Complex Construction Defect Claims Involving Performance Bonds and Insurance: Who Pays First?—Part 1

The Function of Performance Bonds

A performance bond is not insurance. The insurance policy is a contract of indemnity, while a surety bond is a guaranty of the performance of the principal's obligations. An insurance policy is issued based on an evaluation of risks and losses that is actuarially linked to premiums. Losses are expected. In contrast, a surety bond is underwritten based on what amounts to a credit evaluation of the particular contractor and its capabilities to perform its contracts, with the expectation that no losses will occur.

Sureties usually maintain close relationships with their contractor-principals as well as the contractor's bank, accountants, and attorneys. As part of the underwriting of bonds, the surety analyzes the strengths and weaknesses of the contractor and its ability to perform its obligations. In short, the underwriting process is very similar to the process used by a lender in making a loan.

The performance bond is not for the protection of the contractor, but rather for the protection of the owner (obligee). If the contractor fails to complete its construction contract, the surety may satisfy its obligation to the owner under the bond by providing additional financing so that the original contractor can complete the work, or by finding another contractor to complete the construction, or finally, by having the owner complete the job itself, with the surety paying the extra costs.

The performance bond is a three-party document between the owner, the surety, and the contractor, with the surety retaining a right of indemnity against the contractor as well as other third-party indemnitors, typically the individual owners of a construction company. In the event of a claim, the surety will invoke the indemnity agreement with its principal (the contractor) and its indemnitors to hold it harmless and often to defend it against the claim. Thus, the contractor will, in effect, be required to pay the loss from its own funds when it indemnifies the surety. Of course, an insurance company has no right of indemnity against its insured, although it may seek to recover its losses from third parties through subrogation. Also, it is the liability insurer that bears the duty to defend claims alleged against its insured contractor if those claims arguably are covered under the policy.

Performance Bonds versus CGL Policies

Courts have examined the differences between performance bonds and liability insurance in the defective work context with varying results. In Fidelity & Deposit Co. of Maryland v. Hartford Cas. Ins. Co., 189 F. Supp. 2d 1212 (D. Kan. 2002), F&D was the surety on the performance bond and Hartford was the liability insurer for National, the insured contractor. After serious construction deficiencies arose at the project, F&D proceeded to complete the construction, which included demolishing and rebuilding portions of the project. F&D incurred substantial costs, and proceeded as assignee of the insured contractor against Hartford. Hartford argued that the damage to the project, caused by negligent workmanship of National and its subcontractor, Midwest Drywall, was not covered, because providing insurance coverage for the damage would transform the insurance policy into a performance bond.

The court rejected this argument, explaining that the performance bond and the insurance policy are completely different. The court stated that a performance bond does not insure the contractor; it runs to the benefit of the third-party owner only. F&D provided a performance bond on the project that ran to the benefit of the School District, not to National or Midwest Drywall. Since F&D sued National and Midwest Drywall pursuant to an indemnification clause in the performance bond for expenses incurred in finishing the project, the performance bond in no way protected or insured National or Midwest Drywall from liability.

On the other hand, some courts have confused the issues. One of the seminal cases espousing this point of view is Bor-Son Building Corp. v. Employers Commercial Union, 323 N.W.2d 58 (Minn. 1982). In that case, the court analogized the CGL policy before it to a performance bond to bolster a denial of coverage to a general contractor for property damage arising out of the defective workmanship of its subcontractors. The court described the "CGL policy as performance bond" rationale as follows:

Any damages to the building sustained by HRA [the owner] because of defective workmanship or materials flowed from the contract documents and the obligations Bor-Son undertook therein. To protect the owner, HRA, from loss resulting from building damage, Bor-Son was required to furnish a performance bond. To protect those who sustained damage to person or property—other than for damages to buildings which were the subject matter of the contract—Bor-Son was required to carry comprehensive general liability insurance. The distinction between a performance bond and a comprehensive general liability insurance policy, in our view, is crucial to the resolution of the issues of this case. The allegations in the HRA complaints concern faulty workmanship and materials resulting in damage to the buildings themselves. These allegations, if proved, were damages resulting from a breach of contract whether the acts or omissions giving rise to the claims were negligent or intentional. Since the alleged building damages were the result of alleged breach of contract, there was no duty on Commercial Union, the comprehensive general liability insurer, to defend the HRA actions nor to indemnify Bor-Son for its contribution toward the settlement of those actions.

In that case, the court ignored the language of the policy that provided the insured general contractor with coverage for property damage to and arising out of the work of its subcontractors.

Potential Overlap of Performance Bonds and CGL Policies

One of the undercurrents running through the authorities supporting the "CGL policy as de facto performance bond" rationale is that the scope of "coverage" of a performance bond and CGL policy must be mutually exclusive. While it is true that there are many types of risks and losses that fall within the ambit of a bond and not an insurance policy, and vice-versa, there remains a considerable overlap between the two. This is particularly true, where, as in the case of defective work, a breach of the bonded contract may be involved. In that connection, consider the diagram below.

CGL Policy as De Facto Performance Bond Continuum

The diagram illustrates a continuum of job site risks. Along that continuum, at the left are pure CGL policy losses, i.e., bodily injury, and moving farthest to the right, a performance default by the contractor, a pure performance bond loss. Superimposed on that continuum is the scope of coverage provided by a CGL policy and a performance bond, signified by the dotted lines. As can be seen, there is an overlap in the middle.

Starting at the left, assume that an accident at the job site seriously injures the employee of a subcontractor to the insured. In the event the insured contractor is sued by that employee, the contractor's CGL policy would respond to this insurance claim. Next, assume a subcontractor's crane collapses, causing damage to major portions of the project. Absent a waiver of subrogation, the contractor's CGL policy may be required to respond to that loss. At the same time, the collapse and the attendant damage may constitute a breach of the bonded contract and fall within the bonded obligation of the contractor, and thus the performance bond.

Much the same can be said for a leaky roof installed by the roofing subcontractor on a project. Again, the contractor's CGL policy will respond to claims for property damage, even for the cost of repairing the roof itself. Likewise, the roofing failure will constitute a breach of the bonded contract, thus implicating the performance bond. Finally, at the far right of the continuum is a classic default by the bonded contractor due to insolvency. Such a default is a performance bond matter and should not impact liability coverage for the contractor as an insured.

Thus, the diagram illustrates that many claims, particularly defective work claims, may have a potential impact on both the performance bond and the CGL policy. The two seldom can be separated from each other where there is a breach of contract involving the work. Nevertheless, due to the relationships of the parties, that is the two-party relationship between the insurer and the insured, versus the principal-surety relationship involving indemnification obligations on the part of the principal to the surety, the liability policy should usually step up to the plate first in these types of losses.

The potential overlap of a CGL policy and a performance bond was recognized by the court in Kalchthaler v. Keller Constr. Co., 224 Wis. 2d 387, 591 N.W.2d 169 (Wis. App. 1999). There, the court applied the exception to Exclusion (l) to uphold coverage for claims against a general contractor for water damage to the interior of new construction caused by faulty window installation by a subcontractor. In the course of doing so, it stated as follows:

For whatever reason, the [insurance] industry chose to add the new exception to the business risk exclusion in 1986. We may not ignore that language when interpreting case law decided before and after the addition. To do so would render the new language superfluous. [Citation omitted.] We realize that under our holding a general contractor who contracts out all the work to subcontractors, remaining on the job in a merely supervisory capacity, can ensure complete coverage for faulty workmanship. However, it is not our holding that creates this result: it is the addition of the new language to the policy. We have not made the policy closer to a performance bond for general contractors, the insurance industry has.

In reaching its conclusion, the court concentrated on the language of the policy before it and not the insurer's overly simple argument that to grant coverage would "turn the CGL policy into a performance bond."

This overlap between the scope of "coverage" provided by a general liability policy and performance bond further weakens the argument that providing coverage for elements of defective work per the terms of the CGL policy creates an untenable situation vis-à-vis a performance bond. This simply is not the case and the "CGL policy as performance bond" argument can lead to unwarranted restrictions on coverage. These restrictions are contrary to both the language of the policy and the underwriting intent.

Moreover, the overlap in terms of applicability of both a performance bond and a CGL policy to certain defective work claims is demonstrated by the right of equitable subrogation that exists in favor of the surety. Where a performance default involves defective construction on the part of the contractor, once the surety cures the default, it stands in the shoes of the defaulting contractor and has a right of subrogation against the contractor's CGL insurer to the extent the surety's loss involves property damage within the CGL coverage. The issues created by equitable subrogation by the surety under those circumstances are the subject of the second part of this column.

Part 2 explains how performance bond sureties may look to the contractor's CGL insurer to recoup losses.