The Increasing Importance of Performance Bonds

There are now 25 states in the U.S. that hold that construction defects are not an “occurrence” and are therefore not covered under commercial general liability policies insuring contractors.  Couple this troubling statistic with the ever increasing number of policy exclusions and limitations, and we begin to realize that in many situations the contractor’s insurance policy is inadequate (or non-existent) protection against defects. 

The importance of performance bonds as security to pay for construction defects is therefore growing.  While some sureties who sell the bonds will tell you that bonds merely guarantee completion, and do not insure against latent defects, the language of the typical bond defies this position.

 

Bonds plainly state that they guarantee each and every obligation of the contractor under the contract.  Those obligations usually include the duty to perform work according to the plans and specifications, the standard of care, and without defect or nonconformity.  This author has not seen a bond that attempts to carve out construction defects from its coverage.  And bonds do not have the host of exclusions or limited coverage grants that plague the value of insurance policies.  By the same token, bonds are not perfect and owners should consider the following to get the most protection from a bond:

 

First, the bond duration should extend at least as long as the warranty period (typically one year from completion but sometimes longer) and for as many years thereafter as possible, up to the statute of repose period in the state in which the project is located.  Because construction defects often appear years after completion, the bond duration is critical.  You may pay more for a bond with a longer duration, but if the bond is needed, you should be paying less for the unreliable insurance carried by the contractor.

 

Second, the bond should recite that the surety will be bound by the same dispute resolution procedures that the contractor is bound to follow with the owner.  Assuming the contract calls for consolidated dispute resolution (as it should), the surety will then participate directly in the case rather than sitting at the sidelines awaiting a second proceeding against it.

Third, make sure the surety waives any requirement for notice or approval of contract amendments, including those which increase the contract price, and ensure the surety waives and does not require any special notices from the owner which could jeopardize the owner’s rights under the bond.

 

There is no such thing as a risk-free construction project, so owners need to carefully consider in each state whether the insurance resources are adequate or whether a strong bond is required to hedge against the risk of construction defects. 

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Steve Passerine - May 26, 2011 10:28 AM

Great article, as a bond specialist since 1977 I was wondering when someone would "catch" the term Performance, and expand that to construction defect. It would be hard to refute that a construction defect is not covered by the Performance Bond as the bond guarantees performance of the work in accordance to the contract. California has patent and latent defect clauses in the civil code that outline work warranty periods, (337.1 and 337.15) as 4 or 10 years. It could be argued that the Bond is a legal instrument and therefore must adhere to the law, as such the surety is stuck for the prescribed warranty periods.

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