The Basics of Subcontractor Defaults – Key Considerations

Gerard J. Onorata | Peckar & Abramson

The success of general contractors in completing a construction project is often dependent upon the performance of their subcontractors. General contractors have frequently said exactly this. Traditionally, the key subcontractors on a project are the electrical, plumbing, HVAC and structural steel subs. Due to the fundamental nature of the work performed by these trades, the risk of defaulting and terminating one or more of them is likely to have a substantial impact on the project, more so than with the trade contractors that perform their work after a building is made weather tight (i.e., drywall, tile, painting).

Most general contractors have, over a period of years, established longstanding relationships with certain subcontractors that they have come to depend upon. The risk of having to default and terminate one of these subs is minimal. Nevertheless, there will inevitably arise occasions when even a once reliable subcontractor fails to perform and it becomes necessary to invoke the remedies of default and termination. Areas ripe for controversy with subcontractors that often can lead to default and termination often involve disputes over change orders and the scope of work, the installation of defective work and the back-charges that ensue therefrom, and, to a lesser extent, conflicts that arise from ambiguous plans and specifications and the extra work and delays caused by the discovery of unforeseen site conditions.

Preparedness is Essential

The old adage that an ounce of prevention is worth a pound of cure is especially appropriate when it comes to subcontractor disputes. General contractors will want to be in the best position possible in the event they have to default and terminate a sub. When this occurs, the general contractor’s first line of defense is a well written subcontract agreement that clearly spells out both parties’ rights and obligations. Therefore, when preparing the document, attention should be paid to clearly defining the scope of work. Also, since time is money on a construction project, equally important is the identification of key project milestones for the completion of critical items of work. Incorporation of a liquidated damages provision should also be included, especially if the prime contract with the owner contains a liquidated damages provision that can be invoked against the general contractor if one of their subs fails to perform.

Effective subcontracts between general contractors and their subs should have a number of additional key features, including:

  • A “flow-down” provision, passing through to the subcontractor all of the obligations that the general contractor has agreed to in its prime agreement with the owner;
  • A provision that states that compensation for extra work or delay claims will be paid only to the extent the owner deems such work to be “extra”. (This is important because most prime contracts routinely have stringent provisions limiting compensation for extra work and delay type damages.);
  • Incorporation by reference into the subcontract all the terms and conditions of the prime contract between the general contractor and the owner.

When Problems Arise

There are several red flags portending a subcontractor’s poor performance that general contractors need to pay attention to. These include:

  • the failure to properly staff the project;
  • premature demands for money;
  • lien claims from suppliers or vendors;
  • service of writs of attachment based upon judgments entered against the subcontractor;
  • delinquent tax notices or levies;
  • notices of deficiencies from union funds and the state Department of Labor;
  • requests for joint check agreements;
  • baseless change orders and requests for additional compensation; and
  • the filing of bankruptcy.

Defaulting and terminating a subcontractor ultimately becomes an exercise in minimizing risk and maximizing reward. Minimizing risk entails ensuring that no further sums will have to be paid to the subcontractor due to an adverse court decision or arbitration award. Maximizing reward involves recovering money from the subcontractor as compensation for any additional costs that have been incurred. General contractors can help themselves to minimize risks and maximize rewards by consistently documenting all project events while the subcontractor is performing its work on the project. The fact is that most construction disputes boil down to who has created the best “paper trail.”

In addition, with subcontractor disputes general contractors stand in a precarious position. because they are stuck square in the middle of trying to appease a project owner while at the same time protecting themselves from subcontractor claims. As such, general contractors must perform a careful balancing act by successfully documenting its case against the subcontractor, while simultaneously taking care that the information generated does not become ammunition for the owner in any disputes that may arise with the owner. This is not always a simple task.

Consider the following suggestions:

  • When general contractors are documenting a case against a subcontractor, it is best to keep the tone of your written record professional, concise and simple. This is not a time for creating documents full of explosive adjectives that berate a subcontractor’s performance;
  • Correspondence should recite the pertinent contract provisions and clearly indicate key facts and dates. It is important to create an accurate, contemporaneous record of the subcontractor’s performance on the project, because a dispute with a subcontractor may not be resolved until far into the future;
  • In today’s world of electronic transmissions, there is often a tendency for emails to be written as if the writer is having a conversation with the intended recipient, with little attention being paid to detail and the ramifications of what is being stated. Simply put, emails that document the poor performance of a subcontractor should be written with the same level of attention and detail as if they are formal letters;
  • More specifically and as a general rule, documentation confirming the poor performance of a subcontractor should answer the following questions: (a) what transpired; (b) when it occurred; (c) how the general contractor responded; and (d) confirm factually the circumstances surrounding the issue.

Keeping these points in mind will create an evenhanded and valuable record of events without putting the general contractor in harm’s way with the owner.

Subcontractor Termination

Preparing a well-documented record also serves the purpose of having a record to support the proper termination of a subcontractor. In the event it does become necessary to terminate, it is imperative that the termination provision of the subcontract be assiduously followed. By doing so it minimizes the chances of the subcontractor successfully mounting a claim for wrongful termination, which can lead to an award of punitive type damages. To the extent your subcontract gives the subcontractor an opportunity to cure its default, the opportunity must be provided to the subcontractor. Remember, as a basic legal principle, all parties to a dispute have a right to minimize their potential damages. If the subcontractor does not avail itself of the opportunity to cure, a termination letter should be issued in accordance with the terms of the subcontract. If the subcontractor is bonded, a copy of the default notice and termination notice must be provided to the surety. At the time of termination, an accurate written record should be made of any incomplete and/or defective work, supported by photographs and video. To the extent that defective work needs to be corrected, the work should not be removed until the subcontractor is given an opportunity to inspect it. This prevents later allegations of spoliation of evidence. In order to recover any losses that may be sustained in completing a subcontractor’s work or repairing defective work, documentation will be needed to support such a claim, including:

  • Identification of separate work events;
  • Daily reports prepared contemporaneously specifying the tasks performed and confirming the manpower employed with hours expended;
  • Confirmation of how costs are kept, tracked and coded; and
  • Back-charges

Forums

It is not uncommon after a default and termination of a subcontractor for the parties to wind up in a lawsuit. However, the forum in which such disputes will be decided is frequently not given proper consideration during subcontract negotiation. The likely reason is that the parties want to be cautious about sending a hostile signal even before work on a project has commenced. While such thinking is understandable, it is a mistake. A decision should be made whether the dispute should proceed in a court of law or an arbitration. Both forums have their pros and cons.

Proceeding in a court of law provides the parties with such benefits as the right to discovery, including depositions, and the right to appeal in the event they are not happy with the decision rendered by the court or a jury. Filing fees in court proceedings are also relatively low. If the dispute is heard by a judge, without a jury (i.e., bench trial), it is not likely that the judge hearing the dispute will have any special knowledge concerning construction or construction law. This is even more likely in a jury trial. In fact, there are very few positives to having a jury hear a construction dispute. Most construction disputes are complex, involve technical issues, and have protracted hearings that are typically accompanied by days of testimony and volumes of exhibits. Jurors will likely become confused by the morass of paper, testimony and conflicting stories that often occur during the trial. Also, juries can also be swayed by a sympathetic story that has nothing to do with the merits of a dispute and jury verdicts provide very narrow grounds for appeal and are very difficult to overturn. Moreover, litigation in court can drag on for years.

For all these reasons, some contractors have turned to the use of private arbitration. Arbitrations are typically heard by an experienced arbitrator or panel of arbitrators that have construction experience. While not inexpensive, arbitrations do provide for a speedier remedy in a less formal setting, where the rules of evidence are not strictly applied. The downside of arbitration is that there is limited paper discovery, usually no right to depositions and limited rights to appeal if you are unhappy with the arbitration award. Arbitration awards are also nearly impossible to have set aside. That said, many construction disputes are arbitrated.

Considering all of the pros and cons of either arbitration or court resolution, consider the selection of forums in the following order: (1) arbitration, (2) litigation in court via bench trial without a jury, and (3) litigation with a jury (perhaps the least desirable forum).

Conclusion

General contractors walk a fine line when balancing their relationships with owners and subcontractors in order to effectively deliver projects on time and within budget. It is important to keep in mind the aforementioned points in order to meet this goal. Implementing these strategies will facilitate successful project completion and the best possible outcome for your business.

Will Subcontractor Default Insurance Still Have Value in the Recovering Economy?

Nicole Lentini and Rebecca Clawson Juhl | Construction Law Blog

The COVID-19 pandemic has burdened subcontractors with workforce shortages, supply chain issues, and financial difficulties. Therefore, as states lift their stay-at-home orders issued to limit the spread of COVID-19 and construction projects resume, subcontractors’ ability to complete demanding, time-sensitive projects might be impacted. Subcontractor default is already a common and costly problem for general contractors. When subcontractors fail to complete their contractual obligations, a general contractor’s profitability and reputation are greatly impacted. Effectively managing the risk of subcontractor default will be increasingly important for general contractors in the post-pandemic economy.

Subcontractor Default Insurance (“SDI”) is a non-traditional insurance product which can minimize a general contractor’s damages resulting from a subcontractor’s default. It is a two-party indemnity agreement between a general contractor and insurer. It was created as an alternative to surety bonds, with the idea that the general contractor controls the default process and remedy to help keep projects on time and within budget. Under a SDI policy, a general contractor enrolls prequalified subcontractors for either a specific project or policy term. Then, the general contractor is indemnified by the insurance company for any covered costs incurred if one of the subcontractors defaults. Typically, SDI claims stem from labor, work delay and quality issues, as well as financial-related defaults, which are not covered under general liability insurance policies.

In addition to direct costs, SDI coverage usually includes indirect expenses such as liquidated damages, acceleration of other subcontracts, increased overhead and the like. The insurer shares the risk with the general contractor through a deductible and co-pay; the general contractor absorbs some of the costs associated with a subcontractor’s default, usually up the deductible amount. SDI coverage extends to the limits of the individual policy rather than being limited to the value of the subcontract.

In order to lessen their risk, SDI carriers require general contractors to prequalify subcontractors before they can be enrolled on the policy. General contractors are in charge of this process. In order to evaluate a subcontractor both operationally and financially, subcontractors must submit the following types of information: financial statements, proof of available lines of credit, safety record, and history of claims and litigation. For subcontractors, the prequalification process is not different than that for surety bonds, except that it is executed by the general contractor instead of a professional surety underwriter.

After the COVID-19 pandemic, insurance carriers will necessarily adjust their outlook on subcontractors due to the increased risk of loss. Therefore, it will likely be more difficult for general contractors to find subcontractors able to prequalify for SDI policies and, in any event, the process will become more tedious. In addition to the aforementioned information, general contractors will probably be interested in subcontractors’ business continuity plans and specific plans to mitigate impacts like loss of employees and/or project shutdowns.

General contractors must be large and sophisticated enough to have the resources necessary to properly pre-qualify subcontractors, including assessing the financial risks of accepting subcontractors, and monitor their schedules and performance for the duration of the project. While the pre-qualification process is necessary, it is insufficient to thoroughly manage the risk. Even a subcontractor who is prequalified at the outset of a project must be managed throughout the entire course of work. A general contractor’s oversight of subcontractor performance will be even more critical in the post COVID-19 economy as subcontractors are more likely to be operationally and financially stretched thin.

In order to even qualify for SDI insurance, a general contractor typically needs minimum annual subcontractor volume in the $50-$100 million range. In fact, for SDI to be cost-effective, carriers say that annual subcontracted values must exceed $75 million. This is because SDI is expensive, usually ranging from 0.4 to 0.85 percent of total subcontract values.

Given the increased risk of subcontractor default, SDI policies will likely be even more expensive as the economy recovers from the COVID-19 pandemic. Deductibles, which are already high, are likely to increase. Currently, it is not unusual for a deductible to be in the $500,000 range. In addition to that, SDI policies have a co-pay which is paid up the retention aggregate—often three to five times the deductible. That said, SDI will still have value and provide cost savings under the right circumstances. For very large jobs, it would be worth taking on part of the financial risk of default for general contractors to accept SDI’s high deductibles because it would cost much less (now typically 50% less) than subcontractors bonding and passing along costs within their bid. Another consideration is whether the costs can be absorbed by the project. General contractors can also strategically utilize SDI to target high-risk subcontractors.

Cost will not be the only determinative factor in evaluating SDI’s value after the pandemic. It is possible insurers will write more exclusions into policies to manage their own risk associated with impacts associated with mandated shutdowns similar to what the United States recently experienced. Accordingly, subcontractor default stemming from such a shutdown (including impacts like workforce shortages and supply chain backlogs) would unlikely be covered. SDI policies also generally do not cover defaults, which result from the following: misrepresentation, fraud, defaults occurring prior to the policy period, material breach of warranty by the contractor, contracts acquired from other entities, war and losses arising from providing professional services.

To determine whether or not SDI is a worthy investment, a general contractor must separately evaluate each project, and carefully weigh the cost, potential savings and risk involved.

COVID-19 Impacts on Subcontractor Default Insurance and Ripple Effects

Daniel McLennon | Smith Currie & Hancock

Subcontractor default insurance (“SDI”) may be described as an alternative to bonding subcontractors. SDI is first-party insurance that compensates the general contractor insured in the event a covered subcontractor fails to fulfill its contractual obligations. Under SDI policies, general contractor insureds are obligated to develop and implement rigorous subcontractor prequalification procedures.

Basic questions and answers about how SDI might come into play and impact the construction industry in response to COVID-19 follow:

Who may make a claim on an SDI policy?

The general contractor may make a claim. An Owner may make a claim if the general contractor becomes insolvent in many cases. Subcontractors may not make claims on SDI policies.

Does SDI replace payment and performance bonds?

Many general contractors use SDI (now in its 20th year) instead of subcontractor performance and payment bonds. Some general contractors use a combination of the two.

However SDI is not a replacement, on public work, for the required bonding of the general contractor. That law has not changed. When a general contractor provides performance and payment bonds, such as required for most public works projects, the owner receives assurance that funds will be available to complete the general contractor’s performance, and the subcontractor receives assurance that funds will be available to pay for the subcontractor’s performance. When the subcontractor provides the bonds, the general contractor receives assurance that funds will be available to complete the subcontractor’s work, and the lower tier subcontractors and suppliers receive assurance that they will be paid.

SDI, on the other hand, ensures funding to the general contractor. The owner generally benefits indirectly, and the subcontractors and suppliers not at all.

Why purchase an SDI policy?

Primarily, general contractors purchase SDI to protect against catastrophic losses caused by a subcontractor’s significant failure to perform. When triggered, SDI is intended to provide funding needed to correct and/or complete the work, and cover incidental costs, without the need for and delay inherent in litigation.

According to Jim Reichert, Risk Engineering Manager, Subcontractor Default Insurance at AXA/XL, a division of SA/AXA, in New York:

When a subcontractor does default, it typically costs about 65% more to complete the work they were contracted to perform, Mr. Reichert said. About 32% of those extra costs relate to physically completing the work, 21% relates to the costs of correcting poor-quality work, 12% goes to unpaid lower tier subcontractors, 9% goes to legal costs, 5% relates to staffing costs, and 21% are indirect costs, such as adjusting the schedule of the job, he said.

Subcontractor defaults require decisive risk management, by Gavin Souter, Business Insurance, November 8, 2019. SDI potentially protects the general contractor from all of the costs mentioned by Mr. Reichert.

Who pays for SDI policies?

Typically, the insured general contractor pays for the policy as a cost of its work, to help ensure the project will be built on time and on budget, by ensuring–through the required prequalification process–that quality subcontractors perform the work.

What is covered by an SDI policy?

Presently, seven insurance carriers offer SDI coverage, including Zurich, Berkshire Hathaway, Arch, AXA/XL, Cove, and Hudson. Their policies are all similar, but like most insurers, they have differences. An SDI policy typically covers the cost of completing and/or correcting the subcontractor’s work; legal costs of handling the default; investigation of impacts from the default; and other indirect costs, including Owner’s delay damages and/or liquidated damages, designer’s fees, and permit costs, among others.

Will SDI cover defaults by enrolled subcontractors due to COVID-19?

It depends. Generally the coverage grant is broad enough to include the type of losses a general contractor will suffer due to the subcontractors’ inability to complete the work caused by labor and materials shortages. However, SDI contracts vary, and some contain more limitations and exclusions than others. At least one policy expressly excludes coverage for loss caused by an epidemic. Others preclude losses for “acts of God” or actions by government authorities. However, because COVID-19 presents new issues, no case law has interpreted SDI contracts in light of these issues, and opportunities to recover for such losses may be available. The language of the applicable contract must be reviewed carefully to determine what coverage may be available.

How does SDI interact with other insurance?

Although it is called “insurance” it is not insurance in the classical sense, because the insured and the insurer under an SDI policy have a much more involved and interdependent relationship than under traditional insurance. Under SDI contracts, the insured takes on great responsibility to prequalify subcontractors and shares in the risk through high deductibles and copays. Unlike commercial general liability policies, SDI can provide funding where there is no physical injury to tangible property. Typically, SDI claims stem from labor, work delay and quality issues, as well as financial-related defaults, which are not covered under general liability insurance policies.

Thus, the policies cover different risks. Also, due to indemnity and subrogation clauses, the insured may bear a substantial burden to pursue coverage under a CGL policy to reimburse the SDI carrier for amounts paid under the SDI policy. See for example, Pavarini Constr. Co. v. Ace Am. Ins. Co., 161 F. Supp. 3d 1227 (S.D. Fla. 2015). For these reasons, SDI may not be considered “other insurance” within the meaning of typical Commercial General Liability Insurance policies, and SDI may not be called upon to share in a covered loss with the CGL policy. Thus, to the extent general liability applies, it should provide the primary layer of coverage.

How will COVID-19 impact subcontractors enrolled in SDI?

Because general contractors bear the risk of subcontractor default in any case, in this uncertain time general contractors may be expected to be extra vigilant in monitoring performance and stability of their subcontractors. The prequalification process is rigorous. SDI subcontractor prequalification focuses upon the subcontractor’s financial wherewithal. Areas of inquiry by general contractors include:

  • Financial Ratios – how does the subcontractor’s ratios, working capital, current ratio, debt to equity, days in accounts receivable, and days in accounts payable, stack up against similarly-sized companies in the same industry?
  • Bondability – is the subcontractor currently bonded and at what level?
  • Claims and litigation history – is the subcontractor a troublemaker or subject to excessive claims and litigation?

Sample information required of subs includes:

  • Financial statements for most recently completed fiscal year
  • Proof of bonding capacity
  • Proof of available line of credit
  • Credit information authorization

With current threats to workforce availability and supply chain interruptions, subcontractors participating in SDI programs may expect general contractors to become even more concerned about the financial well-being of their subcontractor partners. Subcontractors should expect frequent meetings and calls with general contractors, and discussions may now include issues such as business continuity, contingency, and resiliency plans, actions subcontractors are taking to keep doors open, subcontractor risk mitigation actions, and contingency plans in event of loss of staff and/or project shutdowns.

Techniques to Maximize SDI Coverage and Streamline the Claim Process

Christopher Barbarisi | Construction Executive | February 21, 2017

Design-builders, general contractors and “at risk” construction managers are all vulnerable to the risk of a subcontractor default. Aside from contract-related safeguards, such as increased retention, joint checks and letters of credit, subcontractor surety bonds have been the traditional mechanism for third-party risk transfer.

First introduced in the mid-1990s, subcontractor default insurance (SDI) provides a viable “first-party” insurance alternative to traditional surety bonds. To compete with surety bonds, SDI policies are heavily marketed as having a more efficient claim processes. In practice, the SDI claim process is not without its challenges. Effective techniques can be employed to streamline the process and keep the project funded and on track.

WHAT IS SDI?
In its broadest sense, SDI is a first-party insurance policy that indemnifies the insured for costs incurred as a result of a default by one of its subcontractors. The product was designed to directly address many of the disadvantages associated with traditional surety bonds. Unlike surety bonds, which typically lack transparency as to the types of covered losses, SDI policies typically cover all paid project losses, including costs to complete a defaulted subcontractor’s scope of work and the costs to correct defective or nonconforming work. SDI policies also typically cover indirect costs, such as costs to investigate the default, legal and consultant fees, as well as costs associated with project delays and acceleration.

Typical policies can be purchased with limits up to $50 million per claim/$150 million aggregate for direct claims and $5 million for indirect costs. SDI will not advance payments to the insured for project losses. Rather, the losses must be paid by the insured before they can be recouped through SDI. Moreover, project owners can be added to an SDI policy through a financial interest endorsement, and dedicated limits can be provided.

Another key advantage of SDI is the element of control given to the named insured over which subcontractors are enrolled in the program. The prequalification process usually includes a comprehensive financial analysis of the subcontractor. This control carries over to subcontractor defaults.

Unlike surety bonds, which require the contractor to wait for a surety to conclude its investigation into the merits of a subcontractor default, most SDI policies give the insured the sole right to declare a default, which would trigger policy coverage. Moreover, unlike surety bonds, where the surety decides the post-default course of action, SDI permits the insured to decide whether to finance the defaulted subcontractor or hire a replacement to complete the work.

ADVANCED NEGOTIATION
SDI insurance is not without its drawbacks. Certain key SDI policy provisions can have significant impacts on both the timing and scope of post-default claim recovery. Depending on a firm’s buying power, effectively negotiating SDI policy language during the procurement process can have a dramatic and positive impact on the claim process.

Most SDI policies give the carrier subrogation rights against a defaulted subcontractor. In other words, the carrier paying the claim proceeds to the insured may bring a lawsuit in the name of the insured against the defaulted subcontractor to recover the payment. If the suit is unsuccessful, the carrier can seek recovery of the claim payment from the insured. Before purchasing an SDI policy, the insured, through its broker or counsel, should seek to negotiate modifications to this policy language to avoid disgorgement of the policy proceeds or allow the insured to control the subrogation lawsuit.

Another common SDI term that must be considered is the “other insurance” clause. These clauses typically require the insured to pursue and exhaust any other project insurance triggered by the subcontractor’s default before pursuing the SDI policy. The insured that pays significant premiums for an SDI policy should not be forced to first pursue other project insurance implicated by the default.

SDI policies typically require claim payments within 30 days of the submission of a “satisfactory” proof of loss. In reality, because “satisfactory” is typically undefined in most SDI policy forms, insurers may focus on this undefined policy language to delay the 30-day payment clock. Although the insurer must apply the term in a commercially reasonable manner, the insurer’s judgment may lead to delayed payments. Insureds should seek SDI policy modifications to define the term “satisfactory.”

Moreover, common SDI policy language concerning coverage for project contracts acquired from other entities or those transferred from the insured to another entity should be modified to help maintain coverage in the event that a project requires modifications to project scope completion responsibilities.

Finally, SDI policy language that prohibits enrollment of subcontractors with contractors valued above certain benchmarks (e.g., $40 million) must be addressed. Upfront clarification should be sought from the carrier to determine whether project change orders that bring the value of an otherwise covered subcontract above the benchmark will result in an exclusion of the entire subcontract from coverage.

POST-DEFAULT
Once a subcontractor default occurs, the process of streamlining a claim should begin before a claim is even submitted to the carrier. Almost immediately, the insured should takes steps to minimize the impacts of the default by identifying pitfalls affecting the project owner and the overall completion of the project. Properly documenting the entitlement and facts of the default also will prove useful if the SGI insurer challenges the propriety of the default. A claim strategy should be developed that is proactive and aligns the project controls with the real-time claim preparation.

In preparing a proof of loss, the actual calculations are rather simple: Reconcile the remaining available subcontract value against the work scope completion costs. The overrun is the base claim. The difficulty tends to be more about establishing a reasonable level of documentation, which should be arranged in a way that clearly marks the project status and contract values both pre- and post-default. Investing time to prepare a well-documented claim will pay off by setting the pace of the post-claim process. Claim processing delays can be avoided by giving in on small or undocumented items.

Claims for delays, extended project overhead or increased general conditions will be viewed skeptically by the insurer and lead to claim processing delays unless documentation can clearly link these costs to the defaulted subcontractor.

Although most SDI polices require payment within 30 days after the proof of loss is submitted, the process is, in practice, usually quite longer. The insured should expect a reservation of rights letter from the SDI carrier accompanied by a rather extensive request for information. In many cases, the claim process will involve multiple rounds of RFIs with responses. The RFI process is designed to rectify defects in the proof of loss submission.

Depending on the complexity of the claim, the RFI process can be rather lengthy. The insured should anticipate preparing detailed responses accompanied by backup claim documentation. Practically speaking, the insured RFI responses should take time to build strong narratives, as they will follow the company throughout the claim process. Moreover, the responses should create positive positions by highlighting consistent positions taken by the insurer in other cases. Importantly, the insured should be prepared to keep the project independently funded during this process.

Lastly, most SDI policy forms provide for mandatory, binding arbitration of coverage disputes. This can be problematic particularly given the latent ambiguities many SDI policy forms contain compared to more common insurance policies. These ambiguities are likely to trigger coverage disputes. In that event, insureds will want to take steps to avoid arbitration and have the benefit of a judicial forum, with an appellate process.

SDI policies are viable risk transfer options that offer many benefits. Many of the drawbacks related to the claim process can be eliminated through advanced policy language negotiation, especially for larger policy purchasers, which will be perceived by the carrier as repeat customers. Drawbacks that cannot be negotiated can be minimized by employing preparation, organization and diligence, as well as competent legal counsel.

Subcontractor Default Insurance – A Modest Rebuttal

Michael S. McNamara | Pillsbury Winthrop Shaw Pittman LLP | March 1, 2016

Subcontractor default insurance (SDI) was created more than twenty years ago. Despite its relatively recent vintage, SDI is now offered by multiple insurers and is quickly replacing traditional subcontractor payment and performance bonds as a go-to option on large-scale construction projects. SDI has many benefits that surety bonds don’t. We’ll be going into this in substantial detail at our Fourth Annual Subcontractor Default Insurance Forum that Pillsbury co-presents, along with our friends at Willis Towers Watson, in Scottsdale in May.

SDI is obtained by the general contractor to protect it from subcontractor defaults—much like a performance bond or other guaranty. While the definition of a default depends on the terms of the SDI policy, it is solely based on a failure to fulfill the terms of a covered subcontract. SDI policies give contractors broad authority to determine whether a subcontractor is in default of its contractual obligations. Triggers of default are outlined in the subcontract agreement between the general contractor and the subcontractor that would include insolvency, a failure to perform, or the performance of defective work.

During the lead-up to that meeting, an Op-Ed piece by C. Andrew Gibson, an attorney at Stoel Rives LLP, caught my eye. The title of the article speaks volumes. In the early years of SDI, it would have been unthinkable for a surety bonding stakeholder to acknowledge that SDI had any place whatsoever in the construction industry. But despite having a semblance of balance, Gibson’s article still takes some of the positions that the surety bonding industry has taken over the years. So, we wanted to respond to some of them.

But first, let’s cover the basics—the fundamental differences between SDI and surety bonding.

  • SDI is a two-party contract, between the general contractor and the SDI carrier; the contractor pays the premium to the SDI carrier and the subcontractor pays nothing. Surety bonds are tripartite contracts among the subcontractor (principal), surety, and contractor (obligee); the subcontractor pays the premium to the surety for a performance bond and then bills the contractor.
  • Performance bonds only protect the contractor if a subcontractor commits a material breach of the subcontract, and sureties can take the position (wrongly in our opinion) that the surety need not respond until the contractor terminates the subcontract. In contrast, SDI policies typically define default much more broadly, and do not require the contractor to default terminate the subcontractor. This allows the general contractor to make a claim and without interrupting the subcontractor’s work on the project.
  • SDI is “pay first, question later, if necessary.” Too often, surety bonds are “fight first, pay much later, and only if you have to.”
  • My nearly two decades as a lawyer have taught me that surety bonds are really only protection against one risk: Subcontractor bankruptcy. In any other circumstance that could potentially trigger the surety’s obligation to perform, the surety’s investigation and glacial response pace will wreak havoc on a project. Now that we have that out of the way, let’s turn to the Op-Ed piece.

Who can make a claim

The Op-Ed piece says that only the general contractor can make a claim on an SDI policy; the owner can’t. That’s not entirely true. SDI carriers offer endorsements that provide protection to owners as well. One of Pillsbury’s biggest SDI recoveries was based on a financial interest endorsement that protected the owner.

History

Gibson says that surety bonds have been around for millennia. Exactly! Surety bonds are from the Stone Age. The implication that they are better because they are older is misplaced. The market has spoken on SDI: It’s accepted. Again, our broker friends are better-positioned to comment on that, so look for a guest piece on this blog from Willis. For my part, I’ll say this: The surety industry says bonds have history. I say they are history. Okay, not quite, but they will be.

Statutory requirements

Gibson says that surety bonds are required on certain public projects. That’s absolutely true—for the general contractor in favor of the owner. SDI protects the general contractor against subcontractor defaults.

Prequalification

Gibson notes that sureties prequalify subcontractors. Ah, prequalification…

To finish reading this article