Understanding bonded projects

Performance and payment bonds are types of surety bonds required for most public and many private construction proj­ects to guarantee their completion. And because many prime contractors require similar subcontract performance and payment bonds to guarantee subcontractors' performance and payment, it is important you understand how these bonds work.

Surety credit extension

The word "surety" suggests assurance and guarantee. That is exactly what a surety does when a performance and payment bond is executed in support of a construction contract—the surety ensures and guarantees the bonded construction contract's terms and conditions.

Many surety providers also insure property, casualty and liability. However, the extension of a surety bond is a credit function and not an insurance policy. Unlike insurance, which manages the severity and frequency of insurance losses through underwriting principles, deductibles and risk-control functions such as safety training, sureties expect the contractors they bond to complete construction projects and satisfy all contract terms and conditions.

Surety bonds are three-party agreements in which the bond issuer (the surety) joins the second party (the principal or, in your case, roofing contractor) in guaranteeing to a third party (the obligee, or owner or prime contractor) the principal's fulfillment of an obligation.

If the principal does not live up to the contract terms and conditions, the obligee has a right to demand the surety to fulfill the contract. If a bond obligates the surety to perform the contract terms, the surety typically performs in one of the following ways:

• The surety arranges for the principal to perform after consulting with the obligee.
• The surety completes the contract through independent contractors.
• The surety obtains bids from completion contractors acceptable to the obligee.
• The surety waives the right to perform the contract and pays the obligee.

Sureties provide considerable value to principals and obligees. A surety's relationship with its principal is ongoing and must remain open to dialogue of significant business and operating issues, including management of contract risks that involve warranties and guarantees.

Warranty risk

An important part of the contract review process involves understanding warranties. There are two types of warranties in all construction contracts: implied and express.

Implied warranties seek to impose obligations on you even though there is no warranty language in the construction contract document. Implied warranties are based on common law and statutes and differ from state to state. Ultimately, courts may interpret the existence or scope of implied warranties differently. An example of an implied warranty is that a contractor's work will be performed in a workmanlike manner.

Express warranties appear in contract documents or other contractually binding documents. As an example, common language in nearly all construction contracts states material and equipment incorporated into a construction project will be new, of good quality and free from inherent defects. Other common express warranties include that a contractor be properly licensed; the title to the materials and equipment used on the project shall pass to the owner upon payment; and a manufacturer warranties its materials and equipment.

Equipment and materials manufacturers should provide their warranties to the building owner. These are known as pass-through warranties. Your responsibility involves properly installing materials and equipment. If installation is not performed correctly, a manufacturer may not provide its warranty and you may have to correct the work before the manufacturer will certify and provide its pass-through warranty to the owner.

Some warranty language may overlap and create ambiguity in determining where your warranty begins and ends. A manufacturer pass-through warranty is different from a contractor warranty, and the contract must clearly delineate the various warranty responsibilities to eliminate ambiguity.

Performance and payment bonds are not intended to guarantee long-term warranties or guarantees. Rather, they provide assurances and guarantees during construction and the immediate post-construction phase. However, many contracts and some state statutes attempt to transfer such risk and responsibility to contractors. Managing contractual warranty risk is vital to preserving your assets and financial well-being.

Before signing a construction contract, be certain of the warranty and guarantee obligations the contract document imposes. Although certain one-sided contract language may not be successfully eliminated through negotiation, you must be aware of the risks assumed.

Because some roofing contractors manufacture their own products and materials in addition to providing construction services, there will be overlapping warranties they must satisfy.

If you manufacture products or materials, you are obligated to fulfill the warranty stated in the contract. Also, as a manufacturer, you must comply with manufacturer warranties. If a contract requires a long-term manufacturer warranty, a surety may not agree to assume any long-term manufacturer warranties under the surety bond.

There are several potential solutions to this warranty scenario:

1. The warranty document given to the owner could include language specifically stating the surety bond does not guarantee the warranty.
2. The contract agreement could include language specifically stating the surety does not guarantee manufacturer pass-through warranties. If possible, the contract also should state the surety's warranty obligation under the bond is two years or less without regard to the contractor's implied and express warranty obligations under the contract and is limited to the contractor's workmanship.
3. The bonds can be modified to state the surety does not guarantee the manufacturer or other long-term warranties. This generally will work for private or subcontractor contracts. However, this is not an iron-clad approach because performance and payment bonds guarantee contract terms. Such an approach likely will result in inconsistencies between the contract and surety's obligation. But courts often have allowed sureties to reduce their contractual obligations by modifying the bond form with respect to construction projects involving private owners and subcontracts. Such bond modifications likely are not available with public contracts.
4. Language can be included in the construction contract that eliminates or limits a warranty in whole or in part. Remedies for breach of warranty can be modified through contract language negotiation, and courts will allow parties to negotiate or modify language to the extent it is fair and reasonable. However, there may be restrictions on such modifications when working with public contracts.

Making it work

Express warranties usually are the result of negotiation between a contractor and owner or a contractor and subcontractor. A contract's warranty and guarantee provisions are ways to allocate and transfer risk. Surety companies are interested in supporting good construction risks, and surety capacity is reserved for the best qualifying contractors.

Not only will you need to demonstrate your organization is capable and financially sound, you will need to increasingly demonstrate your ability to review, identify and manage contract risk with regard to warranties, damages and guarantees.

Kevin W. Birch is director and branch manager of CNA Surety, Columbus, Ohio.

What can you do?

To help you better manage your risk when entering into a contract, consider the following tips:

1. Read the contract thoroughly. Make a list of any unusual terms and conditions, and seek to clarify and eliminate ambiguity.
2. Seek to specifically limit contractual obligations to the construction contract document. Some contractors are surprised when owners incorporate terms and conditions from other documents into construction contracts.
3. If there is flow-down language that binds you to a prime contract's terms and conditions, identify it and understand it. It is not unusual to see flow-down language in subcontracts, but the frequency of these terms and conditions being accepted without understanding the obligation is surprising.
4. Seek to understand where your warranty begins and ends. Be careful to understand the contractor warranty and other warranties that may be passed from a vendor or manufacturer. If there is overlapping warranty language, clarify to the extent possible your obligation with additional contract language.
5. Warranties and guarantees are risk-transfer mechanisms, and the amount of risk one party is willing to assume or retain should correspond with the amount of profit or compensation. Higher risk deserves a higher level of profit potential.
6. Seek to eliminate long-term warranties and guarantees. If these cannot be eliminated, seek to limit or cap these obligations to the extent possible.
7. Demonstrate to the surety your experience with warranty expense and begin to build a database that establishes that experience. Begin to accrue, on the balance sheet, a warranty expense based not only on experience but on the potential based on contract obligations.
8. Be proactive, and use your surety agent, surety company and attorney as resources. To find a professional surety agent, access the National Association of Surety Bond Producers' Web site, www.nasbp.org.
9. To the extent possible, limit the remedies for breach of warranty, including recovery of consequential and actual damages. Limit the breach-of-warranty obligation to a short-term manageable obligation, and cap all damages. Eliminate all consequential damages as a best practice. At a minimum, consequential damages must be quantified and capped or limited.
10. Train estimators and project managers to identify and manage contractual risk. They are the driving forces behind profitability.