March 10, 2012
A general contractor* on a private construction project is sometimes required to furnish bonds to an owner, the costs of which are usually borne by the owner as part of the contract price. Generally, three bonds are required: a performance bond, a payment bond and a lien bond. The focus of this article is on the additional exposure to a general contractor created by furnishing a payment bond and a lien bond.
By and large, a general contractor is liable to pay its subcontractors in accordance with the terms of the subcontract agreements. Payment and lien bonds create additional direct contractual rights in the general’s subcontractors, lower tier subcontractors and their suppliers against the general contractor and its surety, which do not exist absent the bonds. In other words, a general contractor’s payment obligations are increased beyond its obligations in its subcontracts.
Owner Fails To Pay General Contractor
By way of illustration, assume an owner is a single-purpose entity created to develop the project and that the general furnished payment and lien bonds for the project. Further, during the course of the project, additional project costs exceed the owner’s financing and the owner becomes insolvent and is unable to pay previously approved requisitions or to finish the project. Because the owner’s failure to pay has rendered the general unable to pay the subcontractors, they may bring direct claims against the general under the subcontract or the bonds and may also bring claims against the surety based on the bonds.
Assuming the subcontracts have enforceable pay-if-paid clauses, payment claims for amounts the general contractor has not received will be barred. However, the surety may not be able to avoid the payment bond claims unless the subcontract and bond language allow the pay-if-paid clause to extend to bar claims against the surety as well. Even with favorable subcontract and bond language, it is uncertain whether a Massachusetts court would extend the pay-if-paid language to the surety.
More importantly, the general contractor and surety will not have similar defenses to the lien bonds claims. A lien bond claim is in lieu of a mechanic’s lien claim against the project property and the claimant need only provide that is entitled to payment in accordance with the requirements of the Massachusetts Mechanic’s Lien Law (M.G.L. c. 254) and that it has complied with the terms of the lien bond; the claimant does not have to prove that the general contractor is directly liable to the subcontractor. The general and its surety cannot avoid the subcontractor lien bond claims under these facts.
If we change the facts of this illustration by assuming that the general contractor did not furnish any bonds for the project, the first tier subcontractors’ direct claims against the general would be barred by the pay-if-paid clause because the insolvent owner failed to pay the general. Further, lower tier subcontractors that do not have a direct contractual relationship with the general contractor would not have any rights against the general contractor. The first tier subcontractors and lower tier subcontractors would be entitled to lien the property pursuant to the Mechanic’s Lien Law and recover to the extent there was any equity in the project property, but the general contractor is not liable under those circumstances.
This alert is one of a series of publications by Murtha Cullina LLP and should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only, and you are urged to consult your own lawyer concerning your own situation and any specific legal questions you may have.
Subcontractor Fails To Pay Lower Tier Subcontractors
In yet another scenario, a subcontractor fails to pay its lower tier subcontractors and then becomes insolvent leaving the lower tier subcontractors to make claims against the payment and lien bonds furnished by the general contractor and its surety. The unpaid lower tier subcontractors, which did not contract directly with the general contractor, can collect on either the payment bond or the lien bond. Without the bonds, the lower tier subcontractors would not have a claim against the general.
Bonds Are Not Insurance Policies
A general contractor furnishing bonds must understand and appreciate that bonds are not insurance. The bond premium charged by a surety company is calculated upon a zero loss basis. Any claims paid by a surety plus any expenses and losses incurred as a result of the surety issuing the bonds will require that the general contractor fully reimburse the surety company for its costs, expenses and losses. Therefore, where bond claims are made in the above illustrations, the general contractor and likely its principal owners, as indemnitors, will be required to reimburse the surety.
How To Guard Against This Additional Exposure
What can a general contractor do to eliminate or minimize the increase in exposure created by furnishing a payment bond and a lien bond? To avoid furnishing bonds to the owner, a general contractor can seek to have the owner accept bonds furnished by the major subcontractors and their sureties rather than the general contractor and its surety. While it cannot be said that this procedure is generally accepted, historically it has been accepted in enough instances to be worth the effort. It is also worth while to show the owner just how much it will cost to provide performance, payment and lien bonds and that the owner can achieve a significant contract savings at the very beginning of the job by foregoing the bonding requirement.
In those instances where the requirement for bonds is driven by an astute owner’s lender who insists upon a statutory form of lien bond and the lender’s form of payment bond both furnished by the general contractor, there is little that can be done to avoid the increased exposure. The general contractor will have to provide those bonds if it wants the job. It can however, reduce its increased exposure by requiring its major subcontractors to provide performance, payment and lien bonds. Then, in the event a major subcontractor defaults on its subcontract, for example by not paying its lower tier subcontractors, both the general contractor and the lower tier subcontractors will have claims against the bonds furnished by the defaulting major subcontractor and its surety.
If the general contractor is obligated to provide the bonds, it may also want to negotiate terms into the general contract that require the owner and its lender to provide monthly reports on the project financing including the initial loan amount, current project costs, current loan balance, remaining amount of loan to be disbursed, and projected project costs. Armed with this information, the general contractor should be able to anticipate potential payment difficulties by the owner.
Although payment and lien bonds are not always required on private projects, a general contractor should be aware that by obtaining such bonds on a private project it is creating new exposure for subcontractor and lower tier subcontractor payment claims that the general contractor would not have but for the payment and lien bonds.
*For purpose of this Alert, the terms “general contractor” and “construction manager” are interchangeable.
Should you have any questions with regard to the above, please contact your attorney or an attorney in our Construction practice group.
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