Construction Bonds and Arbitration

A large percentage of construction contracts require arbitration if there is a dispute between the owner, general contractor and/or a subcontractor.  At the same time, many general contractors have payment and performance bonds in place for the construction project which do not have mandatory arbitration provisions.  If the owner or subcontractor seeks to call on the payment or performance bond, must the parties resolve the bond claim in arbitration? At the most basic legal level, arbitration is only available with the consent of the parties to the dispute.  Therefore, a court cannot compel a reluctant party to arbitrate a dispute absent a clear agreement requiring arbitration.  Typically, this agreement takes the form of a written contract between the parties to the dispute, whether signed before or after the dispute originated.  Bond claims, however, take a somewhat different form.

Consider the usual scenario for a construction bond.  A contractor enters into a contract with a bonding company for two purposes: (1) to ensure the contractor’s performance of the construction job to the owner of the property (a performance bond); and (2) to ensure payment to  subcontractors (a payment bond).  If a subcontractor is not paid for their work, they are permitted to pursue an action against the bonding company for payment as a “a third party beneficiary”.  If the subcontractor is successful in their claim, then the bonding company will pay the claim and pursue the prime contractor for the amount paid.  Notice that the subcontractor is permitted to claim against the bonding company despite the fact that the subcontractor’s agreement is with the prime contractor, not the bonding company. Most bonding agreements contain language that specifies how an individual or an entity becomes a “claimant” to the bond. 

Contractor Bonding: Defined and Explained

Guest contributer: Danielle Rodabaugh
Construction professionals in the D.C. area are probably familiar with the district's various surety bond requirements. Unfortunately, most contractors have a limited knowledge of contractor bonding beyond the fact that they need it before working on certain construction projects. Contractors should fully understand the legal implications of bonds before they purchase them so they know what they're getting into — otherwise they might find themselves in court.

How do surety bonds work?

Although insurance companies typically underwrite contractor bonds, the protection they provide is very different from insurance policies. When underwriting insurance policies, companies assume a certain amount of risk is involved. This is not the case with surety bonds. Unlike insurance companies, surety providers intend to avoid any and all claims, which is why getting a surety bond is often much more difficult than getting an insurance policy. Furthermore, whereas insurance policies involve only the policy holder and the insurance company, surety bonds involve three entities.

• The obligee, typically a government agency, requires the bond to regulate the market and protect against financial loss.
• The principal, a construction professional, buys the bond as a legal guarantee of future work performance.
• The surety financially backs the construction bond as a show of good faith in the principal's ability to complete the project.

No matter the specific bond type that's issued, every surety bond functions in the same basic way: as a legally enforceable contract. If contractors fail to fulfill the contractual terms of their bonds, they face legal action. To avoid the costly and troublesome claims process, contractors should be sure they fully understand the legal language of each surety bond they purchase.