A Cautionary Tale
Date: February 2016
Attractive interest rates combined with the need to repair or remodel existing buildings or construct new facilities finds many MCIT members planning construction projects. There are a host of items to check off in preparation for a public building project. One is ensuring that contractors provide valid bonds for construction projects.
Public entities are required to follow procurement rules set forth in statute to ensure that tax dollars are well spent. One such statute (Minnesota Statutes, Section 574.26) requires that contractors for public projects valued at more than $100,000 provide a performance bond and a payment bond, sometimes known as construction bonds.
Purpose of Bonds for Construction Projects
A performance bond guarantees the performance or completion of the construction project. If for any reason the contractor fails to complete the project, the owner can make a claim against the guarantor (insurance company or surety company) to provide the amount of the bond, which the owner can use to find and pay another qualified contractor to finish the project under the terms of the contract. A payment bond guarantees the payment of subcontractors and suppliers working under the terms of the project.
Construction bonds are an additional insurance that contractors provide to the owner as a condition of being awarded a project. The ability to provide the construction bond is generally a sign of a contractor’s financial stability and quality of work.
Performance and payment bonds are issued by an insurance or surety company to construction companies. The bond is a formal, notarized document that should be provided to the owner at the time of entering into the contract for construction of the public project.
A contract with a public body for doing public work valued over $100,000 is not valid unless the contractor gives:
- a performance bond to the public body with whom the contractor entered into the contract, for the use and benefit of the public body to complete the contract according to its terms, and conditioned on saving the public body from all costs and charges that may accrue on account of completing the specified work; and
- a payment bond for the use and benefit of all persons furnishing labor and materials engaged under, or to perform the contract, conditioned for the payment as they become due of all just claims for the labor and materials.
Reasonable attorney fees, costs and disbursements may be awarded in an action to enforce claims under the act if the action is successfully maintained or successfully appealed.
When a contractor fails to pay its subcontractor according to the terms of the agreement, the subcontractor contacts the bond company and requests payment. Unfortunately, things do not always go as expected.
Recently, a contractor provided several public entities with forged payment and performance bonds. The contractor used a printer and was able to purchase items off of the Internet to create the gold seal and embossed stamp to make the bonds look authentic, even using the name of an established bond company.
The forgeries were discovered after a subcontractor who had not been paid on a project contacted the bonding company to collect under the bond. The bonding company refused payment after determining the bond was fraudulent. The contractor was investigated and eventually charged with criminal fraud.
During the investigation, the contractor indicated he forged the bonds because he was not able to qualify for bonds in the course of business due to his criminal background. Because the bonds were forged, the bond company had no obligation to honor the request for payment, and the owners of the project were responsible for payments to the subcontractors who had not been paid. In many cases, this results in the entity paying double for the project.
Risk Management Considerations
Forgery of construction bonds is not common, but it is something that a public entity should guard against when contracting for public construction projects. Members should add verifying the authenticity of construction bonds to the checklist of items required as the entity enters into a construction contract.
Protect the Organization
STEP 1: Members should verify the validity of the bond. They should contact the surety/bond/insurance company and provide it with the number of the bond. The bond number should coincide with the name of the contractor, the project owner and location, and dollar amount attributed to the project.
If the bond is not a true and accurate representation of the obligation that the surety company has promised to honor, the company can tell the member immediately. Bonds are required by statute as a form of insurance in the event a contractor cannot finish the job or fails to pay subcontractors.
The public entity should make sure the bond is valid to avoid being liable if the contractor cannot meet its obligations for a project.
STEP 2: Members should understand the type of bond that is required by the project. Then have the bond and the contract reviewed by legal counsel.
STEP 3: Construction bonds are evidence of a contractor’s financial stability. Members should consider requesting the bonds as part of the bid documents. It would be most unfortunate to accept a bid because it is lower than others only to have to pay subcontractors.
If members have questions about construction bonds, they should contact their MCIT risk management consultant toll-free at 1.866.547.6516.
Minnesota Statutes, Section 574.29 Failure to Get Payment Bond
If the state or other public body fails to get and approve a valid payment bond or securities in place of a payment bond as required by the act, the public body for which work is done under the contract is liable to all persons furnishing labor and materials under or to perform the contract for any loss resulting to them from the failure. The public body is not liable if the bond does not list the proper address of the contractor on whose behalf the bond was issued or of the surety providing the bond.
MCIT does not provide coverage for this exposure. The MCIT Coverage Document specifically states, “MCIT coverage does not apply to any claim arising from the failure to purchase or secure adequate insurance, surety bonds or coverage.”