Surety Professionals Talking to Lenders About Benefits of Surety Bonds

From time to time, the staff at NASBP is asked how surety professionals should talk to lenders about the importance of performance and payment bonds to lenders themselves. This article is intended to respond to that important question and provide talking points for surety professionals when they meet and talk to lenders about the benefits of surety bonds on construction contracts. As so much else in the construction industry, the discussion all comes down to identifying risks and then implementing risk management and mitigation strategies. Every stakeholder in the construction industry, including lenders, should make risk identification and management a top priority. How can lenders mitigate the risk of loss in construction lending? By requiring performance and payment bonds on projects and becoming a co-obligee by requiring a dual obligee rider on the bonds.

Construction projects are risky business. Nearly every project is subject to unforeseen vagaries and uncertainties that threaten its successful completion. Contract surety bonds—bid bonds, performance bonds, payment bonds, and warranty bonds—provide critical protection on construction projects: prequalification and financial protection. The thorough prequalification process that corporate sureties perform on contractors seeking bonds assures that the bonded contractor is qualified to perform the contracted obligation. If the contractor defaults on its obligation, bonds guarantee that the contract will be performed and certain laborers and suppliers will be paid for work and materials. That is why the federal government, state governments, and many local governments require surety bonds on construction contracts over a certain threshold amount. And while there is no mandate in the private sector for use of bonds on construction projects, many private owners require them on their construction projects for the same reasons the government does.

In most instances, the interests of the owner and the lender are the same in requiring construction bonds. Both entities want to insure that the project will be completed to specifications on time and that all parties that could file liens against the project have been paid. A lender that underwrites a construction loan has an interest in the value of the loan collateral—the construction property—which depends upon the successful completion of the construction. This successful completion is protected by performance and payment bonds.

Unlike an owner, a lender is not a party to the construction contract and does not have a direct contractual relationship with the contractor and its surety. That means that the lender has no direct right of action against the surety under either the performance bond or the payment bond. In order to have a direct right of action on a performance and payment bond, a lender should require a dual obligee rider to the bonds.

A dual obligee bond, sometimes called a co-obligee bond, names an additional obligee to the bond. An additional obligee might be named in the bond itself or, more commonly, will be added in a dual obligee rider (also called a multiple obligee rider), to extend a surety’s obligation under the bond to that interested third party. The additional obligee is usually a construction lender, although other entities having some interest in the completion of a project, such as title insurers, can also be dual obligees.

The dual obligee rider gives the lender direct rights against the surety. The addition of a dual obligee on a bond does not, however, change the extent of the surety’s liability under the bond, absent express language to the contrary. By the insertion of a dual obligee rider, the surety does not guarantee the financial obligations of the owner to the lender nor to indemnify the lender. In particular, it should be noted that the obligation of a surety under a dual obligee bond is not that of a guarantor of the owner’s note to the lender.

Dual obligee riders typically contain language that places both the primary obligee and the additional obligee in the same position and subject both to the same defenses and to ensure that the surety’s aggregate liability is limited to the penal sum of the bond. Typical such language follows:

This language relieves a surety from liability under the bond, to either or both of the obligees, if either of the obligees fails to make payments strictly in accordance with the terms of the bonded contract or fails to perform all other obligations under the bonded contract.

A lender of a construction loan should have the protections of a surety bond as an additional obligee through a rider on the contract bonds. If the lender is not added as an additional obligee, it has no direct right of action against the surety. In such case, it must rely on the owner asserting its rights. Lenders on construction loans should have performance and payment bonds as a critical risk management tool to protect their collateral.

The author of this article is Martha Perkins, General Counsel at NASBP. Martha Perkins can be reached at mperkins@nasbp.org or 202.686-3700.

This article is provided to NASBP members, affiliates, and associates solely for educational and informational purposes. It is not to be considered the rendering of legal advice in specific cases or to create a lawyer-client relationship. Readers are responsible for obtaining legal advice from their own counsels, and should not act upon any information contained in this article without such advice.