Performance Bonds: 3 Steps & 5 Options after the Surety Receives a Claim

What should a surety do once it receives a claim because a G.C. has defaulted under a construction contract that requires a performance bond? What are the surety’s obligations under the bond?

Upon receiving notice of a performance bond claim, the surety should:

1)      Acknowledge receipt of the claim, request from the claimant additional documentation to substantiate the claim, and reserve all of the surety’s defenses and rights.

2)      Begin an investigation of the claim. The surety will look into the facts to determine if the principal is in default and, if so, whether the surety is at risk under the bond. The surety should gather facts from as many sources as possible.

3)      Give written notice to the principal and indemnitors of the claim, any potential losses to the surety, and their indemnity obligations. Also, request their cooperation and any documents and information they may have about the claim.

The surety then has several options:

  1. If the investigation reveals that the default of the principal was improper, deny the claim.
  2. Provide financial assistance to the defaulting principal to help it cure the default (e.g. inject cash to solve a temporary cash flow problem).
  3. Tender a new contractor to take over for the principal and complete the project. The owner, new contractor, and surety would enter into a Takeover Agreement. (The surety and new contractor would also sign a Completion Agreement.)
  4. Obtain bids to complete the project, submit the bids to the owner, tender the necessary funds to the owner, and step away from the project completely. This is a good option if little or no work has been performed on the project.
  5. Require the owner to complete the project and, once completed, request payment from the surety. The surety would be liable to the owner, up to the penal amount of the bond, for the cost to complete which exceeds the amount of the remaining contract balance being held by the owner. A downside to this option is that the owner has little incentive to complete the project cheaply and efficiently (meaning the surety may end up paying more than it should).

In every case, the surety and its counsel should carefully review the language of the bond. In some cases, all of the options above may not be available, or they may be available but may not be desirable. Some performance bonds spell out the available options and make them part of the agreement. Some bonds are silent as to the options when there is a default.

With every claim under a performance bond, the surety must act promptly and, based on the information it collects about the project, select a strategy that best fits its goals for the situation.

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