Performance Bonds – Will the Liability Ever End?

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Construction contracts for commercial projects, including the ongoing boom in apartment projects, routinely require the general contractor and/or the subcontractors to provide performance bonds. Performance bonds are also typically required on government construction projects. Note: Contracts that require performance bonds usually also require payment bonds, such that the term “payment and performance bonds” is often used. There is less concern about long-term post-completion exposure on payment bonds because payment bonds interact with the statutory periods for filing mechanic’s lien. This article addresses only performance bond issues.

The purpose of a performance bond is to provide a means of insuring timely completion of contractually required work. Unfortunately, performance bonds are often improperly treated like long-term tail insurance obligations that impose liability on the surety and bonded contractor long after the bonded work has been fully completed and accepted. In post-completion construction defects claims, performance bonds tended to be incorrectly viewed in the same light as Commercial General Liability (CGL) insurance coverage, with the confusion perhaps arising in part because performance bonds are often issued by insurance companies. But unlike CGL insurance, the bonded contractor is responsible for repaying the bonded surety every penny (including attorney’s fees) that the surety is required to pay or incurs as a result of a bond claim.

To make matters worse, before issuing performance bonds to a corporation or company (i.e., an Inc. or LLC), sureties typically require company owners and their spouses to sign personal guarantees making them personally responsible for repaying the surety if their company fails to reimburse the surety on a bond payment claim. Those personal guarantees of the bond effectively do an end-run around the construction company’s corporate shield and place the company owners, their spouses, their homes and other personal assets directly at risk when a performance bond claim is asserted.

Most performance bond forms have a clause that attempts to limit the bond obligation to a period of one or two years after the bonded-contractor completes the work. For example the AIA A312 – 2010 Performance Bond form states:

"Any proceeding, legal or equitable, under this Bond may be instituted in any court of competent jurisdiction in the location in which the work or part of the work is located and shall be instituted within two years after a declaration of Contractor Default or within two years after the Contractor ceased working or within two years after the Surety refuses or fails to perform its obligations under this Bond, whichever occurs first. If the provisions of this Paragraph are void or prohibited by law, the minimum period of limitation available to sureties as a defense in the jurisdiction of the suit shall be applicable."

Despite its effort to limit the duration of the bond, the two-year limit stated in A312 (and in other bond forms) is invalid and unenforceable in South Carolina and in a number of other states because such provisions are viewed as an attempt to shorten the statutory time limits applicable to filing breach of contract claims. As such, the duration of performance bonds is typically governed by the running of the statute of limitations (the duration of which often presents a jury trial issue) and expiration of the statute of repose, and in South Carolina the statute of repose may not apply in cases involving claims of gross negligence. As a result, the surety, the bonded contractor, and the contractor’s owners and their spouses remain subject to potential long-term liability under a performance bond for construction defects claims that may be filed many years after the contractor’s work was fully completed and accepted. Such exposure can also impede a contractor’s ability (bonding capacity) to bid and receive future bonded contract work.

The best way to avoid the problems and personal liability associated with performance bonds is to not provide one. Well-established, financially stable, and reputable contractors can rightfully question the need for a bond to ensure completion of their work. Owners and contractors can protect themselves by use of retainages and by ensuring progress payments do not get ahead of the amount work actually performed. But many owners and contractors will insist on performance bonds as part of the way they do business, and in those cases the bonded contractor needs to examine a means of controlling the duration of their risk.

At Nexsen Pruet we work with contractors and subcontractors to provide them with a mechanism to limit their performance bond obligations upon completion of their work, thus fairly balancing the purpose of the performance bond against the unintended consequences of continued long term post-completion liability and the associated adverse impact on bonding capacity.

Our Insights are published as a service to clients and friends. They are intended to be informational and do not constitute legal advice regarding any specific situation.