A contractor's ability to obtain performance and payment bonds often is an important factor in obtaining jobs and expanding business opportunities. Your ability to obtain bonding distinguishes your company from others and immediately informs potential customers you are an established contractor with a proven record of success and financial strength.
Bonding is essential to be able to contract directly with government agencies, and many private construction projects require construction bonds. Pursuant to a federal statute known as the Miller Act, contractors who contract with a federal government agency are required to provide performance and payment bonds if their government contracts exceed $100,000.
Similarly, per state laws commonly referred to as Little Miller Acts, contractors who enter into public construction contracts with state agencies or local governments, school boards and political subdivisions exceeding a certain dollar amount set by state statutes also are required to provide performance and payment bonds.
Obtaining bonds qualifies contractors to perform public work and satisfies the requirements of private parties who require contractors to provide performance and payment bonds; however, construction contractors face greater liability exposure as a result of providing bonds, including potential personal liability exposure, for every job for which a bond is issued.
Indemnification obligation to surety
If there is a claim against a contractor's surety, the contractor is obliged to reimburse the surety for every expense the surety incurs pursuant to the general agreement of indemnity executed by the contractor and bonding company at their relationship's inception. Unlike an insurance carrier that pays a claim on behalf of its insured, bonding companies are entitled to be reimbursed for all expenses incurred on behalf of contractors whom they bond in accordance with the general indemnity agreement.
Even more worrisome is the risk of personal liability exposure to the construction company's individual owners and perhaps a spouse and other individuals who personally may have signed the general agreement of indemnity when the contractor was anxious to establish a relationship with a commercial surety.
Bonding companies will seek to obtain as many broad personal indemnification obligations as they can to reduce their financial risks; if a construction company becomes insolvent, the surety wants to be able to be reimbursed for all expenses and does not want to find itself facing a bond claim with an insolvent contractor and no personal liability obligation owed by the contracting company's owners to the bonding company.
Contractors should work closely with bonding agents knowledgeable about construction to try to reduce or be relieved of personal indemnification by developing a plan to demonstrate the company's successful operations, financial strength and proven performance record so the surety is willing to provide bonding without personal indemnity. The contractor, his or her bonding agent and the surety should work together to establish financial benchmarks so the surety will be comfortable with corporate indemnification and willing to reduce and eliminate personal indemnification obligations.
Obligation to "faithfully perform"
Performance bonds in particular pose substantial liability risks to construction contractors. The typical language contained in a performance bond form describing the contractor's obligation is remarkably short and simple: "If the Contractor shall promptly and faithfully perform said Contract, then this obligation shall be null and void; otherwise, it shall remain in effect."
Many contractors believe the obligation to "faithfully perform" a contract is satisfied and there is no further performance bond liability once the contractor completes construction. Their view is that any liability on a performance bond ends when the contractor's work on the project is completed, the project is accepted and the contractor is paid. Indeed, there are numerous, generally older, court decisions stating the performance bond liability no longer exists after substantial project completion so the performance bond surety does not have a post-completion liability exposure.
Unfortunately, from the perspective of contractors who furnish performance bonds and their bonding companies, most court decisions do not find performance bond liability ends when construction is completed. If you did not perform the contract in accordance with the contract specifications, the claimant can argue you did not faithfully perform the contract and proceed to prosecute a lawsuit on the performance bond. If the contract secured by the performance bond includes specific post-construction contractor obligations, such as the one-year express obligation to repair defects included in standard The American Institute of Architects (AIA) construction contracts or other warranty obligations, the performance bond potentially is applicable to post-construction claims unless the bond contains contrary language or a statute of limitations that cuts off bond liability after a stipulated time period.
Statutory and common law bonds
Two categories of bonds are issued for construction projects.
For public works projects when a contractor contracts with a government agency, bonds are required by statute. These bonds, which must conform to the requirements set forth in the applicable statute, often are referred to as statutory bonds.
For private projects, there are common law, or private, bonds; these bonds' requirements and terms are fully within the discretion of the parties involved. The distinction between a statutory bond and common law bond may be critical when determining the liability duration of the surety and the principal under the bond because of statutes of limitations applicable to statutory bonds.
Numerous states have enacted statutes applicable to statutory bonds that include a specific statute of limitations governing a claim on the statutory bond. These statutes are invariably much shorter than the typical statutes of limitations applicable to written contracts and common law bonds.
For example, Georgia, North Carolina, Ohio, Pennsylvania, Texas and Wisconsin each have adopted one-year statutes of limitations for claims on statutory public works bonds. Colorado's statute is six months from substantial completion or 90 days from advertised final settlement. Minnesota has a two-year statute of limitations applicable to a suit on statutory public works performance bonds. Keep in mind these short statutes apply only to public works projects where the bond is deemed to be a statutory bond and would not apply to bonds issued on a private construction project where the law does not require bonds.
When furnishing bonds applicable to a public construction project, contractors and sureties should conform the bond to state law statutory provisions so it unambiguously is viewed as a statutory bond rather than a common law bond and thus is subject to the shorter statute of limitations. If there are inconsistencies between the bond and statutory provisions regarding the content or duration of a bond required for public works projects, the bond might be construed as a common law bond and receive a more expansive interpretation than was required by law. A simple but commonly omitted step would be to reference the public works statute in the bond and/or in a cover letter transmitting the bond. You want to be able to demonstrate the parties' intent was to provide a statutory bond.
The statutes of limitations applicable to statutory bonds can help a contractor facing a claim for alleged defective construction brought several years after completion.
For example, in the 1984 Texas case Transamerica Insurance Company v. Housing Authority of the City of Victoria, the public housing authority was not permitted to pursue a performance bond claim several years after construction even though the claim might have been permitted based on the time provision in the bond because the Texas statute of limitations specifically governing statutory bonds stated no lawsuit shall be instituted on the performance bond more than one year after the date of final completion.
Whenever a lawsuit is filed by a government agency—such as a school board—on a performance bond that was required by state law, the contractor and surety should ascertain whether there is a specific statute of limitations applicable to the statutory bond that may have expired before the lawsuit was filed. Even if the contractor still faced potential liability based on a different statute of limitations for breach of contract or breach of warranty, the claim on the statutory performance bond may be untimely and the surety may be entitled to be dismissed from the lawsuit because it was not filed within the statute of limitations applicable to statutory bonds.
Establish your own statute of limitations
The single most important step contractors should take to limit the duration of their post-completion performance bond liability is to make sure the performance bonds they and their sureties sign contain a specific time limitation running from the time of completion of construction or final payment. For private and public construction projects where there is not a specific statute of limitations applicable to a statutory bond, the time limitation contained in the bond will be the primary tool to manage and reduce post-construction bond liability.
Most states, including Arizona, California, Colorado, Georgia, Illinois, Iowa, Kentucky, Louisiana, Maryland, Massachusetts, Michigan, New Hampshire, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Tennessee, Utah, Virginia and Wisconsin, allow parties to reduce and stipulate their own statute of limitations in a contract. This same principle applies to construction bonds, which are contracts. The general rule is as long as the contractual stipulation is reasonable, the shorter limitations period will be enforced.
Alabama, Florida, Idaho, Mississippi, Missouri, Montana, Nebraska, North Dakota, Oklahoma, South Carolina and Vermont do not allow a contractual shortening of the statute of limitations and will not enforce a time limitation in a contract or bond conflicting with a state statute. Texas prohibits a stipulation of less than two years, and Connecticut prohibits a limitation on performance and payment bonds of less than three years.
AIA bond forms
The performance bond forms developed by AIA—AIA Document A311 and AIA Document A312—and performance bond forms prepared by commercial sureties contain time limitations. The AIA Document A311 Performance Bond, issued in 1970 and still commonly used, states "[a]ny suit under this bond must be instituted before the expiration of two (2) years from the date on which final payment under the Contract falls due."
The AIA Document A312 Performance Bond, issued in 1984, states: "Any proceeding, legal or equitable under this Bond ... shall be instituted within two years after Contractor Default or within two years after the Contractor ceased working or within two years after the Surety refuses or fails to perform its obligations under this Bond, whichever occurs first. If the provisions of this Paragraph are void or prohibited by law, the minimum period of limitation available to sureties as a defense in the jurisdiction of the suit shall be applicable."
Thus, when AIA performance bond forms are used and a performance bond claim, based on an alleged breach of contract because of a construction defect, is brought against the contractor and his or her surety several years after completion and acceptance of the contractor's work, the performance bond claims should be dismissed if the lawsuit (or arbitration proceeding) is instituted more than two years after the contractor finished working on the project.
Bonding companies of course have a keen interest in limiting the duration of their potential liability and routinely include time limitations in their bond forms. These time limitations benefit the surety and contractor, who has the duty to indemnify the surety.
In a state such as Florida that voids contractual provisions reducing the period set by statute to institute a legal claim, a time limitation stated in the bond will not be enforced by courts. In those states, contractors and sureties face a longer period of performance bond exposure, particularly when issuing common law bonds, depending on the length of the statute of limitations applicable to bonds or written contracts if there is no statute of limitations specifically governing claims on bonds. Contractors and bonding companies in those states should seek to limit potential post-construction performance bond liability by including other language in the bond to clarify the bond is not intended to cover post-construction warranty obligations.
Court decisions
In the 1998 case Federal Insurance Company v. Southwest Florida Retirement Center, Inc., the Florida Supreme Court explicitly recognized there is performance bond liability for latent construction defects arising several years after completion and acceptance. The court applied Florida's five-year statute of limitations applicable to claims on contracts and written instruments.
Notably, the Florida Supreme Court did not apply the statute of limitations applicable to claims for deficiencies in construction of an improvement to real property, which, in Florida, is four years from the completion date unless the lawsuit involves a latent defect, in which case the four-year period runs from the time the defect is discovered or should have been discovered. The Florida Supreme Court declined to apply the discovery rule to the claim against the surety on the performance bond and instead applied the five-year statute running from the date of acceptance of construction completion.
In states that permit parties to stipulate to their own, shortened statute of limitations, when a one- or two-year time period is included in the performance bond to file a formal legal claim on the bond, it will cause a lawsuit on the performance bond to be dismissed if the lawsuit is not filed within the time limit stated in the bond. There are many court decisions to this effect. Courts will honor stipulated time limitations in bonds. The contractor still may face a claim for breach of contract depending on the statute of limitations applicable to contract claims in the state where the lawsuit was filed, but the surety no longer will be a party to the lawsuit if the claim for breach of the performance bond has been dismissed.
However, if the performance bond does not contain a limitations period, the statute of limitations applicable to the performance bond claim likely is to be governed by the normal statute of limitations period in the state applicable to written contracts.
The legal consequence of failing to include a time limitation in the performance bond can be seen by comparing the outcome of construction lawsuits that included performance bond claims.
In the 2009 Wisconsin case Milwaukee Board of School Directors v. BITEC, Inc., the roofing contractor's surety was found liable to the Milwaukee Board of School Directors for breach of the roofing contractor's five-year workmanship warranty. Because honoring the five-year warranty was part of the roofing contractor's obligation secured by the performance bond and there was no time limitation stated in the bond, the Wisconsin Court of Appeals ruled the roofing contractor's surety was liable for latent defects in the roofing contractor's work as part of the surety's obligation to cover all the roofing contractor's duties under the contract.
General contractor-drafted bond forms
Knowing the terms stated in a bond can be critically important and standard construction industry performance bond forms contain time limitations, numerous general contractors have promulgated their own performance bond forms they ask subcontractors and their sureties to sign. General contractor-drafted bond forms sometimes are included or referenced in bid packages, or there may be a provision in the general contractor-drafted subcontract requiring the subcontractor to execute and furnish the general contractor-drafted bond. When you see such a provision, you should be wary because the general contractor's objective is to obtain the broadest possible bond coverage, which in turn will result in greater bond liability exposure for the subcontractor and its surety.
Unlike AIA and standard construction industry bond forms, performance bond forms drafted by general contractors for execution by subcontractors and their sureties typically do not contain a time limitation. In that case, the statute of limitations in the state where the lawsuit is filed will apply and that time period likely will be significantly longer than the one- or two-year period customarily included in standard construction industry bond forms promulgated by sureties.
Whenever you are asked to execute a performance bond, you should check whether the bond includes a one- or two-year time limitation similar to the AIA and standard industry bond forms. You should be sure not to agree in advance to execute a bond form drafted by the other party to your construction contract. To indicate your ability and willingness to provide performance and payment bonds, you should state in the contract you are willing to execute standard industry bond forms, such as those promulgated by the AIA or major surety companies.
If no time limitation is included in the bond, you should insert a time limitation or use another bond form that contains a time limitation. When negotiating with a general contractor, you could propose that time limitation in the subcontractor's bond issued to the general contractor would be the same as in the general contractor's bond or that the subcontractor use the same bond form the general contractor has provided to the owner.
Sometimes a bond may contain an illusory time limitation. For example, Providence, R.I.-based Gilbane Building Co.'s performance bond form, which is given to subcontractors and their sureties to sign, states "Any suit under the bond must be instituted before the expiration of (a) two years from the date on which final payment under the contract falls due, or (b) the applicable statute of limitation of the jurisdiction in which the bond is executed, whichever is later."
This time limitation equates to no time limitation because any lawsuit on the bond would have to be filed within the statute of limitations if there had been no time limitation stated in the bond.
Wrapping up
Bonds significantly increase a contractor's financial liability exposure and may well pose a personal liability exposure risk. Contractors should try to actively manage and reduce the financial risk posed by bonds well in advance of a claim arising.
To avoid being exposed to performance bond liability for post-construction alleged breach of contract and warranty claims, contractors carefully should review the language in a performance bond to understand the scope of the performance bond obligation stated in the bond and be sure the bond contains a time limitation for a lawsuit on the bond to be instituted, running from a fixed event, such as completion of construction or final payment, as is provided in AIA and standard construction industry bond forms.
Subcontractors should be particularly wary of bond forms drafted by general contractors, which tend to be expansive in scope and contain no time limitation. Performance bond forms are not all the same. The starting point—and in most cases, the ending point when a court is making a decision—is the language in the bond. When a lawsuit on a performance bond is filed, the judge and lawyers will scrutinize the bond language. You should do the same before signing a bond and be certain the bond you sign contains a time limitation.
Stephen M. Phillips is a partner with Atlanta-based law firm Hendrick, Phillips, Salzman & Flatt.
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