to determine a claimant's last day of work.

Although the specific interpretation may vary among jurisdictions, generally a claimant's last day of work is defined with respect to work performed as part of the claimant's original contract. Warranty work or other work required to correct defects or make repairs cannot be used to determine a claimant's last day of work under a payment bond.

Recovery

Despite strict statutory requirements as to when a bond must be provided, it is not uncommon for an unpaid subcontractor or supplier to learn the required payment bond was never obtained. In such situations, your rights will differ depending on whether the project is for a federal or state public owner and how state law addresses this issue.

If a prime contractor fails to obtain a Miller Act payment bond for a federal project, your only possible recovery will be against the prime contractor. You will not be able to hold the public owner responsible. Courts have construed the Miller Act as creating a cause of action against the principal and surety on the bond only—not against the owner.

If you find the required payment bond was not provided on a state public project, you may have more options. Certain states, including California, Florida, Illinois, Minnesota and Washington, require a public owner to ensure a payment bond is provided on qualifying projects. If a payment bond is required under the law but not provided, you will have a cause of action against the public owner for any claim that would have been covered under the payment bond had it been provided.

In certain situations, you may even have a claim directly against the state public official who failed to verify the payment bond was issued. For example, Oregon Revised Statute §279C.625 provides that the public officer who authorizes a contract but neglects to require the prime contractor to execute a payment bond is personally liable for claims that would have been recoverable under the payment bond.

Protect yourself

If there is a payment bond applicable to a project you are working on, it will provide valuable protection against the risk that you will not be paid for labor or materials. However, to take advantage of this protection, you must clearly understand the legal relationships created as a result of the payment bond, the scope of protection provided by the bond and, most important, the process you will be required to follow to recover under the bond.

Brian P. McCormick is an attorney with Atlanta-based law firm Hendrick, Phillips, Salzman & Flatt.

Concerns when issuing a payment bond

It is not uncommon for a subcontractor to be asked to issue a payment bond using a surety- or general contractor-drafted payment bond form. A general contractor-drafted bond form sometimes is included or referenced in a bid package, or there may be a provision in the general contractor's subcontract requiring subcontractors to execute and furnish a payment bond using the general contractor's form.

The payment bond forms provided by a surety generally will be fair to the principal because the liability of the principal and surety on the bond are equal. But be careful when asked to issue a payment bond on a form drafted by a general contractor because by drafting and requiring its own bond forms, the general contractor is seeking to obtain broader protection than what is provided by standard industry bond forms such as AIA A312 and ConsensusDOCS 261.

For instance, a general contractor-drafted bond form may not include any time limitation regarding when a claimant can file suit against you and your surety on the bond. If this is the case, you and your surety will be subject to liability on the bond for the full statute of limitations applicable to breach of contract claims. Consequently, standard industry payment bond forms should be used in lieu of general contractor-drafted bond forms when possible.

Once a bond has been furnished, have a clearly defined procedure in place to ensure you are aware of all lower-tier sub-subcontractors or suppliers providing labor or materials and that all payments you make are being passed along to these sub-subcontractors and/or suppliers. This could include requiring each of your subcontractors to identify their sub-subcontractors and suppliers in writing at the beginning of a job and detail all outstanding money owed to those sub-subcontractors and suppliers at the time the subcontractor submits each payment application to you.

Finally, be aware of the potential liability that arises when a claim is made on your bond and the surety is required to respond and potentially pay the claim. Under a typical arrangement, someone in your organization would be obliged to reimburse the surety for every expense the surety incurs in connection with the claim pursuant to the general agreement of indemnity (GAI) between that person and your surety.

In most situations, a GAI will be signed by a company's owners or principals. If this is the case, there is the risk of personal liability exposure to the company's principals or owners when claims are made on a payment bond.