LEGAL ISSUES


Even in ‘Good’ Times, Contractors Should Seek Protection from Performance Risk


By Jonathan J. Dunn, SMTD Law LLP I


n this post “Great Recession” economy, contractors may be optimistic. But “good” economies


bring other risks, including over- commitment, new entrants to the marketplace, shortages of qualified labor, and commodity price fluctua- tions, such that contractors should still be wary of non-performance from subcontractors and suppliers. Tis article discusses various


options of securing non-insurable contractual performance, including letters of credit (LCs), surety bonds and subcontract default insurance. Each has its distinct attributes, and one may not fit all circumstances. But performance assurance is an important


risk tool for general contractors. Bonds. Suretyship is one of the


oldest forms of obligations, with references in the temple of Apollo at Delphi and Proverbs in the Bible. Medieval sureties were often relatives taken hostage. Tis lead to legal and equitable defenses going back to 1215 and the Magna Carta. Over time, surety law developed special rights, defenses, and remedies not often found


in the bond. Surety Is Not Insurance. A surety


is one who contracts to answer for the debt or default of another. Te principal and surety obligation is joint, several, and primary to the obligee. As between principal and surety, the principal is primarily liable and the surety is secondarily liable. An insurance policy provides indemnity to the insured against loss from a fortu- itous but statistically predictable event. It is a two-party contract. Regulators set premium based on the statistical certainty of loss, and insurers spread the cost among a group of insureds. A


www.AGC-CA.org


surety bond is a three-party contract between principal, obligee and surety, with premium based on cost for an


extension of credit. Bond Cost and Enforcement.


Costs vary, but generally range between 0.5 and 1.5 percent of the contract amount. For this one premium, an obligee (owner, general contractor, etc.) can obtain a 100 percent performance, 100 percent payment, and often maintenance bonds. However, obligees should not always expect immediate performance where default is contested. Unlike LCs, bonds are typically conditioned upon default and the obligee’s performance. Tis has led to some criticism of surety claims, which may result in litigation. A definite benefit is a principal’s bankruptcy does not typically prevent


enforcement. Letters of Credit. LCs are


decidedly different from bonds. LCs are premised on “pay now, argue later” and meant to be certain and mechanical. Despite Article 5 of the Uniform Commercial Code, many LCs are governed by international banking and commerce agreements. Te legal principles of “indepen-


dence” and “strict compliance” govern, under which LCs are deemed independent from the transactions they secure, and unaffected by disputes regarding performance. Tus, banks don’t usually investigate the default,


and pay on proper presentation. Types of LCs. Te most widely used


LCs are “commercial” and “standby.” Commercial LCs facilitate sales of goods, particularly international sales, and serve as the payment mechanism. Standby LCs guard against nonper- formance on an underlying agreement. Issuing banks presume they will not pay under standby LCs, and only


about 0.03 percent end up as losses. Comparatively, surety bonds and guarantees are secondary obliga- tions, contingent upon default. Tus, a surety or guarantor investigates the default and has no obligation until default is estab- lished. LCs are primary obligations depending solely on the beneficiary’s presentation of conforming documents, with proof of default being irrelevant absent fraud. LCs may also be either revocable


or irrevocable, clean or documentary. A revocable LC may be unilaterally amended or canceled prior to presen- tation; whereas irrevocable LCs may not be amended or canceled without consent until the term expires. Most standby LCs are also documentary, meaning certain documentation must accompany presentment. A clean LC is payable solely with presentation of a draft. Under all LCs, presentation must occur within the effective period, and must strictly comply in form and manner, regardless of whether the


underlying obligation is delayed. LC Cost and Enforcement. Te


fees and costs of LCs are annual and typically a small percentage (1 percent) of the amount of the LC. Nearly all applicants fully collateralize the issuer for the life of the LC. For this reason, LCs in construction are often a small percentage (i.e., 10 to 20 percent) of the underlying contract’s price. In rare instances a draw on an LC can be blocked through injunction based on fraud. Like surety bonds, the bankruptcy of the underlying applicant


Continued on page 20 Associated General Contractors of California 19


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