2nd Source - C111 Chapter 10 Advanced Loss Adjusting

Chapter 10 – Surety Bond Claims

Introduction

-        A bond is an agreement by a surety to ensure that the obligation of the principal (contractor) to the obligee (client) to complete the job is honoured;  surety bonds are mainly used for construction projects

-        Suretyship - the act of legally becoming liable to one party for the debt, default, or failure to perform of another party

-        Surety - insurance company who acts as the obligator and guarantees that the principal will complete the job as set out in the contract with the obligee;  if the principal fails then the obligee will make a claim against the bond for which the surety is responsible
Principal - contractor who purchases the bond from the surety;  the principal also enters into contract with the client to complete the job

-        Obligee - is the entity or person to whom the principal is indebted to complete the job;  the obligee is often the owner of the site where construction is to take place and the building once the job is completed;  this person may own the materials used for construction of the building, even when the building is still not completed;  materials could also have an indemnity agreement which dictates who is in possession of these items in the case of a default of the bond

-        Example - ABC Contractors (principal) has been hired to build an addition to the home of John (obligee) for approximately $60,000.  As part of the contract ABC Contractor was to get a surety bond for $60,000.  ABC gets a surety bond with All Types of Bonding Inc (surety) in this amount.  ABC Contractor takes on many jobs while undertaking the addition of  John's home and is unable to fulfill its obligation under the contract.  John makes a claim against the bond and All Types of Bonding Inc will have to entertain the claim to see if indeed the $60,000 bond will respond

-        The largest purchaser of construction bonds is the federal government

Unique Characteristics of Surety Bonds

Surety v. Insurance

Surety	Versus	Insurance
-        Contract made on the basis that no losses will be incurred -        In the case of default by the principal the surety must pay the obligee -        Surety expects to recover any payments made from the principal, indemnitors, or any other forms of security negotiated -        Surety verifies principal's worthiness and technical competence to the obligee (owner) -        Bond remains enforce until the job is done		-        Contract made on the basis of a pure risk, where a loss is expected to occur, and the contract will respond if the loss is due to a covered peril -        The primary function is to indemnify the insured -        Subrogation recovery is only able to be pursued if a negligent party is responsible for the damage, however if there is no tortfeasor and the loss occurs due to a covered peril (which no tortfeasor exists), then there is no chance of recovery -        The insurer enters into a contract with the insured based on its underwriting (UW) guidelines;  there is no verification by the insurer to any TP since the only parties to the contract are the insured and the insurer -        The contract remains enforce from effective date to expiry date;  if a loss were to occur and the property or injury were to be resolved before the expiry date, the contract remains in good standing and will respond to a subsequent loss as long as the policy contract has not expired

Claims Process

-        The adjuster or consultant working for the surety will have to take quick action in a claims situation because this way there is better control over the loss exposure

-        The claims sequence includes the following:

·         Understanding the contracted obligations

·         Investigating those obligations

·         Resolving the obligations in accordance with the bond

Indemnity Agreement

-        The indemnity agreement is valuable during the claims process because it supports the right of the surety to recover from any loss and this can be used as leverage to resolve a potential claims situation

-        Indemnity Agreement

·         Side contract to a bond which is executed before the bond is issued

·         Provides separate rights to the surety to have property assigned or transferred to itself

·         The agreement will have loss payments reimbursed or to recover funds from the principal to relieve a default

·         The agreement accomplishes for the surety that indemnitors (principal) would agree to assign and transfer their interest for specific assets associated with the project, like contract funds, material for the project, tools and equipment

-        General Indemnity Agreement

·         This agreement will be between the principal the surety  and is structured to apply to any subsequent bond issued by the surety to eliminate the need to sign a new indemnity agreement for each and every bond issued

-        Validity of the agreement needs to be checked by the loss adjuster to see if it can be upheld against each of the indemnitors; if validity is in question then the agreement may not be enforceable
Example - When a spouse has limited business experience and would be considered a vulnerable or weaker party in contract negotiations, the spouse should be made to seek legal help and this should be documented by obtaining from the spouse a Certificate of Independent Legal Advice.  The spouse must understand the consequences of the legal commitment

-        The indemnity agreement cannot be amended once the loss has occurred

-        Indemnity agreements are not registered documents, i.e. the contractor is free to use the assigned assets to secure financing in order to fulfill its obligation to the obligee, also this causes the surety NOT to be first in line to collect on property to be assigned or transferred

-        The indemnity agreement will also have provisions on how notice is to be given, and the loss adjuster must follow these provisions strictly to enforce the surety (insurer's) position

Bond Forms and Claim Procedures

Construction Contract Bond Claims

Bid Bond Claims

-        A bid is an offer to enter into a contract; if the bid is accepted, a contract will be formed

-        Bids are submitted in response to an invitation for bids or some other solicitation

-        Bid Bond

·         Form of financial guarantee and is submitted with the bid

·         Joint promise by principal (the bidder), who is primarily liable, and surety who is contingently liable, that the principal will enter into a formal contract

·         A default occurs when the principal fails to enter into the contract after the bid is accepted

-        If the bidder fails to enter into the contract the bid bond will dictate the damages to be paid to the obligee and both the principal and surety may be liable for any damages

-        In a standard bid bond the damages are limited to 10 % of the amount of the bid or the difference between the amount of bid and amount eventually contracted with a new contractor, whichever is less

-        Bid bond claims are caused by the following

·         The financial collapse of the bidder between the submission of the bid and the awarding of the contract

·         A revocation of the bid by the bidder after recognizing that a mistake was made in the amount of the bid

·         Delays caused by the obligee in executing the final contract

-        In the case where the principal ceased to do business, then any other bids that were made are reviewed; if the bidding prices are relatively close, the obligee (client) can contract with the next lowest competent bidder

-        The surety will settle with the obligee the difference between the new bid and the failed bid but the precondition to settlement depends on the new bidder being:

·         being competent

·         responding to the bid invitation in the same way as the principal

-        When there are delays in awarding the contract, the principal may find it difficult to do the job at the original price quoted; the bid bond specifies a time period to enter a contract following acceptance of the bid and delays with this time frame can cause hardship to the principal

-        When hardships are clearly established the principal and surety may be relieved of any further obligation

-        Making a mistake is the most common reason to withdraw a bid or to refuse to enter into a contract; 

-        Bid mistakes occur because:

·         preparing a bid is a complex process where tremendous amount of information from any sources is required

·         the bid bond amount was incorrectly calculated and the bidder's course of action has been changed

·         the bid bond amount is below the cost of performing the contract and the bond is forfeited to mitigate the losses versus the increased cost of completing the project

·         simple mistakes like addition or subtraction, typographical errors, or transcription errors have materialized which cause the bid to be miscalculated

-        If the bidder's liability extends beyond the bond limit then this could be a source of disagreement with the surety and affect how the claim should be handled

-        The bidder may NOT be free to withdraw unless there was a genuine mistake of fact which must contain the following factors:

·         The mistake affects a material element of the agreement that prevented a meeting of the minds

·         Enforcement of the contract would be unconscionable

·         It was an honest mistake and not the product of negligence

·         The parties remain in essentially the same position as before the bid

-        The items which should be reviewed in a thorough investigation when a claim is made against the bid bond are:

·         Original tender specification

·         Contract general conditions

·         Bidder's working paper

·         Actual bid itself

Performance Bond Claims

-        Construction Performance Bond

·         principal has the primary and ultimate obligation to build and complete the project

-        Surety and principal are jointly and severally liable to the obligee for claims under the performance bond

-        A claim can be presented directly to the surety, bypassing the principal

-        Joint and several liability commits the surety to the obligee, even if the principal is:

·         no longer solvent

·         gone out of business, and/or

·         incapable of responding to the allegation (usually due to death)

-        The bond provides the surety with options on how to fulfill the contract, but the obligee may put pressure on the surety to choose a certain course of action

-        The obligee must prove the following in order to advance a claim under the performance bond:

·         the principal must be declared to be in default of the contract

·         principal must actually be in default of the contract independent of obligee's accusation

-        Most construction contracts have various termination and default provisions
Example - A contractor fails to perform on schedule, the client/owner can invoke a termination provision by providing the reason for the delay and giving notice of its intention to terminate the contract; the contractor may have valid reasons for not continuing the work and therefore have grounds to refute such a position; the loss adjuster must thoroughly investigate the reasons behind the notice of default

-        When the principal is declared in default by the obligee the usual procedure is for the obligee to make a claim against the surety to force performance of the construction contract

-        The three (3) main docs that need to be reviewed by the adjuster are:

·         bond form

·         indemnity agreement

·         principal's most current financial report

-        Other documents that need to be reviewed by the adjuster are:

·         Monthly progress estimates

·         Construction contracts; change orders and specifications

·         Job log records and daily reports

·         Correspondences between obligee and principal

·         Financial records of principal

·         Receipt and disbursements of all contract funds

-        When a default occurs the surety has a duty to promptly investigate it.  Any delay could potentially:

·         increase the cost of completing the project

·         cause other financial loss exposures to the obligee

·         result in allegations of improper claims handling which could lead to additional damages

-        Surety Association of America recommends the following claims handling practices:

·         Promptly acknowledge communications relating to a claim

·         Promptly undertake an appropriate investigation to determine its liability

·         Promptly advise claimants of its position, based on its investigation

·         Promptly provide assistance to the principal, if such actions are needed to resolve the claim

·         Promptly provide the specific basis for denial of claim

·         Promote adherence to these principles by its employees, lawyers and consultants

-        The surety's obligations are discharged under the performance bond in the following ways:

·         Remedy the default

·         Complete the contract

·         Retender the contract and arrange for a new contractor to contract directly with the obligee to complete the work remaining

-        The factors that will influence the decision taken by the surety with discharging its obligations are:

·         whether the contract is close to completion

·         quality of workmanship

·         potential for delay penalties

·         potential of additional claims for or against principal

·         fund availability

·         cooperation of principal

·         financial involvement of indemnitors

·         cooperation of obligee

Remedying the Default

-        Surety may act as a lender only when the contractor is competent but the cause of default is a lack of capital

-        Lender of Last Resort

·         surety advances money to the contractor (principal) due to a lack of capital to complete the work

·         the moneys advanced will allow the work to continue and cure the default

-        The disadvantages of the surety lending money to the principal are:

·         loans (money advanced to the principal by the surety) are usually a permanent loss to the surety

·         loans provided to the principal do NOT reduce the penal sum of the bond and the surety could incur higher costs on a claim that is beyond the penal limit of the bond

·         the surety will have to ask the obligee to reduce the penal sum of the bond for the amount lent to the principal, in which the obligee must accept or refuse

-        The factors the surety takes into consideration when being the lender of last resort are:

·         careful analysis of the factors contributing to the default

·         the conditions of the contract on the project

·         other bonded and unbonded projects the principal is involved in

-        Benefits of lending money to the principal are:

·         keeping up job momentum

·         the shut-down of the job may increase the cost of any subsequent claim

-        Financing is accomplished in two (2) ways:

                             I.     Lending money directly to the principal through a jointly controlled bank account

                          II.     Guaranteeing a bank loan to the contractor

Surety's Completion of the Contract

-        Second option available to the surety is to hire its own consultants or contractors to complete the defaulted job

-        If the job is close to completion the surety will hire either a engineer, consultant or construction manager to complete the project;  if possible the surety will use the defaulted principal's work force to complete the job, but if the workforce is not available then the surety will hire a new contractor with its own work force

-        The loss adjuster must negotiate a price for the remaining portion of the job with the new contractor

-        The loss adjuster must limit the liability of the surety in regards to the penal sum and execute a takeover agreement with the obligee to state the max amount that will be paid is the stated limit in the performance bond

-        The disadvantages in exercising this option include the following:

·         Difficulty in fixing definitive cost for completion

·         Various warranty obligations that extend past the completion of the project

-        The surety may be liable for warranty obligations well beyond the completion of the actual construction of the physical building

Surety's Retendering of the Contract

-        Retendering the contract allows the surety to rebid the project, obtain another contractor to complete the work, and have the new contractor enter the contract with obligee to complete the work

-        The surety will reimburse the obligee the difference between the remaining contract funds and the cost of completing the project with the new contractor

-        The following will need to be considered when retendering the contract are:

·         How much work remains in order to finish the project?

·         The difference in cost to complete the project and original contract now in default?

·         Using original work force or use new contractor's crew to finish the job?

·         Needing the obligee's engineer, architect, and consultant to establish what work remains to be done

-        Relet

·         rebidding the project by public tender or the hiring of a preferred contractor because the original contract is now in default

Buying the Bond Back

-        This is an extra-contractual alternative that is not specified in the original performance bond

-        This involves the surety negotiating a settlement by paying a sum of money in exchange for the obligee surrendering the performance bond

-        This is usually done when the obligee is financially secure to complete the job on his/her own and is willing to receive a lump sum from the surety as settlement

Government Performance Bond

-        The Government is the largest purchaser of bonds in Canada

-        Being the biggest consumer of bonds the government insist sureties use bond wordings that reflect the government's needs

-        Government bonds do NOT permit the surety to retender the balance of any defaulted contract

-        The surety may retender the defaulted contract with a new contractor but it must deal directly with the new contractor and NOT involve the government

-        The surety remains primarily liable for the completion of the contract even though a new contractor is actually completing the work for a defaulted principal

Owners'/Obligees' Breach of Contract

-        The surety's obligation come to the forefront when the principal is accused by the obligee to be in default and is then determined to be actually in default, however the obligee must have also fulfilled all its obligation under the contract

-        If the owner has defaulted on the contract, the default must materially affect the risk otherwise the surety's responsibilities under the bond remains intact

-        Defences can be used by the surety against any accusation of default presented by the owner against the principal if for example:

·         the owner delays in administering the contract which causes the principal to incur further expenses

·         late payments by the owner to the contractor can also cause delays resulting in increased expenses for the principal

-        The surety must think like the principal and review the entire job history (from bidding to the declaration of default) to evaluate the claims and defences available that will be in favor of the principal

-        Possible breaches of contract can involve:

·         unresolved change orders

·         design and site problems

-        The materiality of these problems must be investigated and the extent which these items have prejudiced the contractor need to be quantified;  depending on the level of affect the owner's actions have taken on prejudicing the principal, the surety may be relieved of all its obligations under the performance bond

-        Bond Limitation Period

·         Any claim advanced by the obligee must be commenced within 2 years following the date of the final payment made under the contract was to fall due

·         Defects in the principal's work which obligee could have detected with reasonable inspection must fall within 2 years from the final payment under the contract was to fall due

·         Latent defects (not detectable by reasonable inspection of the obligee) are claimable beyond the specified 2 year limitation period

Receivership/Bankruptcy of the Principal

-        When the principal declares it is insolvent (bankrupt) and appoints a receiver, either by the principal's secured lenders or by the court, will actually be considered a default of the construction contract;   the surety will be forced to step in as the obligee will issue a declaration of default against the bond

-        In rare situations the receiver may elect the principal to complete the job in order to generate cash flow which will be used in the insolvency of the principal's estate

-        The obligee should consult the surety for further instruction while the principal is in receivership, otherwise if the owner doesn't ask the surety for further instruction, the surety can use this as a defence against any claim made against the bond by the obligee

-        The option to have the principal complete the job while in receivership is a great option as long as the principal is bound by the same contractual terms and conditions, however when the principal is in receivership, the receiver will rarely agree to this option

-        Bankruptcy and insolvency laws in Canada permit insolvent parties to conduct business and delay any proceedings against them by their creditors;  the insolvent principal can tender a proposal outlining its reconstruction of the company to the courts, making it difficult for the surety to recover any funds from the surety or permit any loans by itself (lender of last resort) or securing any loans by another financial institution (where the surety acts as a guarantor for the principal)

-        The surety's and the principal's obligations are joint and several to the obligee;  the obligee has the right to make a claim against the bond and his rights are unaffected by the insolvency of the principal

Labour and Material Payment Bond

-        Labour and material bond

·         Guarantees to an obligee that principal will pay its sub-contractors and supplies for labour and material used in the performance of the contract

·         This bond is purchased separate to the performance bond

·         This bond allow unnamed suppliers and sub-contractors to make a claim directly to the surety

-        Second tier claimants

·         In reference to labour and material bonds are suppliers and sub-contractors of those parties having a contract with the principal

-        Private and public sector labour and material bonds are subject to the time limitations for reporting and legally enforcing claims;  any claim that fails to comply with the notice provisions can be denied

-        Statute laws may provide relief for claimants if the surety hasn't been prejudiced by the delay in reporting the claim

-        A claimant under the labour and material bond can present a claim to the surety and it is not a requirement of this bond that the principal be default of its contract with the obligee

-        When investigating a claim under the labour and material bond the adjuster must review the relationship between the claimant and the principal, the contract between the sub-contractor and principal, the purchase order between the supplier and the principal, and all subsequent transactions

-        Documents that are reviewed with respect to sub-contractors in a labour and material bond are:

·         Progress certificates

·         Change orders

·         Invoices

·         Payments

·         Warranty obligations

-        Documents reviewed with respect to material suppliers in a labour and material bond are:

·         Shipping advices

·         Invoices

·         Payments

·         Warranty obligations

-        All forms of labour improving the construction project are claimable under the payment bond

-        Improvements

·         Any further work to complete the building structure as per the contract specification

·         Includes materials and supplies used in improving or adding to the value of the project

-        The bond covers improvements above and also covers parties who provide essential services and certain equipment rentals

-        Excluded from coverage are capital purchases made by the principal

-        Labour and material claimants in many default situations will place a construction lien on the work as well as submit a claim to the surety; a lien on the project discourages owners from paying contract funds

-        The surety can take the following action when a lien is placed on the property:

·         Surety may elect to take assignment of the lien and then discharge it when it is appropriate to do so

·         Surety may assume the position of the lien holder and be entitled to hold back funds which were retained under the contract (the indemnity agreement)

·         Surety can do the above and improve entitlement to contract funds by taking over such assignments

-        Claims are likely to exceed limits of bond especially following the financial collapse of a major contractor due the large number of claims

-        The loss adjuster must review each bonded project separately and indentify each party and the project or projects they were working on;  most bonds are limited to 50% of the contract value

-        The loss adjuster must make reasonable efforts to investigate how much is owed on any project before making payment

-        The surety can pay these claims on a first-come, first-served basis; however, the drawback would be that even if a claimant was to submit their claim before the limitation period, the claim could go without payment due to the order in which the prior claims were paid resulting in the exhaustion of the bond limit; if limits are exhausted before the claimants turn there is no recourse for the claimant against the surety

-        The labour and material payment bond is extremely useful to the loss adjuster who must consider the options for completing a contract under the performance bond;  the ability to pay sub-contractors and suppliers will generally facilitate better cooperation between the parties

-        The adjuster should take into account the following with respect to warranties and guaranties on work performed and materials supplied:

·         Acknowledge receipt of claim from the claimant(s)

·         Request for documents confirming the liability issues alleged by the claimant(s)

·         The loss adjuster reviews the principal's records to verify the extent of liability, if any exists

·         The claimant should present all warranties and guarantees for work performed or materials furnished in accordance with the contract provisions to the adjuster for review

·         The loss adjuster will advise claimant(s) that the terms of the payment for subcontractors will only be paid when the principal is paid by the obligee; even if work was completed by the subcontractor payment under the bond will NOT be available unless the owner pays the principal for the completed job or the obligee has made an interim payment

Salvage/Recovery/Pursuit of Indemnitors

-        Salvage with respect to surety bonds are:

·         Any right to recover losses after payment

·         Includes surety's right to contractual indemnity and subrogation from the principal, indemnitors and their bankruptcy estates

·         Indemnity agreements and subrogation are constructed upon the idea that the principal remains the primary entity with respect to any claim and the surety is brought in place of the principal in the even the principal fails

·         The surety will pursue all actions against the principal to recover any money that has been paid from the bond

-        The consideration of salvage is an important part of the overall strategy in investigating, adjusting, and resolving all bond claims

Contractual Indemnity

-        Despite the commitment obtained by the surety from the principal and the indemnitors, may sureties find these individuals and corporations unwilling to commit their financial resources before or after the surety has made actual payment under the bond

-        Indemnitors will defend their position by claiming the surety either paid too much or went beyond the principal's responsibility

-        Most indemnity agreements give the surety substantial latitude in settling or compromising claims advanced to them and it is the indemnitor who must prove the surety acted in a lack of good business judgement and/or in a lack of good faith dealings

-        When a claim is advanced against the surety, the surety should invite the indemnitor in writing to participate in the solution to resolve the claim;  the surety doesn't need to wait for the indemnitor to respond and can act without the indemintor's approval; the surety is not relieved of its duty if the indemnitor doesn't participate in the claim resolution

-        Some indemnity agreements permit the surety to pursue the indemnitors immediately upon posting a reserve; this is an effective strategy against a hostile indemnitor

Salvage from Third Party

-        It may become apparent to the surety that there are circumstances that implicate another party like:

·         Engineers

·         Architects

·         Other trades persons not contracted by the principal

·         Insurance brokers

·         Chartered accountants

-        Through subrogation the surety can advance claims against these individuals and corporations to recover damages

-        The loss adjuster must preserve the surety's right to permit recovery as the surety may not be in a position to pursue subrogation immediately

Miscellaneous Bonds

-        Other types of bonds include:

·         Fiduciary bonds

·         Court bonds

·         Permit bonds

·         License bonds

·         Tax bonds

-        Some bonds are written on a forfeiture basis, but this is rare

-        Forfeiture Basis

·         In the event of a claim the entire penal sum of the bond is payable to the obligee

·         The obligee is required to return any part of the penal sum no used in settling claims

-        When a loss adjuster processes a claim s/he should:

·         Review the specific bond wording

·         The actual performance guaranteed

·         The indemnity provisions;  these are usually found in the application submitted by the principal

-        For most of the bonds mentioned above there are no additional indemnitors and recovery is limited to pursuing the principal