Brent Chambers and Cornelius “Con” Riordan continue the discussion on the different types of construction bonds. In this episode, they will cover when a surety takes funds control, the impact of project delays on surety bonds, and how the pandemic has affected surety bonding. Con is an attorney with Robbins DiMonte Attorneys at Law and an expert in the construction industry.
Brent: Con, I’m glad to have you back on the podcast today. In our last episode, we spent a lot of time describing what payment and performance bonds were. We talked a bit about how they came about their history, and we got into some detail, if not a lot of detail, about their uses in the construction space. Today, during part two of our discussion, I want to focus most of our time on what happens when things actually go wrong in a construction job and when a payment and a performance bond is called in, or maybe both, by one of the various parties that are associated with it. So if it’s okay with you, let’s just dive in.
Con: Well, thanks, Brent for having me back, and I’m looking forward to part two.
When should I file a claim on the payment bond? How is the filing done?
Brent: So, let’s start with a payment bond. I want to give you a hypothetical situation for us to discuss. So, let’s say I am a second-tier drywall subcontractor on a federal project, and the owner has required the GC, which is my customer, to bond the project with a payment and performance bond. Over time, I’m not getting paid for my labor, for my supplies on the project. In fact, I haven’t been paid in almost 120 days. And as a result, my suppliers are calling me constantly for payment. My questions to you are when can I or maybe it’s better said, when should I file a claim on the payment bond? How is the filing done? And more importantly, how does this help me to get paid?
Con: Well, Brent, it sounds like from your hypothetical that the subcontractor is still working on the job. So, his last date of work hasn’t occurred yet.
Con: The bond is covered by what we talked about last time, the federal Miller Act, which is a statute that governs bonding on federal projects. And the statute sets forth the requirements as to how an unpaid first or second-tier labor material supplier needs to file a claim and attempt to get paid.
Now, as a second-tier subcontractor under the Miller Act, you have 90 days after your last date of work to file a claim. And you do that by sending a notice to the general contractor with a copy to the government or the contracting officer. Although the statute doesn’t require it I would also to send a copy to the surety, if you know the surety. Now, it’s easy to find that out because you can ask the contracting officer for a copy of the bond. You could ask the general contractor, but most general contractors would be reluctant to do that. And in the notice, you have to identify who you are, you have to identify the nature of the work that you’re furnishing, you have to identify the contract with the government and you have to state how much is due. In the case you’re talking about, you have a subcontractor that hasn’t been paid for 120 days but is still working. So he could serve a notice or it could serve a notice for the amount due as of the 120 days that we’re talking about. But that would only cover the amounts that had accrued up to that time. And if the subcontractor is going to continue to work, then the future amounts that he would be accruing would not be covered by that notice. And unless subsequent notices were served, those amounts would not be recoverable under the bond. The subcontractor, if he doesn’t get paid by serving the notice, then has one year after he finishes his work or his last date of work to file a lawsuit. And that lawsuit should be filed in the federal court in the jurisdiction where the project is located.
If I serve notice on a bond before completion, can I still serve additional notices against that bond?
Brent: Great. So I do have a question. So I know we talked about the mechanic’s lien earlier, and the mechanic’s lien sort of operates in a similar fashion. Typically for a lot of states, I have up to 90 days after the last furnishing to make a claim or I ultimately waive my rights. It’s somewhat similar to what you’re saying. A mechanics lien in some states, you still have to give a notice as well. But I can serve multiple notices. And so if I don’t want to 120 days, I’m feeling the pain. I can serve a notice, and then I can still serve additional notices against that bond, hoping again that the Surety will support us in helping us to get paid, correct?
Con: Right. You could either serve additional notices or you could serve an amended notice amending your original notice to a high amount as you go forward in time for the amount that do become due in the future as they become due. So let’s say in your situation, you have 120 days worth of invoices out there for $100,000. And then 60 days later, you complete the work and you’ve got another $50,000 that you haven’t been paid for a total of $150,000, you could then amend your original notice showing that the job is now complete, put your last date of work in the notice and the total amount due. And then the one-year period to file suit begins to commence on the last date of work.
Brent: Got it. So, the notice is just putting everybody in the chain above me in the surety that I’m not getting paid and I want attention. Is that not correct?
Con: That’s exactly right. And the reason for that is that the general contractor knows who his first-tier subs are and knows what the amounts due to them are, but he doesn’t really know what amounts are due to the lower-tier subcontractor. And therefore, as a lower-tier subcontractor, that is you’re working for a first-tier sub, you would alert the general contractor and the Surety as to the amounts that are due between you and the first-tier sub.
How do I file the claim on the payment bond?
Brent: All right, so I give notice. I’m trying to get attention. I don’t get the attention. I’m still not getting paid. How do I file the claim on the bond? The payment bond?
Con: Well, you’ve given your notice, and that notifies the general contractor, your immediate subcontractor, and the government as to what is due. And if you’ve served a notice on the surety, the surety knows as well. The only other step you need to take then is to file a lawsuit. And that lawsuit must be filed within a year after the last date of work. And if you don’t timely serve your notice, and the last day a notice can be served, by the way, is 90 days after your last date of work. So if you fail to do either of those, you lose your bond rights.
Brent: Got it. And again, that’s very similar to the mechanic’s lien in how it operates.
What will the surety do to help me?
All right, so I have filed against the payment bond. What am I going to hear from the Surety? How do they engage and how does it go from there?
Con: All right, this is something I talk about in some of my presentations: the statute requires what I call a bare-bones notification. That is, it gives you the bare bones of who the contractor is, what’s due, and so on. And when I tell Bond claimants in some of my presentations, you’re the first one that’s going to have the Surety’s ear. So, when you put your note together, put some “meat on the bone.” You know why you’re not getting paid. You know what the general contractor is telling you. You can anticipate what those defenses are going to be. So even if you have to give a narrative of some sort, do it, give the surety as many documents as you can to support your claim. Because what the Surety is going to do, when he gets that, he’ll have a lot of information. The Surety may come back and write you what’s called an acknowledgment letter, that is, the acknowledged receipt of your notice. And then they’ll ask you for a list of documents and information that the Surety needs to investigate the claim. But you can beat the Surety to that request by putting those documents in with your notice from the get-go. And therefore you’re giving yourself a little bit of an advantage because you have the stage at that point and you can explain in as much detail as you want as to why you’re not getting paid. And if you know what the defenses are going to be, that is what the general contractor is telling you, anticipate that and tell the Surety why the general contractor is wrong when it says that it raises these defenses to non-payment. For example, the government isn’t paying me or some of the work that you’ve put in is not up to the plans and specs, and so on. So that would be my advice at that point.
Brent: That’s great advice because you speed up the process as well. You get the information out there and you’re right, you’re the first person to get the Surety’s ear.
I have to sue… who do I file against?
So I’ve made my notice, I filed the claim, I’m getting a little bit of attention from the Surety, but I’m approaching one year now since I stopped work and I have to file a lawsuit. Am I filing that lawsuit against the Surety, the GC, the owner, or all of the above? And, by that time I’ve got an attorney involved, am I able to file or claim, let’s say, legal expenses, or other expenses that I’m now incurring?
Con: Well, the statute doesn’t allow for attorney’s fees by the claimant. But when you file your lawsuit, you’re filing a lawsuit on the bond. And what you’re doing is you’re claiming against both the general contractor, which is the principal on the bond, and the surety. The government in a federal project is not going to be a party to that lawsuit. It’s only going to be the general contractor and the surety as to the bond itself, you may also include a breach of contract claim in your lawsuit against your immediate subcontractor.
Brent: Got it. Okay, well, that helps greatly.
When should I file a claim as an owner of non-performance against the performance bond?
All right, so I want to now turn our attention to the performance bond, and I’m going to give you another hypothetical situation. It’s basically the same case. I am a second-tier drywall contractor. I’m not getting paid. The owner is a private company, so this is not a federal job. All right, so I’m not getting paid. Subs are reaching out to me or suppliers are reaching out to me. They’re not getting paid and I want to file against the bond. So, what triggers my ability to make a claim as an owner of non-performance against the performance bond?
Con: All right, so we’re talking about a private job now not a public job. In this situation, the owner has required the general contractor to furnish payment and performance bonds. So you don’t have a statute that is going to control your notice and suit requirements. Those requirements would be controlled by the bond itself. In a public arena, you can simply go to the statute which is publicly available, and find out when you have to serve your notice and when you have to file your suit. But in a private job, you have to be a little bit more proactive. If you see you’re not getting paid, you want to go to the owner and ask the owner for a copy of the payment bond. Most private owners will be glad to do that because they would rather see you pursue bond rights than lien rights. So, once you get the bond, you have to look at the bond and see what is in the bond in terms of a pre-suit notice and a time within which suit might be filed. All of these bonds on private jobs are different. Some don’t have notice requirements at all. Some of the larger GCs who develop their own bond forms have no limits on filing suit and giving notice to the surety in them because they don’t want to restrict the ability of subcontractors to file against a surety. Some owners don’t want to restrict the suits against the surety because it could avoid mechanics liens on their project. It also helps with the flow of funds if you’re going against the bond and not filing a mechanics lien. So you have to get the bond form and you have to look and see what the notice requirements are.
Let’s talk about a standard bond form that’s used by many people, and that is an AIA (American Institute of Architects) form which is called an A312. And under that bond form, the first-tier subcontractor must give a notice but there’s no time limit. And the second-tier subcontractor has 90 days from the last date of work to give notice to the surety. And the bond itself lays out what must be in the notice. The notice would go to the owner and the general contractor. And if the surety is known, you could send it directly to the surety as well. And similar to the Miller Act, as we talked about before, you would identify who the claimant is, the nature of the claimant’s contract, who the contract is with, the type of work he’s performing, and the amount claimed. And that is a precondition, giving the notice to the owner and to the general contractor. And then once the notice is served, then you have one year to file suit after your last date of work, similar to the Miller Act.
Brent: So my takeaways from this Con is on a private job, it’s obviously not a government project, and there are no statutes that lay out the process notices, when you can file. But there are standard bond forms like the AIA, and if you get into a situation where you need to make a claim against the bond, you need to get the form and that standard form (we’re just talking about that standard form), it is going to identify what is required in terms of notices, making claims, etcetera.
Con: Exactly. For example, in the AIA form, you go to section four, if you’re a subcontractor that has been paid in the layout, the timing, and the content of the notice.
As the owner, how long do I need to wait to file a claim of non-performance against the bond?
Brent: All right, so let me add a twist to this. We’ve been talking a lot about subcontractors not getting paid. I am the owner of this private job. I’ve required my GC to bond the project, a performance and payment bond, and the GC is not performing. I’m getting calls now from subs. Obviously, things are going wrong. As the owner, what triggers my ability to make a claim of non-performance against the bond? How bad does it have to be for me to make the claim?
Con: Well, you can send letters to the surety. I mean, there are ways you can alert the surety to the non-performance of the general contractor without actually making a claim against the bond. Because sometimes you don’t want to pull that trigger and alert the surety. The surety may then get together with the general contractor and try to resolve the issues. But if the issues persist, in order to file a claim against the performance bond, the general contractor must be in default of its obligations and the owner must declare that a default exists. That is, a written communication to the general contractor declaring that a default exists. Now, legally, the term default is not equated with just a simple breach of contract. It has to be so serious of a breach that the only result can be termination. Some bond forms will require not only that a default be declared and be in existence, but the general contractor must also be terminated before you can look to the surety under the performance bond. That’s the case under the AIA A312 performance bond – you must terminate the general contractor before you call upon the surety to step in and remedy any default.
Brent: That is interesting. I’ve never heard that. So I’m learning something here today. That really has driven that decision, or let’s just say that clause in the surety agreement, that decision is surety by surety… they make that decision.
Con: Yeah. Well, if we’re talking about a private job, what drives the bond form is generally the bid documents. And you see a lot of AIA forms, Brent, because the architects will put together the bid package and include them – they’re comfortable with the AIA forms, so they just get an AIA form. Some big owners may have their own bond forms. Others may go to other standard bond forms in the industry, like the consensus documents or the engineering documents, the EJCDC documents. Those documents are fairly consistent, that is, the surety bond documents are pretty uniform in terms of what they require. They all are going to require that a default exist, a default be declared, and that there be a termination of the general contractor before a surety is required to step in. Now, there are other conditions in these bonds that the owner has to be aware of and they vary from bond to bond. For example, in the AIA form, the owner must advise the surety that he is making the amount left in the contract, what’s called the balance of the contract price, available to the surety for the surety to use to complete the work.
Are there surety bond documents that don’t require owners’ input?
Brent: Are there surety bond documents that don’t require termination for an owner to step in and request that the surety just take control and reel back in let’s just say the project itself.
Con: here are a few of them, and they’re older bond documents. For example, there’s an AIA document called the 311 Bond Form, which was developed in 1970. And that bond form requires that the general contractor be in default and that the default be declared, but does not require that a termination occur. There’s nothing in the bond that provides that. Sureties have argued that termination must occur under that bond form, but court decisions have rejected that argument and said that you do not need to terminate in order to pursue your bond rights as an owner.
Brent: Interesting. And under those old surety bond documents, default is something that’s defined clearly in the prime contract between the owner and the GC.
Con: Yes, that’s generally the case. The AIA general conditions do that, and general conditions of other contracts do that. Now, depending on the sophistication of the owner and the size of the job, the general contract may or may not actually define what a default is. And in that case, if there isn’t a definition, you would have to look to case-decisions as to what a default could constitute under that situation.
Brent: Great information.
What is funds control and why do Sureties use it?
Con, I’m going to step back here just a second and ask you about funds control. It is something that basically we see from time to time. Some sureties want to take funds control from the outset. Sometimes my understanding is when things are going wrong, substance suppliers aren’t getting paid, they may step in at that point in time and take funds control. Describe to the audience what funds control means and why sureties, do it, or don’t do it.
Con: Well, a funds control is a mechanism whereby the surety actually controls the flow of funds that are received by the general contractor, or at least has veto power over how they’re used. I’ve seen the use of funds control in both situations that you’ve talked about. That is when the bond is issued and when the general contractor gets into trouble. Now funds control is most often used in a default situation or a potential default situation. And the mechanism generally is that the Surety will direct the general contractor to set up a separate bank account, or checking account if you will, to house all of the funds that are received on the project.
Brent: You’re talking about all the payables?
Con: All the payables, correct. All the receipts, all the payments received from the owner. And generally, it’s entitled XYZ Contracting Special account so that the subs and suppliers don’t really know what’s going on. It still looks like a bank account that is controlled by the general contract. And when the funds go into that account, the surety will hire a consultant to work with the general contractor to make sure that the labor and material suppliers are paid out of those funds. And then we’ll allow the general contractor to use some of the funds for its overhead, its own payroll that is applicable to the job. It’s most often, as I said, used in a default situation but I have seen it used when the bond is issued. Sometimes you will have a surety that will issue a bond where a general contractor might be a long-standing account but encountered some difficulties, financial difficulties. But the Surety is still willing to issue the bond provided it can control the funds from the get-go. And I was personally involved in a case like that where I was working with the surety’s consultant and the general contractor. Every time a pay application was prepared, we would review it. It would then go into the owner and when the funds and the owner had a letter of direction from the general contractor, all funds payable against any progress payment would be sent to the surety’s consultant and the consultant would deposit it into the joint control account, what they call the joint control account. And then we would work with the general contractor to make sure labor and material suppliers were paid. And the general contractor does still have some say over how those funds are used. For example, if your drywall subcontractor is behind in his work, the general contractor says, well, he hasn’t really earned the money yet because he’s delayed the job or something along those lines, so in those unique situations, the surety would work with the general contractor to either get the subcontractor up to speed or withhold payment to that particular contractor.
What happens when a surety and client are both trying to get the AR for payment?
Brent: That makes absolute sense. Okay, we’re getting short on time. But there is a question that I have to ask. It’s one that’s near and dear to a lender’s heart. As a finance firm in the construction space, my client’s AR is my primary collateral. In fact, we will always file a UCC 1 financial statement, a blanket lien, which will include the AR. Now, we do fund on bonded projects. We know they’re a little more risky for us, but we do. But on bonded projects, I understand that the agreement between the Surety and my client also gives the Surety the right to the AR as collateral. So, what happens when a project goes wrong and we’re both trying to claw back on that AR for payment?
Con: Well, that raises some interesting issues because one thing we haven’t touched on yet is sometimes a surety will be asked by the general contractor to finance the general contractor rather than go into a default situation, that opens a whole new can of worms. But in a situation you’re talking about where a lender advances funds or lends funds to the general contractor, it will always, I’ve never seen it happen otherwise, file its UCC on the day that the loan documents are filed so it has a perfected security interest as of that date. Sureties, on the other hand, when they issue bonds, do not typically file a UCC statement at that time, although they’re entitled to do it under what is called an agreement of indemnity between the Surety and the general contractor. That is a security instrument like your loan documents. And the Surety generally will file a UCC only when it starts to receive claims, so that the bank, in your situation, will have a prior perfected security interest over the Surety as to those accounts receivable. However, the surety has what’s called subrogation rights. And since it is going to be called upon to actually complete the job and pay to get it done, the law says that the surety subrogation rights to those receivables would be superior to the bank because it’s the one that’s taking the loss on that job. So it would be able to recover the receivable from the owner to the extent of its loss. What the lender wants to do in a situation like that, and the Surety, is get together and try to work out an agreement in advance as to how those funds are going to be treated because it’s in the lender’s interest to get the job done as it is in the Surety’s interest because it’s the best hope that the lender will get the profit from the job, so to speak, which it bargained to get in the first place. It wasn’t bargaining to get the money that would be used by the general contractor to pay its labor and material suppliers to pay its employees, to pay its overhead on the job, its general conditions if you will. It was expecting to receive as collateral the profits from these various projects. So, working with the surety, what would be called an inter-creditor agreement, it’s probably the most sensible thing to do because I’ve been involved in cases where you get into court fights with a lender and the results of those are never pretty. Nobody really wins in the end, although you may have a winner, as a practical matter, nobody wins because of the attorneys fees and other expenses involved in things like that.
Brent: Yeah, unfortunately, we have been there and you’re right, we’ve won, but we never felt like a winner because at the end of the day, the cost of all the legal proceedings, it drains the pot.
Con: Right. And even though from a Surety’s perspective and a lender’s perspective, those attorney fees are recoverable, when you’re both chasing what many times is an insolvent entity, nobody wins.
Brent: You are correct. So, Con, we’re going to have to leave it there. We could talk on and on about the bid and payment and performance bonds.
I want to tell you, it’s been a pleasure having you on this podcast. You have been a treasure trove of information. And I got to tell you, it’s obvious that I and our listeners are walking away from this more knowledgeable on the bonds and the bonds process. For our listeners that are out there, I would tell you, if you’re ever in need or have a need for legal assistance when it comes to bonding in the construction space, give Con a call and I’m sure Lisa has provided that information or will provide that information. If anybody, the listeners do have any questions and they want to get to you, Con, they can come to us at CapitalPlus and get a hold of me and I’ll share that information. So, Con, thank you again for being a participant in this and I’m sure you and I will be talking again soon.
Con: Well, I appreciate the opportunity, Brent. It’s been a pleasure.
Lisa: Thank you Brent and Con for your time today. I’m sure our listeners will find today’s podcast very helpful when dealing with construction bonds, as Brent mentioned. If you would like to speak to Con, you can find his full contact information at RSPlaw.com. Thanks again. Until next time. Be well.
Please note: the information in this article is not legal advice and should not substitute for talking to your attorney.Back to podcasts