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…