Use Performance and Payment Bonds to Protect Against Downside Risk

Eugene J. Heady – July 26, 2012

By nature, most contractors are risk takers.  To a contractor, calculated risk can be fortune’s accomplice.  Failure to recognize, calculate and properly manage the risk inherent in any construction project can, however, lead to financial disaster for any one or all of the participants in a construction project.  Once project risks are recognized, carefully drafted contract documents can help to allocate project risks between or among the various contracting parties.  For example, common strategies for allocating project risks include the use of contractual indemnification provisions, requirements for builder’s risk and commercial general liability insurance policies, and requirements for performance bonds and payment bonds.  Requiring performance and payment bonds on a project can provide significant protection against the downside risk of a failure to perform the work or failure to pay subcontractors and suppliers.

It is important to understand two types of bonds that you are likely to encounter on a construction project—performance and payment bonds—and to understand the relationship among the parties.  There are three parties in the construction surety bond relationship: the surety, the principal and the obligee.  The principal is the party obtaining the bond, typically the contractor or subcontractor.  The obligee is the party to whom an obligation is owed under the bond, typically the owner or contractor.  The surety is the party issuing the bond.  The surety is bound to perform in accordance with the contract and the terms of the surety bond if the principal fails to perform.  Performance bonds are obtained to ensure the contractor’s faithful performance of its contract with the owner or to ensure the subcontractor’s faithful performance of its subcontract with the contractor.  Payment bonds are obtained to ensure payment to third party “claimants” who furnish labor, material or equipment on a project.

A performance bond is a project specific contractual agreement between a contractor and a surety by which the surety guarantees to arrange for the completion of a contract if the contractor runs into trouble and fails to complete the project.  A performance bond is intended for the protection of the owner (or of the contractor, if dealing with a performance bond provided by a subcontractor).  A performance bond is different from a payment bond in that a performance bond is not intended to protect unpaid subcontractors or suppliers.

A payment bond is a project specific contractual agreement between a contractor and a surety by which the surety guarantees payment for the labor and materials contracted for and used by the contractor on the project.  It is a guarantee of payment that is intended to benefit and protect subcontractors and suppliers if the contractor (bond principal) fails to pay for the labor or materials furnished on the project.  A payment bond differs from a performance bond in that the payment bond does not directly protect the owner.  While the owner may make a claim against a prime contractor’s performance bond, an owner does not typically furnish labor, material or equipment on a project with the expectation of payment under the prime contract and thus would not be a claimant under the prime contractor’s payment bond.

Given the important protection provided by a payment bond, subcontractors and suppliers who may be potential claimants under a payment bond should request and obtain a copy of the payment bond at the outset of the project—well before there are payment problems.  Potential claimants should carefully review and become familiar with the terms of the payment bond and the requirements for asserting a claim against the bond if it becomes necessary.

You should be aware that both performance and payment bonds involve various notice and timing requirements relating to asserting claims and initiating mediation, arbitration or litigation.  It is critical to identify all timing and notice requirements and to then strictly follow these requirements.  Failure to comply with notice and timing requirements may bar an otherwise valid claim.

You should familiarize yourself with any state and federal bond statutes that are applicable to your project and determine whether the applicable state or federal statute requires posting of a performance and payment bond.  Importantly, the applicable state or federal statute involved, together with court decisions interpreting the respective statutes, will dictate which project participants may recover under the bonds and what procedures must be followed to perfect your claim against the bond.  It may be helpful to seek the advice of competent construction law counsel at the outset of a project and, certainly, upon the first hint of trouble on the project.

via Use performance and payment bonds to protect against downside risk – Lexology.

Changes to North Carolina Mechanics Lien Laws

In July, Governor Perdue signed two bills into law which make substantial changes to the state’s mechanics lien and bond laws.  With respect to private projects, the most significant changes relate to the creation of “Lien Agents” who must be placed on notice by any potential lien claimant.

Beginning April 1, 2013, all private construction projects valued at $30,000.00 or more will require the designation of a Lien Agent.  The project owner must designate the Lien Agent from a list of title insurance companies or insurance agents maintained by the N.C. Department of Insurance.  The Lien Agent is entitled to collect a fee from the Owner of not more than $50.00.

If a building permit is required for a project, the permit is required to identify the Lien Agent and be posted at the project site.  If the building permit fails to identify the Lien Agent, or if no permit is posted, a lien claimant can submit a written request to the owner to identify the Lien Agent.  The owner must respond to this request within seven (7) days.  Likewise, a contractor or subcontractor must provide a materials supplier with written notice identifying the Lien Agent within three (3) business days of contracting with the supplier.

Any potential lien claimant (i.e., contractor, subcontractor or materials supplier) who wishes to preserve its full lien rights must serve a Notice on the lien agent.  Under the new statute, the Notice must include the following:

  1. lien claimant’s name, mailing address, telephone number, fax number and electronic mailing address
  2. the name of the party with whom the potential lien claimant contracted
  3. a description of the real property sufficient to identify it
  4. notice of the potential lien claimant’s right later to pursue a claimed lien for the improvements described in the Notice

In order to preserve all lien rights, the potential lien claimant must serve the Notice on the Lien Agent within fifteen (15) days after first furnishing of labor or materials to the project.  Failure to file the notice of lien within this time can result in the termination of the claimant’s rights if the property is sold or the subordination of the lien claimant to a new deed of trust or mortgage.  The Notice must be served by one of several designated methods including physical service of the notice (with a receipt of delivery) or by certified mail, return receipt requested.

The requirement that Notices to a Lien Agent be served is mirrored in another change to the lien laws.  Beginning January 1, 2013, all claims of lien on real property must be served on the owner, and a claim of lien on real property asserted by a subcontractor or supplier by subrogation must be served upon the contractor as well as the owner.  Prior law allowed a claim of lien to be filed but not served.  Beginning in January, a claim of lien on real property will not be perfected until it is both filed and served.  Therefore, service and filing of the claim of a lien on real property must occur no later than 120 days from the last furnishing of labor or materials to the project by any person claiming the lien.

Owners, contractors, subcontractors and suppliers need to revise their current procedures with respect to potential lien claims to take into account the significant changes wrought by the recent session of the General Assembly.  New forms for a Notice to Lien Agents need to be developed to accommodate the modifications required  for lien claims on real property.

Second Circuit Clarifies Copyright Protection for Architectural Works and Drawings

David M. Kohane and Adam J. Sklar, August 22, 2012

Until 1990, federal law extended copyright protection to original architectural drawings, but generally did not extend such protection to actual buildings, even buildings constructed from protected drawings.  The drawings were protected from copying as “pictorial” or “graphic” works, just like any sketch or painting.  The drawings only had to have a minimal degree of originality to enjoy protection.

Except for purely ornamental features separable from the structure, buildings did not enjoy the same protection.   Buildings were considered functional works excluded from protection under the Copyright Act.  In 1990, Congress passed the Architectural Works Copyright Protection Act of 1990 “AWCPA”, amending the Copyright Act to fill that gap.  The AWCPA explicitly extended copyright protection to “architectural works,” so as to include completed buildings themselves registered with the Copyright Office.

Last week, the Second Circuit Court of Appeals clarified that the pre-existing protection of architectural drawings as “pictorial” works survived enactment of AWCPA.  In Scholz Design, Inc. v. Sard Custom Homes, LLC, Docket No. 11-3298 2d Cir. August 15, 2012, the court considered a design firm’s claim for infringement of front elevation drawings showing the appearance of the front of three houses, surrounded by lawn, bushes and trees.  There was no dispute the defendants had published exact copies of the drawings.  The lower court had held, however, that these drawings were not protected under the Copyright Act, as amended by AWCPA.  The court interpreted previous decisions as holding that architectural drawings only could be protected if they contained sufficient detail from which a building could be constructed.  That interpretation sought to reconcile the extension of copyright protection to architectural works, through AWCPA, with the long-established principle that copyright law does not protect ideas, only the particular expression of ideas.

The Second Circuit disagreed.  The court held that regardless of whether the drawings were protectable as “architectural works” under AWCPA, they remained protectable as “pictorial” works under pre-existing law.

Scholz Design confirmed that AWCPA’s extension of copyright protection to buildings did not result in a contraction of protection for the underlying drawings.  Thus, according to the Second Circuit, the unauthorized publication or reproduction of original architectural drawings, even where lacking in detail needed for actual construction, has been and remains unlawful.

via Second Circuit clarifies copyright protection for architectural works and drawings – Lexology.

Residential Construction Liability

Sarah A. Cardwell and Curt M. Covington – July 26, 2012

A letter arrives from a homeowner. Picking it up, you notice it was sent by certified mail, return receipt requested. As you read the letter, it quickly becomes apparent that the homeowner is complaining about your work. You want to investigate whether there really is a problem; and if there is, of course, you want to make it right. How can you protect yourself along the way? Didn’t the Texas Residential Construction Commission use to handle these things? And what must you do now under the Residential Construction Liability Act?

This article will answer these questions. Since the sunset of the Texas Residential Construction Commission (TRCC) in 2009, the Residential Construction Liability Act (RCLA) has assumed—once again—its role as the governing law for both residential construction disputes and the procedure to follow before there is a full-blown dispute. But many builders, contractors, and remodelers are unfamiliar with the RCLA. The state of the law is certainly confusing now that the TRCC—whose procedures were mandatory—has vanished.

Being familiar with and taking advantage of the RCLA is very important in limiting exposure in potential disputes and—hopefully—resolving issues out of court and before they turn into disputes. After looking at the state of the law in this area, this article will examine the applicability of the RCLA, what to do when a letter like the one above arrives in the mail, and how to limit your exposure in those instances when the customer just cannot be pleased.

The Sunset of the TRCC and the (Re)dawn of the RCLA

From 2003 to 2009, the TRCC was the governing body that would handle the initial claims from dissatisfied homeowners. In 2009, the Legislature opted to sunset the TRCC. The TRCC stopped receiving new claims in September 2009, stopped processing existing claims in September 2010, and thus completely shut down by September 2010. The removal of the TRCC’s framework for handling construction disputes brought a return to the RCLA’s framework, codified in Chapter 27 of the Texas Property Code.

Without a commission to process these claims, the process has returned to direct communication between the homeowners and contractors, governed by the terms of the RCLA. While this is not new (the RCLA was enacted in 1989 and has been amended multiple times), it can certainly be unfamiliar territory since the TRCC was at the forefront for six years.

How Do I Know if This Statute Applies to Me?

As a general rule, the RCLA and its producers will not normally apply to subcontractors, trades, design professionals, and suppliers. The RCLA most frequently concerns only builders, large remodelers, and warranty companies. Precisely naming to whom the act applies, however, requires working through the definitions and statutory language.

First, the RCLA applies to any action to recover damages arising from a construction defect. It does not apply to personal-injury, wrongful-death, or damage-to-goods claims. Next, “construction defect” is defined as “a matter concerning the design, construction, or repair of a new residence, of an alteration of or repair or addition to an existing residence, or of an appurtenance to a residence, on which a person has a complaint against a contractor.” Finally, a “contractor” is (and thus the act only applies to):


  • Anyone making “material improvements” to residences or appurtenances
  • Anyone making large, interior improvements to residences or appurtenances ($20k plus)
  • Anyone building a new home or condominium
  • Warranty companies or risk-retention groups

Contractors are not: 

  • Architects or engineers
  • Suppliers, construction managers
  • Those working with a license supplied by the State and working in the area in which they’re licensed (i.e., trades)

The Nuts and Bolts of Limiting Exposure

The RCLA provides a great opportunity to limit exposure if the contractor makes a “reasonable” offer of settlement to a homeowner. The ultimate decision-maker (judge, jury, or arbitrator) will determine if the offer was reasonable. Most importantly, if the homeowner rejects a reasonable offer, in a later lawsuit he can recover only the cash value of that offer plus any legal fees incurred up to the date of the offer was rejected. Since legal fees at that point are normally small, this is an opportunity to limit future damages at the outset by making a reasonable offer. The purpose behind this process is to reduce litigation by encouraging contractors to make reasonable offers of settlement and encouraging homeowners to accept such reasonable offers.

Here’s how it works. The homeowner must notify the contractor, describing in reasonable detail the nature of the complaint, 60 days before filing suit. After receiving that letter a contractor has 35 days to inspect the home and 45 days in which to make the offer. The homeowner has 25 days to accept or reject the offer and must state in reasonable detail why it is unreasonable. The contractor then has 10 days in which it may make a supplemental offer.

The categories of damages the offer should address (if they are justified) are the categories of damages available under the RCLA: (1) the reasonable cost of repairs necessary to cure any construction defect; (2) the reasonable and necessary cost for the replacement or repair of any damaged goods in the residence; (3) reasonable and necessary engineering and consulting fees; (4) the reasonable expenses of temporary housing reasonably necessary during the repair period; (5) the reduction in current market value, if any, after the construction defect is repaired if the construction defect is a structural failure; and (6) reasonable and necessary attorney’s fees. The offer does not need to include all of these categories. But, since these are the types of damages available under the statute, it is good practice to include an amount for each category to the extent it is justified.

Thus, as you hold the letter from the homeowner and prepare to respond, keep in mind these categories of damages to the extent they may be justified by the defect.

The RCLA statute itself and court decisions interpreting it do get a bit more complicated; but this is the general framework and it is imperative that contractors be familiar with it. It is always a good idea to engage competent legal counsel at the outset of this process to ensure you’re following the statute and doing everything possible to limit exposure.

Creativity can Forfeit a Construction Lien

David Anderson – August 6, 2012

As a construction project winds down, money to pay for it can start to dry up. But contractors with construction liens have super-priority. That is, contractors can get their payments before other creditors get theirs. When money is short, that can be the difference between getting paid or not. But management of a construction lien requires strict compliance with lien law.

The Oregon Court of Appeals recently issued a decision that serves as a warning to contractors looking to enhance their construction lien in creative ways. In Evergreen Pacific Inc. v. Cedar Brook Way LLC, the contractor and the owner had a dispute about the contractor’s work.

The dispute itself was nothing special. The owner claimed that the contractor did not perform the work as required and did not pay the contractor. The contractor filed a construction lien claim against the property.

Then complications arose. The owner had obtained a loan from a bank and, to secure payment on that loan, granted the bank a trust deed to the property: The owner used the property as collateral for the loan. That meant that if the value of the property was less than the sum of the construction lien and the amount owed the bank under the loan, either the contractor or the bank would not be paid in full. In modern terms, if the property was underwater, not all creditors would be paid if the owner ran into financial challenges.

Not surprisingly, the bank was not happy with the situation. It counted on the property as collateral to ensure that the loan would be repaid. The owner’s refusal to pay the construction bill, even if justified, reasonably caused the bank to wonder if it would be repaid on the loan. Although some types of trust deeds or mortgages can take priority over construction liens, the bank’s trust deed in this case did not. The bank demanded that the owner take care of the construction lien.

Heeding the bank’s bidding, the owner sued the contractor to invalidate the construction lien. In an attempt to resolve the dispute in a mutually beneficial manner, the contractor and the owner reached an agreement: The owner would pay the contractor for the work it had performed, some new work and additional repair work (the owner would make an immediate partial payment and pay the balance in lump sums after the contractor finished new work or repairs).

Rather than rely exclusively on its right to file an additional construction lien if the owner again failed to pay the contractor for its work, the contractor agreed that the owner would grant the contractor a trust deed to secure payment. From the contractor’s view, this provided a belt and suspenders to ensure payment.

By tacking a trust deed on top of the right to a construction lien, the contractor sought extra payment protection. In case there was any question about its right to a construction lien, the contractor ensured that the agreement expressly stated the contractor did not release or waive the contractor’s right to record a construction lien if the owner failed to make required payments. At least that was the plan.

Even the best made plans can go awry. The contractor performed the new work it agreed to perform. But following completion of the new work, the owner refused to make payment and even refused to let the contractor access the property to finish the repairs. Meanwhile, the owner also failed to make payments on the bank’s loan. This led to a showdown between the contractor and the bank as both sought to sell the owner’s property and be paid from the sale proceeds. As expected, more litigation followed.

Between the bank and the contractor, there was no dispute that the contractor’s construction lien took priority over the bank’s trust deed. The bank argued nonetheless that the contractor’s lien was invalid because the contractor forfeited its construction lien rights by taking a deed of trust on the owner’s property.

A well-respected trial judge ruled for the contractor, explaining that the construction lien was valid and noting that the bank had no right to complain because it knew about the settlement agreement between the contractor and owner in which the contractor expressly did not waive its construction lien rights.

The bank appealed, and the Oregon Court of Appeals ruled that the trial court was mistaken. It explained that by taking a deed of trust, the contractor forfeited its right to a construction lien. As support for its decision, the court relied on cases from 1861, 1879 and 1932.

Even though those cases were very old, the court reasoned that nothing had changed. It stated, “The parties have not identified any statutory changes that undermine the general principles announced in (1879), or call the continuing viability of (those earlier decisions) into question, and we are not aware of any.”

In other words, ancient law can be enforceable when nothing has changed to affect that law.

So, what is the lesson? When it comes to construction liens, wearing a belt and suspenders is not stylish. Ancient cases can complicate the world of lien law.

Yet properly administered construction liens provide powerful payment protection for contractors. Contractors should take advantage of these liens to ensure payment on projects to the greatest extent permitted by law and business sense.

But contractors should be cautious about managing this complicated area of the law on their own. Sometimes disputes merit complex or creative solutions. In executing a unique agreement, a lawyer’s caution is needed to ensure that Civil War-era laws do not undermine what would otherwise be a benign solution.