Another Risk Management Tool for Private Owners in a Volatile Market

Originally published as an Op-Ed by the Oregon Daily Journal of Commerce on March 16, 2022.

Given, well, the state of everything, private owners should seriously consider requiring the contractor to secure a performance bond (a third-party surety guaranteeing the contractor’s performance under the contractor’s contract with the owner), when evaluating risks now inherent in construction projects.

Traditionally, private owners did not consider bonds (either payment or performance bonds by the general contractor) due to the additional cost. Naturally, all owners anticipate that all contractors and their subcontractors, suppliers and vendors will perform the obligations of the contract terms, and the owners will make payment for that performance. The current volatile market, much like the Great Recession, should cause owners to question that prior confidence.

Current risks, for large or medium projects, may well bear the cost of a performance bond to provide the owner with an additional tool for the guarantee that the project will be completed for the contract price, and more closely on time than if there were no performance bond. Given the market volatility arising from understaffed contractors and subcontractors due to labor shortages, unskilled labor, supply chain failures, unchecked inflation, value-analysis for alternative products if available, contractor threats to walk if the owner does not agree to questionable change orders, and excessive escalation of cost claims, none of which is covered by traditional project insurance, owners need to evaluate how they will manage these risks if the contractor should fail to perform despite demands to cure a default in performance.

While an owner must look realistically at how to negotiate a reasonable, financially realistic deal so that the risk of a completed project is objectively evaluated or tabled if financially necessary until there is greater stability, the owner may be able to pay the cost for the general contractor to secure a performance bond to hedge against a potential performance failure of the contractor, which may otherwise be ultimately at the owner’s financial risk.

Customarily, where there is no performance bond the owner’s only options in the event of a prospective or actual contractor default is to (a) demand performance, but often under project duress negotiate a resolution and possibly pay more to the contractor to continue performing (under protest, with the hope that the funds may later be recovered), or (b) move through the default and termination process with the contractor (delaying the project further and often without a good substitute), usually resulting in costly dispute and arbitration or litigation, and a stalled project.

If the contractor, however, has its contract covered by a performance bond for the full and faithful performance of the owner’s contract, based on the owner’s viable default claim, the owner will have the option to give notice of the anticipated contractor default to the surety. The notice to the surety on the bond often (a) incentivizes the contractor to properly complete the project under threat of the surety stepping in to perform and the surety then seeking indemnity from the contractor, which the surety has already secured by contractor assets, or (b) among other bond options, require the surety to step forward with a substitute contractor to complete the project for the remainder of the contract value and under the contract time obligations, subject to the contractual ramifications for delay. Therefore, rather than the actual substantive risk ending up with the owner by a contractor default, where there are often difficult and lengthy litigation or arbitration processes for a successful legal “win” by the owner on such a claim, the owner with a performance bond will have an additional tool to use promptly for leverage and better project management to completion at or near the contract time and at the contract value.

It is important to note, however, that surety performance is not automatic, as it does have a duty to the contractor to evaluate the claims made by the owner. In a factually contentious dispute, therefore, the surety may assume all contractor defenses and refuse to live up to the bond commitment, thereby still resulting in arbitration or litigation on the claim by the owner, but with both the contractor and the surety at the table.

Owners must realistically evaluate potential uninsured risks of a contractor’s failure to properly perform the work under the contract. That evaluation, in this volatile market, must include the cost-benefit analysis of hiring a contractor that can provide the owner with a performance bond to better ensure the project will be performed as agreed to and as represented by the contractor.