Developer's options for protection against contractor default

For many years, the only device available to developers to protect them against the failure by the construction manager or general contractor (collectively, "construction manager" herein) to perform its work and to pay its trade contractors would be performance bonds and payment bonds. Performance bonds are issued by a surety company which guarantees the completion of the project or performance by the construction manager, and payment bonds guarantee payment by the construction manager to the trade contractors. Several years ago an insurance product came to the market called Subguard. During my conversations with developer clients, I realized that some developers did not understand that Subguard did not afford the same protections as the bonds, and that the process for settling claims is not exactly the same as it is with the performance and payment bonds. There are several differences which each developer should understand. While a performance bond will essentially indemnify the developer for all costs incurred to complete the contractor's work from dollar one upon a default up to the amount of the contract with the construction manager, Subguard indemnifies the developer for losses due to a particular trade contractor's (subcontractor's) default. However, there is a deductible of several hundred thousand dollars for each trade contractor loss caused by the trade contractor's default. In addition, a claim against the performance bond concerns the failure or default by the construction manager regardless of whether it was a trade contractor or the construction manager itself who caused the loss. Unlike the performance bond, Subguard will not provide relief to the developer for losses caused by the failure by the construction manager (e.g., to coordinate the work of the different trades). In essence, there is a gap in coverage unless the developer requires the construction manager to provide it with professional services coverage. Notwithstanding the foregoing, Subguard is an insurance policy and not a surety contract. Upon presentation of the contract documents and accounting records showing the loss, Subguard will promptly pay the claim. On a performance bond claim, there is ultimately always a dispute as to whether the construction manager caused the default or whether the default was caused by the developer or its architect. In those instances, the surety generally takes the side of its principal (i.e., the construction manager) and the parties end up in court for several years litigating the dispute. As I stated above, when a construction manager puts up a performance bond, there is a corresponding payment bond issued as well. The payment bond provides protection to the developer and to the trade contractors in the event the construction manager fails to pay the trade contractor. This is important to the developer because when there is no payment bond, the only avenue for relief to the trade contractor is a breach of contract against the construction manager and the filing of a mechanic's lien. If the construction manager has financial difficulties, the developer may very well find itself in the middle of a mechanic's lien foreclosure action for several years and end up paying lawyers tens of thousands of dollars. If the trade contractor sues on the payment bond, the developer has a better chance of avoiding having to participate in a lawsuit. Subguard has no such protection against the failure by the construction manager to pay the trade contractors. Thus, while Subguard affords the developer protection against performance issues by the trade contractors, there is no protection against claims by those very same trade contractors. Ultimately, the client asks me why the construction managers push Subguard and refuse to post performance and payment bond, and why should they accept Subguard if they will get greater protection from the bonds. First, the most respected, larger construction managers in the New York City area will not agree to provide the bonds in this market. The construction market is so hot that the most respected construction managers will choose to accept a project utilizing Subguard over one where the developer requires the bonds. Also, with performance and payment bonds, the owners of the construction manager have to sign an indemnity agreement whereby they must personally guarantee any losses sustained by the surety under the bonds. Under Subguard, there is no personal guarantee. Thus, there is less risk for the owners of the construction manager. I have also been advised that the cost for Subguard can be less than the premium for the bonds. Each developer should compare the cost of each with their insurance agent to see if there is any difference in price. Clearly, while both products offer protection to the developer for defaults, there are many differences between the bonds and Subguard. In sum, the developer must choose between additional protection (if the construction manager will even agree to post bonds) of performance and payment bonds and the efficiency of settling claims using Subguard. Andrew Richards, Esq., is a partner with Kaufman Dolowich & Voluck LLP, Woodbury, N.Y.