Never accept an AIA A312 performance bond from a subcontractor

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Bill Blancato

Nor should an owner accept an A312 bond from a general contractor

By Bill Blancato, special to North Carolina Construction News

There is an old adage: “Never say never.” This is usually good advice, but when an owner bonds a general contractor or a general contractor bonds a subcontractor you need to ignore the adage and NEVER accept an AIA A312 performance bond from the general contractor or subcontractor. The following is written from the perspective of a general contractor bonding a subcontractor, but the same rules apply to an owner bonding a general contractor.

Surety companies will tell you that performance bonds are not insurance, which is technically correct, but at a practical level a performance bond insures against the excess costs that may be incurred if a subcontractor defaults. Like an insurance policy, a performance bond should pay promptly and without too much hassle if a covered loss occurs. The form of the bond affects whether the payment is prompt and hassle free or not. Unfortunately, the A312 performance bond is designed to create hassles which can lead to delays, or worse, denial of payment. There are other bond forms that do not have the hassles or risks of the A312, so when bonding a subcontractor you should use one of those other forms.

By statute, general contractors are required to provide performance bonds on all federal projects in excess of $100,000 and all projects for the state of North Carolina in excess of $300,000 or $500,000 if the project is for the University of North Carolina or one of its constituent institutions. On private projects whether or not a bond is provided to protect the owner is a matter of contract between the owner and general contractor.

There is no requirement on federal projects or North Carolina public projects for a general contractor to bond its subcontractors. Bonding subcontractors on both public and private projects is a matter of contract between the general contractor and the subcontractor. Whether to bond a subcontractor depends on several factors: the size of the subcontract, negative consequences if the sub fails to perform, experience with the sub, financial health of the sub, cost of bonding the sub and potential cost of not bonding the sub.

If a general contractor decides to require payment and performance bonds from the subcontractor, the sub’s surety may use its preferred form, send it to the general contractor who notes that the form was received and puts it in a file. With any luck, there will be no subcontractor default and the bond will never see the light of day again. But, if the subcontractor defaults and you need to make a claim the performance bond, the form used can affect when the surety responds, how it responds and whether it responds.

A general contractor bonding a subcontractor is like an owner bonding a general contractor. The same forms are often used. It is therefore instructive to look at the bonds the largest and most sophisticated owners in North Carolina use when bonding general contractors. Those bonds are prepared to protect the interests of the owners. General contractors should insist that the bond forms tendered by their subcontractors protect the general contractor.

Those large sophisticated owners are the United States of America and the State of North Carolina. The bond forms promulgated by the federal and state governments are just one page long and on the face of the bonds there is just one condition to be satisfied before the surety has to perform: the principal, which would be the subcontractor, has to fail to perform. That’s it, if the subcontractor fails to perform, you can make a claim on the performance bond. To be sure, there are some other requirements not specifically stated in the bond such as the general contractor cannot be in default of its obligations under the contract and the general contractor has to make sure it does not overpay the subcontractor, but the face of the bond is simple.

The operative paragraph of North Carolina’s bond reads:

NOW, THEREFORE, if the principal shall well and truly perform and fulfill all the undertakings, covenants, terms, conditions and agreements of said contract during the original term of said contract and any extensions thereof that may be granted by the contracting body, with or without notice to the surety, and during the life of any guaranty required under the contract, and shall also well and truly perform and fulfill all the undertakings, covenants, terms, conditions and agreements of any and all duly authorized modifications of said contract that may hereafter be made, notice of which modifications to the surety being hereby waived, then, this obligation to be void; otherwise to remain in full force and virtue.

The federal form is even simpler. ConsesusDOCS has a similar performance bond form that only requires a subcontractor default, that the general contractor not be in default and that the general contractor make any sum remaining under the subcontract available to the surety to defray the cost of completing the work. Under these forms, there is little hassle and the subcontractor’s default can be addressed promptly, efficiently and in the manner that best suits the project.

In contrast, AIA’s A312 three page performance bond attempts to impose numerous conditions not found in the state, federal or ConsesusDOCS forms. First, you must send notice to the subcontractor and the surety that you are “considering declaring a . . . default,” and you have to state whether you want to have a conference with the surety. If you do not ask for a conference, the surety has five days to request a conference. If there is to be a conference, it is supposed to be held within ten days of the surety’s receipt of the letter. So you have a subcontractor that is not performing which may be affecting the critical path and you have to tell the surety you are considering declaring a default and then wait to see if there will be a conference. You may want to supplement the subcontractor’s forces but if you do that before giving notice that you are considering a default or attending the conference, the surety will argue it is not responsible for the cost of supplementation.

If the first notice and the conference do not remedy the situation, you next have to declare the subcontractor in default, terminate the subcontract and notify the surety. If the subcontractor has abandoned the project why should you have to terminate the subcontract? It’s just unnecessary paperwork, but if you do not terminate, the surety will argue it has no obligation. What if the subcontractor is trying, but just needs some supplementation. You don’t want to terminate the sub because you lose its knowledge about the project. On the other hand, supplementation could cause the cost of the work to exceed what the subcontract price. Supplementation could exceed the subcontract price by hundreds of thousands of dollars which the federal, state and ConsesusDOCS forms would cover, but under the AIA form, if you do not terminate the subcontractor, the surety can argue it has no obligation.

The third thing A312 requires before the surety has to act is an agreement from the general contractor to pay the balance of the moneys owed under the subcontract to the surety or to any replacement subcontractor. The law requires that these funds be available to complete the subcontractor’s work and any surety can raise a defense if a general contractor misapplies the money. But, under A312, if a contractor does not make this formal promise a surety can argue it does not have to respond.

If you successfully clear these hurdles, the surety is supposed to either (1) arrange, with the general contractor’s consent, for the subcontractor to complete the work, (2) undertake to perform the work itself or through independent agents or contractors, (3) obtain bids from other subcontractors to perform the work and arrange for a contract to be entered between the successful bidder and the general contractor, (4) make a payment to the general contractor or (5) deny liability citing the reasons for the denial. And if the surety does not do one of these things, you are supposed to send the surety a notice demanding that the surety perform its obligations within seven days. If you do not send this notice, a surety can argue it has no liability. So a surety can ignore you, but if you do not send a notice demanding that the surety perform, it can argue it owes nothing.

In contrast to the hurdles and pitfalls of the A312 form, the federal, state and ConsesusDOCS forms simply require a subcontractor default, that the general contractor not be in default and that the surety be timely notified of the default. You don’t have to terminate the subcontractor, you don’t have to make a formal promise to pay the contract balance, you don’t have to wait for a meeting and you don’t have to send a notice telling the surety to comply with its obligations just to have a claim under the bond. So to eliminate unnecessary hassles and paperwork in the event you ever have to pull the bond out of the file and make a claim, you should use something based on the federal, state or ConsesusDOCS forms when bonding a subcontractor, not an A312 form.

You have the power through your subcontract to require a reasonable bond form is used. If you decide to bond a subcontractor, you should include a provision in the subcontract specifying the form to be used. ConsesusDOCS 260 Performance Bond is a good choice. Another option is to have your attorney prepare a bond form that suits your needs. The subcontract should require use of your designated form and should also state the any bond provided that does not comply with your form will be deemed amended so it does comply with your form. That way if an incorrect form is submitted and not rejected you can rely on the rule that the bond is construed in conjunction with the underlying contract to argue that regardless of the bond form actually submitted it must be construed in light of the subcontract’s requirements. Of course, to eliminate any argument about what bond form controls, if you receive an incorrect form you should send it back and demand that the proper form be provided.

If you get stuck with an A312 form and your subcontractor defaults, the best thing you can do is strictly follow the terms of the bond so that the surety will not have any arguments to defeat coverage. If you are unable to follow the strict terms of the bond and the surety uses that to try to defeat coverage, your attorney can turn to the line of cases which hold that a bond issued by a compensated surety is to be liberally construed in favor the promissee (the general contractor) and strictly against the surety and that a compensated surety must prove it has been injured by the failure to follow the strict terms of the bond.2 Unfortunately, the courts in North Carolina have not yet applied these principles to a case involving an A312 performance bond and there is no guarantee that the cases about compensated sureties will carry the day. Also, some states still require strict compliance with all provisions of a surety bond and if your project is in one of those states you need to strictly follow whatever bond form is used, especially one with as many steps as the A312.

Editor’s note:  We asked  the writer for his observations on the impact of avoiding the AIA bond on subcontractors.  Here is his response:

How avoiding A312 would affect subs is a little complicated.  Affect on subs is same as affect on GCs when the GC is the one providing the bond.

There should be no affect if there is no default, unless the surety company charges a lower fee if they can use the A312, which I doubt.  And if there is a higher fee for a non A312 bond it should usually be passed upstream to the GC and the owner by being included in the contract price.

The real cost, if any, arises if there is default and a claim on the bond.   The sureties always get a guaranty from the principal which with smaller GCs and subs means personal guaranties from the individual owners.  So if the surety pays, it will have a claim for reimbursement from the guarantors.  But, every performance bond claim I have seen arose in connection with a GC or sub failing through mismanagement and evaporation of working capital.  The GC or sub is out of money which leads to the default.  Which means that the guarantors typically have nothing for the surety to recover.

So if the bonding company avoids paying because it has used A312, the guarantor may not have to face a claim from the surety, but that may not matter much if the guarantor is bankrupt anyway.  Where the A312 may lead to a bigger claim against the guarantor is in accumulation of attorneys fees.  The surety may be more willing to litigate if it has issued A312.  Sometimes attorneys fees are almost as much as the claim.  The worst thing is if the surety litigates, loses and then makes a claim for attorneys fees and the claim payout.  If there had been a simpler form, the surety may have settled instead of running up big legal bills.

Bill Blancato served as general counsel for John S. Clark Company, LLC for six years and is now a member of Doughton Rich Blancato PLLC in Winston-Salem. Bill has experience representing contractors, subcontractors and owners and in drafting and negotiating contracts. Bill is also a certified mediator and serves on AAA’s panel of arbitrators. Bill can be reached at bill@drbattorneys.com.