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Thursday, July 19, 2012

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. 

If the construction contract contains express language requiring the parties to arbitrate any disputes, but the bonding agreements do not contain similar language, is a bond claimant required to arbitrate its claims against the bonding company?  After all, the bond claimant could not pursue a bond claim absent an agreement with the prime contractor and that agreement contains an arbitration requirement.  The other side of the argument, however, is that the bond claimant is not pursuing an action against the prime contractor, they are pursuing a third-party action against the bonding company and the bonding agreement does not contain an arbitration provision.
In Virginia, resolution of this issue is controlled by two trial court opinions.  The first, Blumenthal-Kahn Electric Ltd., Partnership v. American Home AssuranceCo., decided by the United States District Court for the Eastern District of Virginia in 2002, held that  the bond claim was “inherently inseparable” from the subcontractor’s claims against the prime contractor.  Consequently, the court held that, since the prime contractor would be ultimately responsible for the payment of the debt, the prime contractor could require that the claim be arbitrated rather than litigated in court.

The second case, Francis O. Day Company, Inc. v. The Tyree Organization, Ltd., decided by Judge Chamblin of the Loudoun County Circuit Court in 2003, held that the bonding company and the prime contractor were entitled to invoke the prime contractor’s arbitration rights because the bonding company’s liability could not be determined until the prime contractor’s liability to the subcontractor was determined.
What these cases failed to address is whether the bonding company is required to participate in the arbitration proceedings despite having never agreed to arbitrate.  In a case argued by the attorneys at Gross& Romanick, an Arlington County Circuit Court Judge held that, if the bonding company invokes the arbitration clause of the prime contractor’s agreement with the subcontractor, then the bonding company can be compelled to participate in the arbitration. 
Of course, this legal complication would be avoided if the bonding agreement, the prime contract and the subcontractor agreement contained mirrored arbitration provisions.  If arbitration is the preferred method of dispute resolution, then the prime contractor should expressly require subcontractors to arbitrate claims before pursuing a bond action.  Subcontractors should carefully review the dispute resolution provisions of the subcontract, the prime contract and the bonding agreement before signing to ensure a proper understanding of how disputes and payment claims will be resolved, especially if it does not want to be required to arbitrate a dispute. 
Prime contractors and subcontractors alike should always consult with legal counsel regarding the substance of any contract.  Understanding payment terms and dispute resolution provisions before engaging in contract work is the best way to avoid both litigation and arbitration.  The attorneys at Gross & Romanick, P.C. are well versed in the legal nuances of bonding agreements and the broader issues related to the construction industry.