The Wrong Bond at the Wrong Time

When a general contractor finishes a job that its subcontractor started, the general is not automatically entitled to make a claim against the subcontractor’s payment bond for the extra costs incurred. So ruled the Arizona Court of Appeals in March 2003 in American Casualty Company v. D.L. Withers Construction, L.C.

Background. After being awarded the contract for the construction of Pinnacle High School, D.L. Withers Construction subcontracted with 1st Mechanical of Arizona for HVAC installation. In its contract with Withers, 1st Mechanical agreed to furnish all labor, materials and equipment necessary to complete the job.

Withers required 1st Mechanical to furnish a payment bond. The bond provided payment claim rights to parties “having a direct contract with [1st Mechanical] for labor, material, or both …”

As the project went forward, 1st Mechanical fell behind schedule. At a jobsite meeting to discuss the delays, the two companies agreed that Withers would provide 1st Mechanical with additional manpower. Withers contracted with Midstate Mechanical to finish the job, resulting in extra costs incurred by Withers. Seeking reimbursement for those costs, Withers filed a claim against 1st Mechanical’s payment bond.

The issuer of the bond, American Casualty, rejected Withers’ claim, arguing that Withers was not a proper claimant since it did not have the required “direct contract” with 1st Mechanical for labor, material, etc.

Predictably, a flurry of claims and counterclaims ensued. Withers argued that it was entitled to reimbursement because of the agreement it reached with 1st Mechanical to bring in more labor. That agreement, Withers contended, constituted a direct contract sufficient to satisfy the bond requirement.

The Superior Court judge disagreed and ruled for American Casualty, and Withers appealed.

Ineligible Claimant. The Court of Appeals upheld the trial court’s decision, based in part on a distinction between a payment bond and a performance bond.

A performance bond, wrote the court, “indemnifies the obligee [Withers] for the principal’s [1st Mechanical] failure to fully perform the contracted work.” Unfortunately for Withers, what 1st Mechanical had was a payment bond, which “protects the obligee from claims by the principal’s unpaid laborers or suppliers.” In this case, 1st Mechanical had paid everyone, so there were no unpaid laborers or suppliers to go after Withers.

The court ruled that the payment bond’s definition of “claimant” could not be reasonably interpreted to include Withers, since, according to the court, Withers did not have a direct contract with 1st Mechanical to provide labor, material, etc. Withers’ subcontract agreement with 1st Mechanical provided that, if the subcontractor failed to perform, Withers had several remedies, one of which was to “assist” the subcontractor by “securing any labor” necessary to complete the work.

Withers argued that because the payment bond incorporated the subcontract agreement, Withers had a direct contract with the subcontractor. The court disagreed, and Withers had to eat the extra costs of bringing in Midstate to finish the job.

Dual Purpose. The court did agree with one of Withers’ arguments: that the classification of a bond as either a “performance” or “payment” bond does not, per se, determine who gets to make a claim against it. Unfortunately for Withers, the court found that argument to be inapplicable to this case.

However, the court’s discussion on that point is instructive and could provide valuable guidance to contractors hoping to avoid Withers’ predicament. The court cited Davis Wallbridge, Inc. v. Aetna Cas. & Sur. Co., which provided that “[I]n all events, it is the language employed in the bond which determines the beneficiaries.”

Thus, the court noted, a performance bond “containing language purporting to benefit laborers and materialmen” serves the dual purpose that would have legitimized Withers’ claim.

Recommendation. If you require a subcontractor to furnish a bond — performance or payment — be sure that its language (a) provides you with your desired remedies for subcontractor non-performance and (b) protects you from claims by the subcontractor’s unpaid laborers and suppliers.