Sureties Accelerate Resolution of Performance Bond Claims Through Expedited Dispute Adjudication

BY TODD R. REGAN

CRITICS OF THE use of surety bonds often point to perceived delays in the resolution of performance bond claims as a basis for turning to alternate forms of performance guarantees, such a letter of credit (LOC) or subcontractor default insurance (SDI). In order to address these concerns and to meet the particular needs of public private partnership (P3) projects, some sureties offer performance bonds that provide for expedited adjudication of disputed performance bond claims. In some instances, these bonds may also provide immediate, on-demand payments to the obligee upon the declaration of default. These bonds seek to minimize potential project delays and the associated liquidated damages and other costs that could accrue during the surety’s investigation of a contractor default, while at the same time maintaining the essential characteristics of a performance bond.

The Needs of P3 Projects

P3 projects have traditionally relied on LOCs and the associated liquidity provided rather than using surety bonds to secure contractor performance. P3 projects allow government bodies to tap into private sector resources and ingenuity to fund, design, construction, operate, and maintain facilities that benefit the public and that would otherwise have been procured under the typical design-bid-build project delivery system. A P3 project will typically involve an agreement between a public owner and a private entity, often known as the concessionaire. The concessionaire in turn will have agreements with lenders and equity investors to finance the project, as well as a separate agreement with a design-builder for the construction of the project.

Delays can be particularly costly on P3 projects, because concessionaires generally raise funding from investors and lenders based on a future revenue stream, often referred to as the concession (for example, future toll payments or availability payments from the public owner). Lenders and investors have favored the use of LOCs over surety bonds in order to provide liquidity to hedge against liquidated damages and lost revenues resulting from project delays following a default by the design-build contractor.

Unlike the AIA A312 Performance Bond, which requires the obligee to provide the surety with a written declaration of default and provides the surety with an opportunity to investigate and with various performance options, a LOC is an on-demand instrument that entitles the owner to an immediate cash payment simply by alleging a default. Thus, a LOC satisfies the need for an immediate cash infusion needed to cover debt service obligations and immediate project costs following a contractor default.

The Benefits of Bonding P3 Projects

The benefits of bonding 100 percent of the design-build contract value are well established. Sureties bring their industry experience and deep knowledge of a contractor’s complete financial background to bear in the underwriting process. This permits sureties to conduct a far more reliable prequalification of the proposed design-build contractor than could otherwise be conducted by the public owner or concessionaire alone. Furthermore, sureties often work behind the scenes to fortify a struggling contractor, so that a potential default across multiple projects is avoided. In this respect, having bonds in place can reduce the likelihood of contractor default in the first place. In addition, sureties bringvast experience in investigating and remedying defaults.

Yet, despite the surety industry’s well-established track record of successfully providing performance security for large, complex projects, performance bonds are not universally required on P3 projects. Indeed, of the 33 states and one territory that have enabling laws permitting the use of P3s for certain types of projects, only 26 of those jurisdictions require bonds. Instead, some jurisdictions call for performance security packages, which may include a combination of a LOC, parent company guaranties, retainage, and SDI.

The Surety Solution for P3 Projects

Against this background, sureties have developed performance bonds that are designed to satisfy the needs of P3 projects. One such example is Zurich’s Public-Private Partnership Performance Bond, which is exclusively offered for use in Canada, where P3 projects have historically been more common. The Zurich P3 Bond, which can be tailored for specific projects, features both a liquidity component and an accelerated dispute resolution feature. Typically, when written for P3 projects, these bonds will have a lower penal sum than standard performance bonds, usually in the range of 50 percent of the contract sum. In order to provide liquidity, the bonds have an “on-demand” feature that requires the surety to make an immediate payment to the obligee of up to 5 percent of the penal sum upon the declaration of contract default, in order to cover liquidated damages. In addition, in order to avoid project delays, the bond contains a fast-track dispute resolution procedure. All disputes concerning the validity of the declaration of the contractor default are submitted to a pre-selected adjudicator for expedited resolution.

Another product that has been offered for use on P3 projects in the U.S. is Travelers’ Expedited Dispute Resolution Performance Bond (EDR Bond). Unlike other bonds developed for the P3 market, the EDR Bond does not provide an on-demand payment or liquidity component. Instead, in the event that a dispute arises concerning a performance bond claim, the surety or the obligee has the right to submit the dispute to JAMS for expedited resolution before a pre-selected adjudicator. The adjudicator is then tasked with answering three questions: (1) Is the principal in default of its obligations? (2) Has the obligee complied in all material respects with its obligations? (3) Is the surety liable to perform under the bond?

All parties are required to continue to perform on the project pending resolution of the dispute, which must be issued no more than 43 days from the referral of the dispute for resolution. The adjudicator’s decision is binding on the parties until the project is completed, but the parties reserve the right to later appeal the adjudicator’s decision to a court of competent jurisdiction.

Notably, the EDR Bond provides coverage up to the full contract value for the design and construction work to be performed under the P3 agreement and expressly provides coverage for liquidated damages and the contractor’s warranty obligations.

The EDR bond was accepted for the first time as part of the performance security package for the $899 million Pennsylvania Rapid Bridge Replacement Project, the largest road project in the state’s history. This high-profile project involved the replacement of 558 structurally deficient bridges across the state over a three-year period, procured through a design-build-finance-maintain P3 agreement between PennDOT and Plenary Walsh Keystone Partners as the concessionaire/developer.

Quite significantly, the $899 million EDR Bond posted by Travelers, along with Zurich and Chubb as co-sureties, was the first performance bond ever to receive credit from Standard & Poor’s as liquidity support equivalent to a 10 percent LOC, per S&P’s criteria in establishing Construction Phase Investment ratings.

Not a One-Size-Fits-All Solution

Although performance bonds requiring expedited adjudication of disputed claims and providing on-demand payments may meet the needs of certain projects, they are not a one-size-fits-all solution, nor are they likely to replace the use of the AIA A312 Performance Bond on many projects. As noted above, the A312 Performance Bond provides the surety with important rights and defenses, including the right to receive a written notice of intention to declare a contractor default from the obligee, the right to a pre-default conference, and an opportunity to investigate the circumstances surrounding the declaration of default, as well as various performance options. These rights protect both the surety as well as the contractor-principal, in the event that the contractor disputes the grounds for termination.

Although accelerated adjudication bonds do provide the surety with the option to challenge the validity of the contractor default before an adjudicator, the expedited nature of the proceedings may not provide the surety with sufficient time to fully investigate the claim. Furthermore, sureties may be reluctant in certain instances to submit their defenses to an arbitrator, who may be less inclined to strictly enforce a surety’s legal defenses or to dismiss a claim in a summary manner. However, regardless of the form of the bond used, there can be no question that a timely and efficient investigation of a performance bond claim by the surety is in the best interests of all project players in order to minimize potential delays to the project. ●

Todd R. Regan, a partner with Robinson + Cole’s Construction and Surety Practice Group, represents the full range of construction and surety industry stakeholders in claims involving project delays and inefficiencies, defective design and construction, unfair trade practices and bad faith, and mechanic’s liens and bond claims. He also counsels clients in the negotiation of complex construction agreements. Regan serves on the NASBP Attorney Advisory Council. He can be reached at tregan@rc.com or 860.275.8293.