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July 15, 2021

Impact of the General Agreement of Indemnity That Sureties Require in Construction

Many owners, especially municipal entities, who bid out construction projects require that prime contractors or general contractors supply surety bonds to qualify to submit a bid. Surety bonds include bid bonds, payment bonds, and performance bonds. In order to obtain these bonds, the contractor must sign a general agreement of indemnity (GAI). GAIs are serious business and carry enormous risk for the contractor.

Surety Exposure Explains Why GAIs Are Required

By issuing construction bonds, sureties take on major risk; therefore, it is no surprise that the surety does everything it can to shift the risk to the contractor in the form of the GAI. A bid bond commits the surety to compensate the owner for the cost difference between the initial contractor’s bid and the next-lowest bid. It is designed to prevent the owner from engaging a contractor who submits an unrealistically low bid and then defaults. A payment bond commits the surety to pay the subcontractors and material suppliers if the contractor fails to do so. A performance bond commits the surety to complete the project, regardless of the cost to complete or to pay the owner for the cost to complete the project.

If a surety has to complete a project pursuant to its performance bond, the cost to complete may be higher than the original contract price the owner and contractor agreed upon. For example, if a contractor bid out a project for $30 million and goes bankrupt after performing one-third of the contract, the surety is not merely obligated to complete $20 million of work, it is obligated to complete the project. So, for example, if the cost of fuel, lumber, or other raw materials has dramatically risen making the remaining cost to complete $25 million, the surety will spend $25 million to complete the project, but will only be paid the contractor’s contract balance of $20 million.  

In the above example, the owner gets the completed project at the original price but the surety has a $5 million loss and a bankrupt principal. So how does the surety recover the $5 million it just lost?

GAI Creates a Big Tent of Persons From Whom the Surety Can Recover

Sureties typically require the contractor and its principals to sign the GAI. Often, the surety will require indemnity from entities owned by the principals of the contractor even though those entities are unrelated to the project against which the surety issued the bonds. The practical effect of the GAI, then, is that the individuals who are the principals of the contractor put all of their own resources at risk. All of the people who sign the GAI indemnify the surety for any losses the surety incurs. Therefore, in our example, the individual principals of the contractor will end up paying the $5 million cost overrun out of their own pockets even though the contractor entity has filed for bankruptcy.

GAI Gives the Surety Total Control Over the Project, Litigation, and Settlement

Perhaps even more concerning to contractors than the indemnification provisions of the GAI are the control provisions. First, if there is a claim on a performance bond, the typical GAI provides that the contractor’s rights are assigned to the surety. This means that by merely claiming against the performance bond, the owner gives the surety control of the project, any litigation, and any settlement discussions. The typical GAI expressly states that the surety has the right to decide which contractor will complete the project and either to pursue claims against the owner (such as inadequate project design) or not to pursue those claims. Accordingly, if the contractor has what it believes to be a strong case showing that the design caused cost overruns or delays for which the contractor should be compensated, the surety does not have to pursue those claims; the contractor can’t pursue them because they have been contractually assigned to the surety via the provisions of the GAI.

Additionally, if the surety thinks it is easier to simply collect that $5 million loss from the indemnitors rather than continue with litigation against the owner, the surety can settle away the contractor’s rights and then sue the contractor for the balance. So, if the surety settles the claim against the owner that the design was flawed for $2 million, the surety will have recourse against the indemnitors for the remaining $3 million and all of its legal fees and costs incurred in the litigation with the owner.

Some of these results can be harsh from the standpoint of the contractor. Nevertheless, United States courts have consistently upheld the rights of the surety to enforce all of the above provisions of the GAI.

Conclusion

Contractors should carefully scrutinize the GAI and understand that the GAI gives the surety tremendous rights while at the same time taking away the contractor’s rights and exposing those individuals’ personal assets. Contractors may decide that bidding on certain jobs isn’t worth the exposure.

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