Standard construction document CCDC

a guide to constructionsurety bonds

Canadian Construction Documents Committee

222002

TABLE OF CONTENTS

INTRODUCTION

1. WHAT IS SURETYSHIP?

1.1 HISTORY

1.2 WHAT IS A SURETY BOND

1.3 TYPES OF CONSTRUCTION SURETY BONDS

1.4 DEFINITIONS

1.5 HOW SURETY BONDS DIFFER FROM OTHER FORMS OF SECURITY?

2. HOW SURETYSHIP WORKS

2.1 THE THREE Cs OF SURETYSHIP

2.2 INDEMNITY AGREEMENTS

2.3 HOW TO GET THE BOND?

2.4 WHAT DOES THE BOND COST?

2.5 VALUE ADDED TAXES

3. BOND FORMS

3.1 CCDC 220 BID BOND

3.2 CCDC 221 PERFORMANCE BOND

3.3 CCDC 222 LABOUR AND MATERIAL PAYMENT BOND

The Canadian Construction Documents Committee is a joint committee composed of owners andrepresentatives appointed by:

The Association of Consulting Engineers of CanadaThe Canadian Construction AssociationConstruction Specifications CanadaThe Royal Architectural Institute of Canada

Committee policy and procedures are directed and approved by the constituent organizations.

This document has been endorsed by each of the above organizations and the Surety Associationof Canada.

Enquiries should be directed to:

The SecretaryCanadian Construction Documents CommitteeSuite 40075 Albert StreetOttawa, OntarioK1P 5E7Tel: (613) 236-9455Fax: (613) 236-9526www.ccdc.org

or

The PresidentSurety Association of Canada6299 Airport RoadSuite 709Mississauga, OntarioL4V 1N3Tel; (905) 677-1353Fax; (905) 677-3345www.surety-canada.com.

CCDC guides are products of a consensus-building process aimed at balancing the interests of allparties on the construction project. They reflect recommended industry practices. Readers arecautioned that the guides do not deal with any specific fact situation or circumstance. CCDCguides do not constitute legal or other professional advice. The CCDC and its constituentmember organizations do not accept any responsibility or liability for loss or damage which maybe suffered as a result of their use and interpretation.

CCDC Copyright 2002

Must not be copied in whole or in part without the writtenpermission of the CCDC.

Standard Construction Document 2002

CCDC 22 2002 1

INTRODUCTION

The purpose of this guide is to help the construction and business communities in Canada betterunderstand surety bonds and the suretyship process. This guide was prepared by the Surety Sub-Committee of the Canadian Construction Documents Committee (CCDC) and is endorsed by theconstituent organizations of the CCDC and the Surety Association of Canada.

Surety bonds are by far the most common means of securing contractual obligations in theconstruction industry today. Bonds are unique in that they are the only contract securityspecifically designed to be used with construction contracts. Despite their extensive use,however, such bonds and the suretyship process are not well understood. Those who use bondsas an integral part of their business (i.e., contractors, construction purchasers, subcontractors,suppliers, design professionals and even surety companies themselves) often have divergentideas about and expectations of surety bonds and the suretyship process. Too often bonds areperceived as an obstacle another document to obtain before the bid is submitted or the contractis signed. This Guide attempts to fill the information gap and assist all sectors of theconstruction industry in using surety bonds to their advantage.

The following pages describe the suretyship process and clear up some commonly heldmisconceptions. The guide is divided into three parts. Part 1 reviews suretyship, what a bond isand how it differs from other risk management tools. Part 2 discusses how suretyship works inpractice, how bonds are obtained, the requirements of a surety company, and how the companyproceeds through the prequalification process. Part 3 examines the various forms of bonds witha view to understanding the purpose of each bond and the claims process.

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1. WHAT IS SURETYSHIP?

1.1 HISTORY

Although North Americas first corporate surety bond was written in Canada in 1872, it wasntuntil the Post-World War II that suretyship was used extensively by public constructionpurchasers and became the preferred method to provide third-party assurance that a contractorscontractual obligations would be met.

More recently, the Canadian surety industrys commercial results have proven to be extremelyvolatile. During the 1990s, the industry showed tremendous growth and profitability, but thencame a downturn of unprecedented proportions.

The formation in 1992 of the Surety Association of Canada signalled the industrysdetermination to ensure that the product and process keep pace with the business realities of theconstruction community and the demands of the construction purchaser.

1.2 WHAT IS A SURETY BOND ?

A surety bond is a contract by which a third party (the Surety) guarantees that one party (thePrincipal, usually a contractor or subcontractor), fulfills its obligation to a second party (theObligee, usually an owner or general contractor). More simply, a surety bond is a third-partyguarantee of the Principals performance.

All bonds are structurally the same, and share a number of common features. A bond is afinancial instrument. The first paragraph of any bond, including bid, performance and paymentbonds, is identical: it is a promise on the part of the Principal and Surety to pay up to the bondamount to the Obligee.

Other paragraphs define the conditions that trigger liability under the bond. The conditions ofthe various types of surety bonds are different. In a performance bond, for example, thecondition is the performance of the obligations set out in the underlying contract. If the contractis performed, the obligation of the Surety, as set out in the first paragraph, is no longer an issue.

There is one aspect that sets a surety bond apart from other forms of contract security. Undersurety bonds, the obligation of the bonding company is secondary. The Obligee cannot claimunder a bond until the Principal is in default under the contract. That said, however, theobligation itself is joint and several in that both the Principal and the Surety are obligated toperform under the terms of the bond. In other words, if the Principal is unable to perform, theobligation to perform is owed by the Surety.

The on default nature of a surety bond raises a question often asked of surety companies:What constitutes a default under a construction contract? That question is not easy to answer andthe existence of default is determined largely by the terms of the contract and the particularcircumstances and problems of the job at hand.

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While there is no one size fits all definition, there may be some guidance that can be given.Perhaps a good rule of thumb in deciding when to declare default is to look carefully at the issuesraised and assess their effect on the overall performance of the contract. A bonding companyshould be called in when the non-performance of a contractual obligation is so significant in itsimpact that it becomes difficult or impossible to continue with the work. Some examples wouldbe:

- Insolvency of the Principal

- Abandonment of the site by the work forces of the Principal (provided this was not theresult of a breach on the part of the Obligee)

- Extensive delays and scheduling problems on the part of the Principal.

1.3 TYPES OF CONSTRUCTION SURETY BONDS

In response to the needs for contract security in the construction industry, the CCDC endorsesthree forms of surety bonds:

Bid Bonds provide financial protection (as described in the bond) to the Obligee in the event thatthe Principal fails or refuses to enter into a formal contract after its bid has been accepted inaccordance with the bid documents.

Performance Bonds provide an owner or contractor (the Obligee) with protection (as describedin the bond) ensuring completion of the contract in the event of default of the Principal.

Labour and Material Payment Bonds ensure that the Principals outstanding payables forlabour and materials, supplied under the bonded contract, are paid as described in the bond,thereby reducing the likelihood of liens and construction schedule delays.

1.4 DEFINITIONS

While terms are defined in each bond, for the purposes of this guide the following generalmeanings will be assumed:

Bond Amount the maximum amount for which the Surety will be liable under the bond.

Principal the contractor or subcontractor whose performance is guaranteed by the Surety andwho has entered into a written construction contract with the Obligee.

Obligee the owner or contractor who holds the bond and who has entered into a writtenconstruction contract with the Principal. It is the Obligee alone who is entitled to make ademand under a bid bond and a performance bond.

Surety the surety company that prequalifies the Principal, and issues and (with the Principal)executes the bond.

Contract the written agreement between the Principal and the Obligee.

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1.5 HOW SURETY BONDS DIFFER FROM OTHER FORMS OF SECURITY?

In an effort to better understand suretyship, it is instructive to compare bonds to otherinstruments and forms of contract security.

Surety vs Insurance

Surety bonds are often confused with insurance policies. This confusion is understandablebecause bonds are not only written by major insurance companies, they also share the samedistribution network and, in the marketplace, a common jargon. For example, fees for bothsurety bonds and insurance policies are referred to as premiums and payouts are referred to asclaims.

Despite these similarities, surety bonds are distinct from their insurance counterparts. Forexample, surety bonds involve three parties, while insurance instruments are two-partyagreements whereby one party (the Insurer) agrees to indemnify another (the Insured) for adefined loss or set of losses.

Insurance is based on the risk-spreading principle of underwriting. Premiums are collected froma large population of insureds, and premium levels are determined by actuarial analysis, whichtakes into account demographic and other factors. It is accepted that losses will be incurred;however, under the principle of risk-spreading, the losses of a few are covered by the premiumsof many.

Surety bonds, by contrast, are effectively credit instruments, and are underwritten much like abanker assesses a loan application. In this case, no losses are anticipated and if the underwriterbelieves a contractor may not be able to perform his or her contractual obligations, no bond willbe issued. Premiums for bonds do not pay for losses; rather, they are a service fee forextending the required credit.

The Surety also has the right to recover any losses from its Principal should it be forced to payout under a bond. Principals seeking surety bonds are invariably required to sign an indemnityagreement under which they specifically agree to those terms.

Surety vs Letters of Credit

Occasionally, an owner will prefer a cash deposit or Letter of Credit to bonds. There are anumber of reasons for this decision. Letters of Credit offer an owner the promise of cash ondemand. They are first demand instruments under which the issuer (usually a bank) must paycash to the holder immediately upon a demand. There is no need to prove that the contractor isin default although a certificate to that effect is usually required.

Additionally, a Letter of Credit or other liquid security allows the owner to fully control thedefault rectification process and eliminates the need to deal with the bonding company.

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While these liquid security alternatives hold advantages for the construction purchaser, the quickcash solution is not without problems. Control of the default rectification process can be adouble-edged sword. For example, while the owner may have control of the default rectificationprocess, he or she must now complete the defaulted job and shoulder all the associatedadministrative burden and costs.

More importantly, the requirement to post cash or Letters of Credit can have a negative impacton a contractors cash reserves and/or borrowing power. It has been suggested that a Letter ofCredit can cause the very problem it seeks to protect against by restricting a contractors accessto cash that may be required to address a problem on a job.

The performance bond is in force for 2 years following Substantial Performance of the Work.Contractors posting cash or Letters of Credit press hard to have the security returned orconsiderably reduced following completion of the project but long before the expiration of thewarranty period. This has caused stress for owners and hardship for contractors cash flow.

Restricted access to cash can also create further problems. Liquid security requires that acontractors cash reserves or borrowing capacity be the same as the amount posted; therefore, theavailable security is limited by the contractors access to cash. Due to this restriction, Letters ofCredit are typically for a smaller percentage (10-15%) of the contract value than performancebonds (50% or 100%). These smaller amounts have proven inadequate to cover the shortfall in amajority of defaulted contracts. Finally, Letters of Credit or cash deposits do not address theproblems of unpaid subcontractors and suppliers, who would be protected under a Labour andMaterial Payment Bond.

Unlike Letters of Credit, bonds are not liquid security: Letters of Credit provide cash ondemand while surety bonds guarantee performance on default. Bonds do not necessarilyprovide the construction purchaser with the funds necessary to rectify the problem; instead theysolve the problem by guaranteeing performance. A bonding company may arrange for thecompletion of the defaulted contract.

In addition, a bond is not intrusive in the sense that it does not restrict a contractors cashresources or borrowing power. By allowing access to all available cash, the potential for cashflow problems, as discussed above for a Letter of Credit, is reduced. As contractors ondefault instruments, performance and payment bonds are available in amounts up to 100% ofthe contract price.

Also, unlike Letters of Credit, bonds do not respond on demand. It must first be established thatthe Principal is in fact in default of the contractual obligations; simple declaration of default willnot suffice.

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2. HOW SURETYSHIP WORKS

Construction surety bonds are marketed through the insurance industry, and usually by insurancebrokers and insurance companies which specialize in construction suretyship.

A Principal must establish a surety relationship well in advance of bidding bonded projects.

Surety companies that provide construction surety bonds have varying underwriting guidelinesand often prefer certain types of contractors and sizes of contract. A specialized surety brokercan best match a construction firm with an appropriate surety company. It is important for thesurety company to understand the contractors business plans; the surety brokers role is toensure that the surety company underwriter understands and supports the contractors businessobjectives.

2.1 THE THREE Cs OF SURETYSHIP

As part of the underwriting process, a surety company will assess a number of factors todetermine whether the contractor is likely to succeed in meeting its contractual obligations. Inother words, a contractor must qualify for a bonding program. If a contractor does not qualify,no bonds will be available.

Each surety company has its own assessment criteria. However, all companies look at the basicthree Cs of suretyship character, capacity and capital. As a starting point, most suretycompanies require the following confidential information:

- Background about the company, including ownership, related companies, type and size ofprojects previously completed, previous suppliers and subcontractors, andarchitects/engineers/general contractors for whom the applicant has previously donework;

- Details about the contractors line of credit including a reference letter from the bankoutlining the amount of the line of credit, the amount currently in use and how it issecured;

- Details about the current work program (work on hand schedule) including the contractprice, billings and costs to date, and estimated costs to complete;

- Financial statements of the company (and any related companies) for the last three yearsand any interim financial statements prepared since year end; and

- Personal financial statements of the company owners.

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Character

The underwriter will assess the individuals who run the firm executives, estimating and officestaff, site superintendents, etc. as to their honesty and approach to business. Generally,resumes of key personnel will be requested and references checked. The underwriter mustdetermine the reliability and integrity of the owners of the construction firm. In the event of aproblem, will the owners do the right thing when managing the business under pressure?

Capacity

An underwriter will investigate the capacity of the construction firm to perform its contracts. Isthe equipment in place to perform the work? Do the administrative and construction personnelhave the requisite skills and experience to successfully undertake the current project? Arequalified people available for the contract? Where a different technique or new equipment isbeing employed, are the people and equipment in place to ensure success?

Capital

An underwriter will need assurance that the company has the financial resources to meet not onlyits current commitments, but also to withstand the problems inherent in the construction industry unresolved disputes, unpaid receivables, varying site conditions, holdback provisions, tightoperating margins to name a few. There will be particular attention paid to the workingcapital, equity, and ongoing profitability of the business. An underwriter will require regularupdates of financial statements, aged listings of accounts payable and receivable, work on handschedules, and details of the contractors bank line of credit. Other financial information may berequested depending on the surety companys underwriting requirements.

2.2 INDEMNITY AGREEMENTS

When a surety company completes its investigation and agrees to a surety program, thecontractor must execute (i.e., sign and seal) an indemnity agreement. In the event of a loss, theObligee looks to the Surety to make it whole in accordance with the terms and conditions of thebond. The surety company, in turn, looks to the parties who executed the indemnity agreementto make it whole. The criteria for indemnity vary from one surety company to another; however,most will ask for the indemnity of the construction firm, its owners and their spouses, and anyrelated companies (including holding companies).

Once the indemnity agreement is in place, the contractor can request bonds from the suretycompany. The contractor must continue to inform the surety company about any changes withinthe firm, and also any changes in the financial position and ongoing work of the firm. Thisinformation is usually relayed through the contractors surety broker.

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2.3 SECURING THE BOND

When bidding or commencing a project that requires a bond, the contractor contacts its suretybroker with the project details. While the information required varies by surety company,contractor, and type of work, the following basic information is usually required:

- Full legal name of the Obligee;

- Description of the work, including type of work and location;

- Estimated contract value should the Principal seek to submit a bid and require a bid bond;

- The actual contract price (and other bidders and their prices, if known) if the Principal isseeking a Performance and/or Labour and Material Payment Bond;

- Confirmation that there is an engineer and/or architect on the job;

- Bid or contract date;

- Payment terms;

- Maintenance or warranty period;

- Penalties for delay;

- Estimated or actual completion time;

- Amount and type of work to be sublet (the surety company may request that some of thesubcontractors provide bonds); and

- Amounts and types of bonds required.

A fourth C of surety, Conditions, is often discussed at this stage. The Surety may requestspecific details about the project (including the terms and conditions of the contract) prior togiving the surety broker approval to issue the bond.

Some surety companies give specialty surety brokers Powers of Attorney enabling them to issuebonds in their offices. All bonds are executed under corporate seal by the attorney-in-fact of thesurety company and must also be similarly executed by the Principal (i.e., the contractor). Bondsare legal documents and must be issued accurately with the proper legal names of the parties tothe bond, as well as a clear description of the work to be undertaken. Bonds must be signed,sealed and delivered to the Obligee to be operative.

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2.4 BOND COSTS

Surety companies generally do not charge clients for the bonds necessary to bid on a project;however, most companies charge an annual administration fee to cover some of the costs ofissuing these documents. Surety companies receive remuneration when a contractor is awarded aproject and a Performance Bond (and perhaps a Labour and Material Payment Bond) is issued.The surety companys fee is calculated per $1,000 of the contract price. Standard rates arecharged annually. Long-term rates may be available for projects where the construction scheduleexceeds 24 months. Both standard and long-term rates include warranty protection for up to oneyear. Rates vary by surety company and are based on the financial position of the constructionfirm.

In addition to the requirement of a Bid Bond, a contractor is occasionally asked to provide whatmay be referred to as an Agreement to Bond, Consent of Surety, Bid Letter, etc. These can be inthe form of a letter or an undertaking signed by the Surety under which the Surety agrees toprovide a Performance Bond and, if required, a Labour and Material Payment Bond on behalf ofthe contractor. When the project is awarded to that contractor, the Obligee may choose to waivethe requirement for performance and payment bonds. Although the owner has used the servicesof the surety industry to prequalify the contractor, the surety company receives no remunerationfor its prequalification efforts. In these circumstances, most surety companies will charge aprequalification fee.

2.5 VALUE ADDED TAXES

Surety companies do not receive the benefit of input tax credits and therefore may be exposed toValue Added Taxes (e.g. the Goods and Services Tax, the Quebec Sales Tax and the HarmonizedSales Tax) costs in the event of a claim. As a result, they may include the Value Added Taxes inthe bond amount and compute the premium on a Value Added Taxes inclusive basis.

Clarification on the effect of Value Added Taxes on surety bonds may be required for individualcircumstances.

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3. BOND FORMS

Contract surety bonds are distinctive among methods of contract security they are the onlyinstruments designed to respond to the unique needs of the construction industry. CCDCendorses three forms of contract surety bonds: CCDC 220, Bid Bond; CCDC 221, PerformanceBond; and CCDC 222, Labour and Material Payment Bond.

3.1 CCDC 220 BID BOND

Bid bonds provide construction purchasers with assurance that the contractor submitting the bidhas been examined by the surety company and has been found qualified to perform the work.Specifically, this bond offers an Obligee financial protection should a successful bidder not enterinto a formal written contract, or not provide the specified security. This protection is limited tothe lesser of the bond amount (usually 10% of the bid) and the difference in price between thePrincipals bid and the next lowest compliant bid. This is the primary prequalificationinstrument issued by a surety company to ensure that construction purchasers receive a bid froma qualified contractor.

Condition of the Bond

The bidding process, which defines the obligation under a Bid Bond, is usually described in theInvitation to Bid.

Provided a bid is submitted in accordance with the Invitation to Bid and is capable of acceptance,the proper acceptance of the bid creates an obligation on the part of the Principal to enter into aformal contract as specified in the Invitation and, often, to provide contract security (usually aPerformance Bond and a Labour and Material Payment Bond).

The condition of the form 220 Bid Bond is that if the Principal satisfies the obligation to enterinto a formal contract and, if required, provides the specified contract security, the bond is thennull and void. If the Principal defaults in this obligation, the bond remains enforceable, subjectto its conditions.

The Claims Process

Surety Investigation

When a demand is made by the Obligee under a Bid Bond, the Surety will investigate thecircumstances surrounding the demand. The investigation will focus on several questions:

- Has the bidding process created an obligation for the Principal to enter into a formalcontract and to provide certain contract security?

- If such an obligation has been created, is the Principal in default of the obligation?

- If the Surety is liable under the bid bond, what amount should be paid under the bond?

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Making a Demand

A demand should be made promptly in writing to the Surety. The form of a demand is notspecified in the bond, but it will assist the Surety investigation and response if the demandincludes:

- notice that the Principal has an obligation to enter into the formal contract and/or providesecurity, and a brief description of the circumstances giving rise to the obligation (i.e.,the submission and acceptance of a bid, and the proper award and delivery for executionof a formal written contract in accordance with the bid);

- notice that the Principal has defaulted on the obligation, and that demand is being madeon the Surety under the Bid Bond; and

- confirmation that a written notice of the default has been provided to the Principal andthat no satisfactory response has been received.

Copies of the following documents, provided with or shortly after the demand; will also assistthe Suretys investigation:

- Invitation to Bid (or similar document to which the bid responded);

- Principals bid as submitted;

- documented proof of the acceptance and contract award in accordance with the Invitationto Bid;

- the formal written contract as presented to the Principal for execution;

- any documents showing evidence that the Principal has refused or failed to honour theobligation;

- the list of bid results;

- any formal or written bid analysis on the basis of which the Principals bid was accepted;

- the next lowest compliant bid ; and

- the signed contract that the Obligee has entered into with another party to perform thework.

Common Problems to Avoid

- Accepting an informal or non-compliant bid;

- Accepting a mistaken bid;

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- Failing to follow the prescribed bid process, or failing to properly accept or award thecontract;

- Presenting for execution by the Principal a contract that is materially different from thesubmitted bid;

- Postponing acceptance beyond the period stipulated in the Invitation to Bid, or beyondthe period specified in the bond;

- Failing to institute legal action to enforce the bond within seven (7) months of the date ofthe bond (not from the date of the bid closing, award, or Principals default);

- Entering with another party into a contract that is in a different form or that includes anobligation(s) that differs from the original contract;

- Failing to mitigate damages.

The Bidding Process: An Obligees Bid Bond Checklist

Pre-bid

- Include specific reference in the bid documents to the CCDC 220 Bid Bond as there aremany non-standard forms in the marketplace.

- Ensure the bid documents clearly define the bidding process, including time limits forreview and acceptance of bids, the document or act that constitutes acceptance of a bid,when a formal contract must be signed, and what constitutes entering into a formalcontract, including the form of the contract (e.g. CCDC 2, 3 or 4).

Before extending the acceptance period of a bid, keep in mind the Bid Bond is not enforceableafter seven months from the date of the bond.

After Bid Closing

- Ensure that the bid bond received was accurately drawn and executed.

- The formal contract presented by the Obligee to the Principal must be essentially thesame contract that was bid in order for the Obligee to rely on the Bid Bond. ThePrincipal and the Surety are not bound to pay under the Bid Bond if the formal contract,which the Principal fails or refuses to enter into, is materially different from thecontractual terms and conditions set out in the bid documents.

- Payment under the Bid Bond requires that the Obligee actually enters into a contract withanother contractor.

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3.2 CCDC 221 PERFORMANCE BOND

The Performance Bond guarantees that the Principal will perform the contract in accordance withits terms and conditions. This bond protects the Obligee financially from the excess costs ofcompletion of a bonded contract should the Principal fail to perform. Usually the Surety willparticipate actively in arranging for completion of the defaulted contract and in resolving anyresultant issues. For example, instead of simply funding a cost over-run, the Surety may remedya default, complete the contract, or re-bid the remaining work under a new contract.

Without a Performance Bond, the construction purchaser would have to finance the additionalcosts to complete a defaulted contract, and bear the risk and expense of recovering the costs fromthe defaulted Principal. Under the Performance Bond, the Surety essentially finances theadditional cost of completing a defaulted contract up the bond amount, and assumes the risk andexpense of recovery.

The Bond Condition

The condition that the Principal must be in default is the fundamental characteristic of a suretybond, one that clearly distinguishes it from other forms of contract security. If the Principalperforms, the bond is null and void. If the Principal defaults, the undertaking to pay the bondamount or elect one of the alternative settlements described in the bond remains in full force andeffect.

The construction contract between the Principal and the Obligee establishes the obligations ofthe Principal. Assuming the performance bond is properly drawn, and has been signed, sealed,and delivered to the Obligee and is, therefore, operative, the Surety will be liable if:

- the Principal has been declared to be in default pursuant to the terms of the contract;

- the Principal is, in fact, in default under the contract (i.e., the declaration of default isjustified and proper given the circumstances); and

- the Obligee has honoured its obligations under the contract.

Surety Options

If the Principal has defaulted in the performance of the contract, and if the Surety is liable underthe bond, the Surety can satisfy its obligation in a number of ways as described below. TheSurety has the discretion to select the settlement option, but will often consult with the Obligeeand consider the unique circumstances of the default when making its decision. It is in the bestinterest of the Surety and the Obligee to act expeditiously to mitigate the cost of completing thecontract.

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Remedy the Default

The Surety may elect to remedy the default by providing assistance to the defaulted Principal.This may involve financing a cash-strapped Principal through to the completion of the bondedproject.

Complete the Contract

The Surety may elect to complete the contract. Although under this option it may appear that theSurety has simply replaced the defaulted Principal and is acting as the contractor orsubcontractor under the contract, it is important to note that the Surety is not a party to thecontract and will be acting in its capacity as Surety under the bond. The Surety will complete thedefaulted contract using the unpaid balance of the contract price, which it is entitled to receivefrom the Obligee, and seek recovery from the Principal any additional costs or expenses arisingfrom the default.

There are several ways by which the Surety can complete the contract. For example, the Suretycan hire one or more general or subcontractors, project or construction managers, or suppliers toprovide the required services. Under this option the Surety makes financial and paymentcommitments directly to the parties retained. The Obligee must be informed of the arrangementsand commitment for the unpaid contract balance to be made available to the Surety, subject toany statutory requirements or obligations imposed upon the Obligee (e.g., lien holdback).

Re-bid

Under this option, the Surety may seek bid(s) for completion of the contract and arrange for anew contract between the successful bidder and the Obligee. Usually, the terms of thecompletion contract, including scope of work, payment terms and bonding requirements, are thesame as in the defaulted contract. However, agreement about the scope of the remaining work,as well as provision for approved and pending changes to the work, will be required.

The Obligee administers the new completion contract and makes payments directly to the newcontractor. If the amount payable to the completion contractor exceeds the amount the Obligeewould have otherwise been required to pay to the defaulted Principal had there been no default,the Surety pays this additional amount to the Obligee under the bond as the work progresses,subject to the bond amount.

Pay the Bond Amount

The Surety, when it accepts liability under the bond, is entitled to pay the bond amount to theObligee in full satisfaction of its obligation under the bond. A Surety would consider this option,for example, when satisfied that the Obligees completion costs, which the Surety would beliable for under the bond, exceeded the bond amount. Where the completion costs for which theSurety is liable are less than the bond amount, the Surety may satisfy its obligation under thebond by tendering payment of the lesser amount to the Obligee.

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Disputed Default

Occasionally, when presented with a demand under a Performance Bond and following itsinvestigation, the Surety will be unable to determine whether there has been a default. Thecontract between the Obligee and the Principal sometimes gives rise to genuine disputes whichcannot be resolved or determined by the Surety, and which require resolution by some alternativemeans or, ultimately, by the courts.

In this situation, the Performance Bond continues to provide the same degree of financialprotection to the Obligee. If a determination is ultimately made in favour of the Obligee, andassuming the Obligee has given proper notice to the Surety and preserved its rights under thebond, the Surety will be liable to the same extent as if the default had been clear at the outset.

In a disputed default, the parties often agree to put aside the dispute in the interests ofcompleting the job as expeditiously and economically as possible. In these circumstances, aSurety might propose or accept an arrangement whereby the work is completed and funded bythe parties while preserving their respective rights under the contract and the bond. Thisapproach focuses the parties energies on promptly completing the work, mitigating the costs,and avoiding additional disputes about the costs of completion.

The Construction Process - An Obligees Performance Bond Checklist

Pre-construction

- Include specific reference in the bid documents to CCDC 221 as there are many non-standard bond forms in the marketplace.

- Ensure that the fully executed bond is accurately drawn and in the possession of theObligee. In the event the bond is not delivered to the Obligee, it cannot becomeoperative.

During Construction

- Notify the Surety of material changes in the contract, and obtain the Suretys consent toremain bound under the bond. Since the performance of the contract referred to by thePrincipal in the bond is the condition of the bond, a material change in the contractwithout the Suretys consent releases the Surety.

Understandably there is often confusion among Obligees, Principals and consultants as to when achange to a contract is material. Regrettably, there are no absolute criteria to define materialchange and indeed a change which may be material in one contract can be insignificant inanother.

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Some owners have attempted to address this issue by establishing a percentage change threshold(e.g. 25%) in the contract and/or bond. They deal with this issue by defining a material changeas any change which increases the contract price by an amount greater than that percentage.Unfortunately a material change may not have any effect on the contract value and this approach,however well intentioned is probably misguided.

The good news is that even though there are no hard and fast rules there are some indicators.Significant extensions of time or increases or decreases in the contract price, changes in thepayment terms (e.g., advance payments), major changes in the scope or nature of the work (e.g.,the addition of design responsibility) are examples of changes which, in specific circumstances,can be material to the Suretys risk. Probably the best advice to an Obligee is to take the cautiousapproach. If you think theres a chance that a change to a contract may be material it is best toinform the bonding company as described above.

Default

If a default occurs for which the Obligee intends to look to the Surety, the Obligee or itsconsultant should ensure that the default is first properly declared to the Principal in accordancewith the terms of the contract.

The Surety should be provided with a clear and unequivocal written demand under the bond,advising that the Principal is in default under the contract (naming the specific provision(s) of thecontract that may have been breached), and that the Obligee requires the Surety to meet itsobligations under the bond. Keep in mind that the Surety will not likely take any action until thetime allowed under the contract for the Principal to remedy the default has expired. Notice mustbe given to the Surety so that it has an opportunity to consider its options under the bond. Ifnotice is not given, the Surety is discharged.

Investigation by the Surety

The Surety will investigate the circumstances surrounding the declaration of a default and thedemand on the bond, and will attempt to answer the following questions: Is the Surety liableunder the bond and, in the event of liability, what arrangements should be made to complete thecontract and settle the Suretys financial obligation to the Obligee?

Keep in mind that it may take some time and, indeed, may not be possible to determine whetherthe Surety is liable under the bond. Contractual disputes are often complex because they haveevolved over a period of time.

The Obligee should assist the Surety in its investigation by providing:

- copies of contract documents, including general, special, and supplementary conditions,specifications, drawings, latest approved schedule, approved and pending change orders,minutes of meetings and other correspondence or documents relevant to the default;

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- a full accounting of the contract price, including reconciliation of the price or unit valuesspecified in the contract at the time of award with the current contract value, including arecord of all payments, credits or backcharges, holdback or other amounts retained, andcopies of payment certificates;

- reasonable access to the work-site and assistance in determining the status and conditionof the work;

- information about any special or urgent circumstances necessary to the Suretysinvestigation.

Should it be necessary to preserve or protect the work while the Surety is investigating, seek theSuretys agreement that the Obligee undertake reasonable and economical action, with theresultant expenses treated as costs to complete the contract.

Verify that project insurance remains in force and, if necessary, notify the Surety of any pendinglapse and seek agreement that the Obligee pay any premium for interim coverage, which shouldbe treated as a cost to complete the contract.

Completion and Settlement

When considering a Suretys proposal to complete the contract and satisfy its financialobligation, it is important to keep the following in mind:

- The settlement option proposed by the Surety often involves arranging for or evendirectly performing some of the work called for under the contract. However, the Suretydoes not replace the Principal. In fact, after having satisfied its obligations under thebond, the Surety will usually attempt to recover from the Principal the excess cost tocomplete the job, just as the Obligee would have had there been no bond. Additionalcosts of completing the bonded contract are, in essence, financed by the Surety, butultimately paid by the Principal.

- When electing to remedy the default or complete the contract, the Surety may ask theObligee to acknowledge that the Surety is acting in its capacity as Surety under the bond,and is subject, therefore, to the terms and limitations of the bond. This acknowledgementcan avoid confusion and expense where it appears that the Surety is acting as thePrincipal contractor.

- If the Surety proposes to complete the contract, it will require a clear commitment by theObligee to pay to the Surety the contract balance as defined in the bond, subject to anystatutory requirements or obligations imposed on the Obligee (e.g., lien holdback). It istypically part of the completion agreement between Obligee and Surety that the Obligeewill pay these amounts as the work progresses, in the same manner as they would havehad the original contractor not defaulted.

- The Suretys financial responsibility is limited to the bond amount.

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It is important to record the date on which the Principals default or abandonment occurred.Should completion of the contract or financial settlement with the Surety extend over a longperiod, steps should be taken to preserve the right to recover under the bond. It is a goodpractice to evaluate the status of the work immediately after the default in order to have anaccurate record of the work performed and any deficiencies observed. Any suit against theSurety under the bond must commence within two years from the earlier of:

1) the date of substantial performance of the contract as defined in the lien legislationwhere the work is taking place or, if no such definition exists, the date when thework is ready for use or is being used for its intended purpose; or

2) the date on which the Principal is declared in default by the Obligee.

3.3 CCDC 222 LABOUR AND MATERIAL PAYMENT BOND

This bond provides financial protection to subcontractors who have a direct subcontract with thedefaulted Principal to provide labour and materials for the project covered by the bond. Labourand Material Payment Bonds are usually available only together with Performance Bonds.

Under the bond provisions, should the Principal pay the claimants for all labour and materialused in the performance of the contract, the obligation of the Surety would then be null and void.That is, if the Principal fulfills its obligations to the claimants, the Surety has no liability underthe bond.

While some non-standard or Government of Canada Labour and Material Payment Bondsprovide limited coverage to secondtier subcontractors and suppliers, this is not the case withCCDC 222.

It is important for claimants to realize that coverage under this bond is limited to labour and/ormaterial supplied to the specific project described in the bond. While it is not uncommon for asupplier to maintain a running account with the general contractor, and to simply apply paymentsto the oldest outstanding invoices, this can pose problems for both general contractors andsubcontractors in relation to this bond. Potential claimants should, during the performance oftheir agreement with the Principal, identify the project for which they are supplying materials,general contractors should identify which invoices are being paid at any one time. Where asupplier sells materials in bulk, it maybe unable to recover unpaid debt under a labour andmaterial payment bond because it is not possible to prove the ultimate destination of the supplies.

Bond Conditions

Potential claimants should understand the terms and conditions of the Labour and MaterialPayment Bond, especially the following:

- Claimants cannot sue under the bond until 90 days after the date on which they lastsupplied labour and/or materials to a project.

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- Under their contract with the Principal, claimants must provide notice of their claim(other than for holdbacks), indicating the exact amount or their claim, within 120 daysafter the date on which the claimant did or performed the last of the work or labour, orlast furnished materials for which the claim is being made.

- With respect to statutory or other holdbacks (e.g., maintenance holdback), claims must besubmitted within 120 days after the claimant should have been paid in full under theclaimants contract with the Principal.

- No suit or action shall be commenced by any claimant under this bond after one yearfollowing the date on which the Principal ceased work on the contract, including workperformed under the guarantees provided in the contract and provided the claimant hascomplied with the conditions of the bond. This condition simply limits a suit and does notserve to extend the notification period within which a claim must be made.

- Claimants should note that written notice of their claim must be sent to each of thePrincipal, Surety, and Obligee by registered mail.

Proving the Claim

While the requirements for proving the claim may vary, the following documentation is normallyrequired:

- Copy of the complete contract or purchase order with the Principal;

- Copies of all change orders and change directives concerning the contract;

- Copies of all invoices and/or progress billings submitted to the Principal;

- Copies of all statements of account rendered to the Principal;

- A summary of all payments, including the date and amount of each payment;

- Evidence of the last date upon which labour and/or material was supplied to the project;

- Signed delivery tickets and/or time sheets;

- Evidence and documentation to support other amounts being claimed and which may nothave been agreed to or authorized in writing under the contract or within a change orderor change directive; and

- Proof of acceptance of the work by the owner or consultant.

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Benefits of Labour and Material Payment Bonds

While Labour and Material Payment Bonds clearly benefit subcontractors and suppliers, theyalso benefit Obligees who may appear to be nothing more than trustees for the claimants and notdirect beneficiaries. The benefits to Obligees include the following:

- In the event of a default by a Principal, construction purchasers and/or theirrepresentatives will have to deal with subcontractors and suppliers who, in turn, may feelthat the construction purchaser has a direct obligation to them. This can become asignificant administrative burden to an owner who is deluged with phone calls fromangry, frustrated and confused subtrades and suppliers. Furthermore, an owner has astatutory obligation to retain and properly distribute any holdback monies for thoseparties who may have registered liens against the property in question. With a Labourand Material Payment Bond in place, the surety company deals with these claimants and,upon payment, will be subrogated to their claims.

- Owners who do not require Labour and Material Payment Bonds, may do so to their owndetriment. Many subcontractors and suppliers are reluctant to enter into a contract on aproject where there is no Labour and Material Payment Bond, because of the inherentcredit risk, and may, consequently, increase their prices to reflect the additional risk.

- A Suretys obligation under a Performance Bond is limited to the balance of the work tobe completed under the contract. There is no obligation on the part of the Surety to dealwith unpaid labour or material suppliers to the Principal. These unpaid parties typicallyrefuse to return to a project until paid for the work already completed; since the Suretyhas no obligation towards them, the Surety would likely contract with replacementcontractors for the balance of the work. This would then require additional time tocomplete the contract in that replacement contractors must familiarize themselves withthe work in place. With a Labour and Material Payment Bond in place, the Surety is in aposition to bring the sub-trades up-to-date financially, to obtain their co-operation tocomplete the contract, and to maintain the integrity of the warranties. Obviously, anyunpaid sub-trade has no obligation to maintain or honour a warranty.