Contractor Bonds: Executive Guide to the Coming Elevated Claims Environment

3-26-2020

The disruption from the COVID-19 crisis is, directly and indirectly, placing significant pressure on contractors, increasing both contractual and solvency risk, both of which present major implications for the Surety industry. As detailed in our recent article “Stay-at-Home”: List of Essential Services Matters Greatly to the Surety Industry, construction is largely exempt from the orders, particularly in California. However, the effects of the orders and the illness itself are broad, cumulative and indirect, resulting in reduced work for contractors in the aggregate and more important the potential for substantial project delays.

This article examines some of the emerging risks that should be considered by Surety underwriters and executive officers with respect to their companies’ existing and prospective construction exposures, encompassing performance and payment bonds as well as license and permit bonds.

What new risks lurk in construction in this environment?

Government restrictions on construction work are one thing, but project owners can also halt work for contractors. Homeowners, businesses and government entities may elect to put a project on hold construction as a precautionary measure from fear of infection or to slow the spread of COVID-19. The resulting delays, and even project terminations, can create significant strain on contractors’ balance sheets and contractual obligations.

Contractors may halt work themselves due to a misunderstanding of Stay-at-home Orders, if they or their employees feel sick or are at-risk, or just doing their part to avoid the spread of COVID-19. Many older contractors will feel added pressure to stay home based on the advice of the CDC. While work experience has long been an important criteria for Surety underwriters, it may increase risk during these upside down times.

All of these emerging risks are compounded by the fact that, prior to the outbreak, construction was booming. Contractors were already spread thin by an abundance of work and insufficient supply of skilled labor and now must complete this huge backlog of projects with potentially severe labor, subcontractor and materials shortages.

Project owners might not be so forgiving for delays, especially given the challenges facing almost all participants of the economy right now, and may demand the contracts be upheld. Who is in the right? Unfortunately, the contractor is bound by the contract and will face the consequences for defaulting, which the Surety may share in, unless the contract has provisions for suspension of work or change orders can be agreed upon between the contractor and the project owner.

Subcontractors add more complexity. With organizations making their own determination of what is an appropriate response to social distancing, increased numbers of subcontractors on the jobsite increases the chance of delays.

What Defense Measures are Available to Surety Claims Handlers?

Lawyers in the construction industry are racing to determine if claims filed for COVID-related delays or performance failures can be mitigated by certain contract clauses or common law that address major unforeseeable events. Most standard contracts include a Force Majeure clause which may excuse the contractor’s performance when certain specified events outside of the contractor’s control hinder timely performance. The American Institute of Architects (AIA) form AIA A201-2017, considered the standard in construction contracts, includes the following Force Majeure language in the emphasized section below:

If the Contractor is delayed at any time in the commencement or progress of the Work by (1) an act or neglect of the Owner or Architect, of an employee of either, or of a Separate Contractor; (2) by changes ordered in the Work; (3) by labor disputes, fire, unusual delay in deliveries, unavoidable casualties, adverse weather conditions documented in accordance with Section 15.1.6.2, or other causes beyond the Contractor’s control; (4) by delay authorized by the Owner pending mediation and binding dispute resolution; or (5) by other causes that the Contractor asserts, and the Architect determines, justify delay, then the Contract Time shall be extended for such reasonable time as the Architect may determine,” (emphasis added).

The consensus among construction law professionals is optimistic that Sureties will be able to utilize a Force Majeure defense in cases of default due to COVID-19 and the resulting Orders. However, surety underwriters and agents should advise their clients of best practices to ensure Force Majeure is a viable defense. Under common law, conditions-precedent to making a Force Majeure defense include timely notice to the project owner and immediate and meaningful efforts to mitigate damages.

In order for Force Majeure to be accepted as a defense, Sureties must prove that the contract breach was COVID-19 related and not through any fault of the contractor. Even if a Force Majeure defense is deemed applicable, courts may still find a contractor, and ultimately the Surety, partially responsible for a percentage of the damages if it is found the contractor was partially responsible for the default or could have mitigated some of the damages.

What Can Surety Companies Do to Mitigate Risk on New Contracts?

As discussed above, standard Force Majeure language may be sufficient to mount a defense on many claims or projects started before the pandemic, but Sureties should strongly consider requiring more clearly defined language on new contracts to account for delays should the crisis continue for many more months. An example of such language would include the following insertion:

Contractor shall not be liable for any delays, overruns (including for labor, material and/or costs) or impacts related to its work caused by or stemming from the COVID-19 epidemic as defined by the United States Centers for Disease Control and Prevention. In addition, Contractor shall be entitled to change orders for any and all time and costs relating to such epidemic.”

Contractor License Bonds: Death by a Thousand Cuts

Contractor license bond premiums equate to approximately $150 million in annual premium for surety carriers. These seemingly innocuous license requirements have historically shown reasonably low loss ratios with the exception of major economic events that can spell catastrophe for carriers, especially in some of the larger western states where contractors are regulated at the state level. While most bond limits are relatively small in comparison to contract surety, the high frequency of claims in an economic downturn can bury claims handling teams and spike claims handling costs to unsustainable levels in an already high expense ratio line.

Most small contractors do not have access to lawyers or capital to navigate the contractual and economic hardships created by the COVID-19 pandemic. These small operations are most likely not reviewing their contracts to see how they are impacted. Contractors may not fulfill obligations under existing projects to preserve cash, or because they, their employees and/or subcontractors either fear contracting the virus, are currently infected by the virus or are misinformed about the legality of their work.

An economic downturn, which is all but guaranteed at this point, does not bode well for Sureties with outstanding contractor license bond liability. During the past two major economic downtowns 2001-2003 and 2008-2010, both of which were far less severe than what is predicted over the next several months, industry loss ratios on contractor license bonds nearly doubled.

Many small contractors will likely fail during this crisis. Hungry for cash, homeowners and others may file claims more aggressively. As of now, it is unknown how the stimulus package from Congress will affect small contractors. There may be a ray of hope that small businesses, including contractors, with low income will receive enough in subsidies to decrease the amount of loss for the Surety.

What is the Impact on Obligees?

Each individual state, city and county leader is making their own decision on how to combat COVID-19. Their different departments (the obligees) will either follow suit or could enact stricter shut down procedures. It is doubtful a sub-department would act in defiance and adopt looser social distancing procedures. While these agencies play a part in regulating one of the largest industries in the nation, it is likely that some, particularly the smaller departments will slow services, and in some cases could even halt services altogether.

Larger obligees, like the Contractor State License Board in California remain open while only halting certain functions, such as testing for new license applicants. However, it is much more difficult to track how each individual permit or inspector office is choosing to operate under COVID-19 Orders. Several small government offices have temporarily closed. Some are open; however, offices like the San Francisco City Permit Office, are closed to visitors but currently provides permitting only for what they consider “essential infrastructure”.

Overall, contractors and surety companies will likely experience delays filing their licensing and bonding paperwork

Public Works Continues at a Delayed Pace: Permit Bond Implications

With delays coming in from all angles, permit bonds will most likely spell trouble for Sureties as well. Permitted projects with bond requirements will face government and contractor caused hindrances as discussed above elevating the risk to the Surety.

The regulation surrounding permits compounds issues. Permits may only be valid for a specified period of time, thus requiring due notification for extension. The obligee’s permit contract may include unilateral hold harmless agreement in their favor, which leaves liability for delays upon the contractor and ultimately the Surety.

Public works have been deemed essential in every Stay-at-home order we have reviewed, a silver lining to the defined work a contractor can perform. The effectiveness of the contractor is another story if inspectors, permit officers, materials, subcontractors and employees are unavailable due to the implications of COVID-19 orders.

How Can the Surety Industry Respond

Between construction delays, work confusion and an economic downturn how much of the tab will the surety industry be left holding?

Due to the nature of losses in the Surety Industry, we cannot yet estimate the severity of destruction to a Surety’s reserves. Moreover, as more news comes to light regarding the spread of COVID-19 it appears the situation will only get worse before the light at the end of the tunnel emerges.

So how can Sureties mitigate losses now?

Taking steps to revise indemnity and limit exposure may be necessary. Educating contractors on their rights to work and how to protect themselves with necessary change orders may be difficult, but is necessary to limit what may be the worst setback to Surety this century.

Please email media@suretypedia.com with issues your organization is facing. We would love to add your contribution to the overall surety discussion.