Understanding the Surety Bond Claims Process

by Wendel, Rosen, Black & Dean LLP
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The following guest post is from Sara Aisenberg, Director of Educational Outreach at SuretyBonds.com, a nationwide surety bond producer that helps contractors fulfill their bonding requirements.

Case Closed stampEarlier this year, my colleague Danielle Rodabaugh shared a guest post on California Construction Law Blog about how to establish a construction company in California. In her article, Danielle discusses the importance of gaining experience within the construction industry, how to draft a legal team and why construction professionals must plan a budget that includes the cost of performance surety bonds. Today, I’d like to delve further into surety bonds for California construction projects — specifically how claims are filed on bonds and what the repercussions can be.

What is a surety bond?

A surety bond is a legally binding contract between three parties: a principal, an obligee and a surety. When it comes to construction bonds, the principal is the contractor required to purchase the bond, the obligee is the government agency or the construction project owner that requires the bond and the surety is the underwriting company that produces the bond. By posting the surety bond, the contractor pledges to adhere to the agreed-upon contract. By producing the bond, the surety company backs this pledge.

Generally, there are two types of surety bonds that contractors will most often run across: contractor license bonds and contract bonds. Contractor license bonds are a type of license and permit bond, while contract bonds are an umbrella group of bonds that are required by private construction project owners/developers to ensure that contractors have a solid work history and the skills and materials to finish a job on time, on budget and according to the required specifications. Unless otherwise specified, it’s safe to assume that construction professionals are referring to contract bonds when talking about surety bonds.

As Danielle states in her article, “contractors typically file surety bonds because they pay just a fraction of the required protection, but cash or certificates of deposit can also be filed with the state. The California Contractors State License Board (CLSB) requires every contractor to file $12,500 of financial security with the state as a part of the licensing process. Applicants with good credit could pay just $110 for annual license bond protection while those with bad credit could pay as much as $1,350 for annual license bond protection.”

Furthermore, most publicly funded projects in California require performance bonds to be issued for 1/2 of the contract price. And, all public works projects contracted for more than $25,000 require payment bonds issued for full contract price. Surety underwriters typically charge premiums calculated at 1-4% of the bond amount. So, if you need a $50,000 performance bond for a $100,000 project, your premium would likely be between $500 and $2,000.

Without the appropriate surety bond(s) in place, the project developer won’t allow you to begin work on the project. If you plan to work on multiple public projects contracted for more than $25,000 each year, you’ll need to have enough cash on hand to pay for your bond premiums up front and in full. (Also note that while surety bonds aren’t legally required for privately funded projects, the developer can still choose to require them.) If you can’t afford to get bonded, you won’t be approved to work on projects. The costs associated with bonding is one factor that can limit the reach of “small contracting firms.”

When is a claim filed on a bond?

If a contractor fails to uphold the terms set by the project owner and stated in the surety contract — such as failing to pay subcontractors/suppliers, missing the project completion deadline, exceeding the agreed-upon budget for the project or completing the project with structural flaws or other problems — a claim can be filed on the bond. As stated on the CSLB website, “claims against a surety company may be filed by homeowners, any person damaged by a willful and deliberate violation of a construction contract, employees damaged by the contractor’s failure to pay wages, or an express fund damaged as a result of the contractor’s failure to pay fringe benefits for eligible employees. (A court case has held the express trust fund provision superseded by federal law.)” In most cases, the construction project owner/developer or another harmed party would file this claim with the surety underwriting company that produced the bond.

Once a claim is filed, an investigation will ensue. According to the CSLB website, “surety companies will investigate any claim filed against a bond, and the CSLB will investigate any complaint filed against the license.”

What happens when a claim is validated?

If a claim against a contract surety bond is filed and validated, two things will happen. First, the surety company will repay the obligee or harmed party (project owner/developer, government agency, subcontractor, supplier, etc.) up to the full amount of the bond. The contractor must then reimburse the surety company.

Depending on the severity of the situation, a proven claim might call for the revocation of a contractor’s license. If this occurs, it will be nearly impossible for the contractor to legally work on construction projects within the state of California. The ability to obtain a contract surety bond is based almost exclusively on credit score, past work history and previous bonding history. Any blemish on this record — especially that of a validated bond claim — will severely affect the contractor’s ability to be bonded and, therefore, work in the future.

Surety bonds can be confusing, especially when it comes to the claims process. Still, it’s important to remember that the surety industry is one of minimal loss. The goal of surety bond requirements is to ensure that professionals of all types — contractors included — perform their duties ethically and in accordance the laws of the state and industry. Over the years, surety bonds have held countless professionals accountable for their actions while on the job with a relatively low amount of resulting financial loss. California’s surety bond requirement for contractors is just one more way to ensure that these professionals produce quality, lawful work while completing projects on time, on budget and according to other specifications.

Sara AisenbergSara Aisenberg is the director of educational outreach at SuretyBonds.com, which is a leading resource within the surety industry. Through her writing, Sara strives to help professionals of all types understand the intricacies of surety bonds and how they pertain to their specific industries. You can keep up with Sara on Google+.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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