Protections Against Subcontractor Defaults

Among every construction project’s worst nightmares is the subcontractor default, where a particular trade subcontractor cannot meet its contractual obligations due to insolvency, mispricing, or other misallocated risks.  A subcontractor default poses potentially significant damages to the prime contractor and owner including corrective work, costs of completion, and delay.  Two chief options exist to protect against such risks – performance bonds and subcontractor default insurance (SDI)– but choosing one over the other can be complex as each vehicle carries its own unique characteristics and project consequences.

Vehicle Structure and Form.  A performance bond is a three-party agreement between the principal, the obligee, and the surety.  The surety agrees through the bond to answer for the debt or default of the principal.  Any damaged party may make a claim.  In contrast, SDI is a two-party agreement between the insured and the insurer in which the insurer undertakes to indemnify the insured against loss as a result of a contingent default.  With SDI, only the general contractor may make a claim, not the owner.

History.  Suretyship has been around for millennia, with references found in Ancient Greece and the Old Testament.  In 1884 the American Surety Company began underwriting construction performance bonds, and in 1894 Congress passed the Heard Act requiring surety bonds on federally funded projects.  Conversely, SDI has a much shorter history, first created by Zurich N.A. Insurance Company in 1995 and subsequently offered by several others around 2010. 

Intended Use.  Performance bonds are required by statute for any federal or state public project in excess of $100,000, and are also used on some private projects.  Although courts have imposed insurance-like duties (such as claims-handling procedures) on sureties, bonds are not insurance policies.  Typical SDI projects are large, as policies involve annual volume thresholds in the tens of millions of dollars or projects in excess of $100 million.  SDI is also generally not allowed on public projects.

Cost and Deductibles.  Bond premiums vary but can range from 0.5% to 1.5% of the contract amount with the average above 1%.  While there are no deductibles, bonds require an indemnity agreement and collateral, often with personal guarantees.  SDI policies do not require collateral. SDI premiums are typically lower and can be 50%-70% the cost of a bond, not counting deductibles and co-pays.  This lower cost can provide an advantage in bidding a project.  However, many SDI policies carry large deductibles, from $350,000 to $2 million with co-pay sharing at $1 million-$5 million.

Subcontractor Prequalification and Risk Shifting.  With a performance bond, the surety remains responsible for screening and prequalifying subcontractors, investigating any default, and responding to complete the contract or make payments.  However, the surety also has a self-interest in denying the predicate of a default occurrence.  Under SDI, the contractor screens the subcontractors and retains the majority of risk through deductibles and co-payments, which could balloon if multiple defaults occur in the same calendar year.  The contractor might also run into difficulty with subcontractors reluctant to share sensitive financial data.  Still, the contractor retains control of the completion of the project and can maximize efficiencies to avoid further delays and increased costs. 

Damages.  Recoverable damages on a performance bond generally cannot exceed the penal sum of the bond, which can pose a problem in projects involving numerous change orders if the bond sum does not include those changes.  Typically, delay damages are not recoverable on a bond though courts in Pennsylvania and California have allowed recovery.  SDI tends to afford broader recovery for damages, including the cost of completion, losses due to corrections of defective work, indirect losses including possibly liquidated damages, and legal costs. 

Legal Precedent.  Performance bonds’ long history and statutory frameworks provide considerable legal authority that help predict outcomes of disputes under a bond.  Conversely, with SDI there is virtually no legal precedent from which to glean interpretation of disputes, with just a dozen or so reported cases, most not interpreting policy language. 

Summary.  SDI can provide some advantages in the form of lower costs, control over subcontractor selection, and direct management of default situations.  However, there are financial risks to the general contractor, who may also face opposition by subcontractors in the prequalification process.  The dual insurance relationship is not a clear substitute for the tripartite surety bond setup, and the lack of legal decisions regarding SDIs injects a higher level of uncertainty as to how the policies might be interpreted.  Project participants should carefully consider the benefits and risks of all options to protect against defaults prior to commencing their next construction project.

"Protections Against Subcontractor Defaults" was originally published by the Daily Journal of Commerce on Friday, November 20, 2015.