Michael McNamara and Lexie Pereira | American Bar Association
Subcontractor Default Insurance (“SDI”) is marketed as a substitute for a subcontractor performance bond as SDI provides coverage for a prime contractor’s losses due to a subcontractor’s failure to perform on a project. Based on the purpose of SDI and with “Default” in its full name, many naturally assume that the prime contractor must formally declare the subcontractor to be in default to trigger SDI coverage. To dispel a common misconception, prime contractors do not actually have to declare or notify a subcontractor that it is in default – much less terminate that subcontractor – in order to submit a claim under common SDI policy forms. Indeed, some SDI forms allow prime contractors to benefit from SDI coverage while the defaulting subcontractor remains on the job.
Background on SDI Coverage: SDI vs. Bonds
Bonds and SDI are the primary loss protection vehicles used on construction contracts to provide prime contractors and, indirectly, owners, some security on their subcontractor risks. While used for similar purposes, bonds and SDI differ in important ways.
Performance bonds are tri-partite agreements among the surety, obligee (owner or prime contractor), and the principal (prime contractor or subcontractor). The bond provides that the surety will step into the shoes of the obligee to answer the principal’s default, in exchange for a bond premium (which, on average, is just above 1% of the contract amount), an indemnity agreement, and an interest in collateral. Essentially, performance bonds are a guaranty of performance, which is why performance (and payment) bonds are required by statute 1 on almost all public projects and are also often required by private owners, particularly for major subcontractors on large projects.
On the other hand, SDI is an agreement only between the prime contractor and its insurer. The insurance carrier agrees to indemnify the insured contractor in the event of loss caused by a subcontractor’s default. An SDI carrier will not step into the shoes of the defaulting subcontractor but, instead, will provide coverage for the losses the prime contractor incurred as a result of the default. In exchange for this insurance coverage, SDI carriers require a premium (that is typically lower than that of a cost of a bond) as well as deductibles and co-pays. Since prime contractors retain the risk of deductibles and co-pays, larger GCs and CMs often see SDI as a profit-making tool – provided they are able to contract with properly pre-qualified subcontractors and, if needed, require bonds for those subcontractors that are considered too risky to carry under SDI.
Declaring Default?
A key difference between SDI and performance bonds, though, lies in the details of the default itself.
Performance Bonds
When a default occurs on a project requiring a performance bond, the surety is required to step in and, therefore, has a self-interest in denying the existence of a default. The American Institute of Architects’ (“AIA”) A312-2010 performance bond form – the most common form for a performance bond in the industry – explicitly requires the prime to declare the subcontractor in default and notify the surety at §3:
If there is no Owner Default under the Construction Contract, the Surety’s obligation under this Bond shall arise after…the Owner declares a Contractor Default, terminates the Construction Contract and notifies the Surety.
So, the prime contractor must actually terminate the subcontract before the surety is obligated to step in and perform under the bond. Similarly, even without the express language of the AIA A312, many courts have required the obligee to terminate the contract before a surety on a performance bond is obligated to step in and perform. See L & A Contracting Co. v. S. Concrete Servs., Inc., 17 F.3d 106, 111 (5th Cir. 1994); W. Sur. Co. v. U.S. Eng’g Constr., LLC, 955 F.3d 100 (D.C. Cir. 2020) (holding that the owner must provide timely notice to the surety of any default and termination as a condition precedent to the surety’s obligations under the bond). Other courts have focused on the language of the actual bonds to evaluate whether an obligee must terminate the contract before the surety must perform. Colorado Structures, Inc. v. Ins. Co. of the W., 167 P.3d 1125, 1130 (Wash. 2007) (affirming the decision and reasoning that “by the plain terms of the bond, the obligee was not required to formally declare the principal in default and that, regardless, adequate notice of default was given to the surety”). And some courts find that terminating the contract is a precondition to the surety having to perform under the bond – likely because the surety puts up a strong fight in trying to not perform. ; CC-Aventura, Inc. v. Weitz Co., LLC, No. 06-21598-CIV, 2008 WL 2557434, *4 (S.D. Fla. June 20, 2008) (holding that since the obligee did not terminate the subcontractor, where the bond itself stated that the obligee must declare a default and formally terminate the principal’s right to complete the contract, the surety was relieved of liability).
Subcontractor Default Insurance
Some SDI policies aim to make life easier on a prime contractor by not making termination of a defaulting subcontractor a prerequisite to coverage. Contractors should view this as a significant benefit of SDI over bonds because terminating a subcontract in the middle of a project presents significant downsides to a contractor – even if that subcontractor is in material default. It is also a benefit because of the uncertainty of conflicting legal authorities – some which require termination and others that don’t – makes that decision even more problematic.
The language of the standard form SDI policy offered by AXA XL does not explicitly require the contractor to even notify the subcontractor that it is in default – much less actually terminate the subcontractor. The AXA XL form does not even require the default to be “material:”
The Company will indemnify the Insured for Loss…to the extent of a Default of Performance by the Insured’s Subcontractor/Supplier.
[Section 1]
Default of Performance means failure of the Subcontractor/Supplier to fulfill the terms of the Covered Subcontract or Purchase Order Agreement as determined by the Insured or a legally binding authority.
[Section 9(e)]
[KSX 050 0515]
On the other hand, the common SDI forms offered by Zurich – which has more recently decided to exit the SDI market (a market that Zurich created 25 years ago under the name Subguard) – requires a material breach and notice of “Default of Performance” sent to the subcontractor, but still does not require formal termination of the Subcontractor:
[W]e will indemnify you for Loss…but only to the extent of a Default of Performance by your Subcontractor/Supplier.
[Section I]
Default of Performance means material breach by the Subcontractor/ Supplier in fulfilling the terms the…Subcontract or Purchase Order. [Section II(D)]
You shall give written notice to us within one hundred eighty (180) days from the time you send written notice of Default of Performance to a Subcontractor/Supplier who (i) is in Default of Performance…or (ii) you become aware is Insolvent.
[Section VII(B)]
[U-SDG-100-A CW (01/13)]
And importantly, these SDI forms differ in their requirement that the subcontractor be in material default. Under the AXA XL SDI policy, a subcontractor only need to have failed to perform a contractual obligation. See 10 Corbin on Contracts § 53.4 (2023) (“Courts also commonly classify breaches as either ‘material’ or ‘immaterial’ breaches…Material and immaterial breaches are distinguished by the severity of the breach. A total breach of contract is a non-performance of duty that is so material and important as to justify the injured party in regarding the whole transaction as at an end.”)
So what?
The ability to collect insurance proceeds from a subcontractor that has defaulted on its subcontract, without actually notifying them of their default nor terminating for such default, is an important business advantage. So, aside from the touted business advantages to using SDI in lieu of performance bonds on projects that so allow, SDI provides even more of an advantage because – as it would turn out – that ‘d’ in SDI is a bit more silent than one might think at first blush.
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