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What Are Performance Bonds?
To understand what is extended pay, you must first understand how performance bonds work. Purchasing a performance bond (as well as a payment bond) is a legal requirement under the federal Miller Act of 1935 for being awarded a federally funded contract in excess of $150,000. Similar legislation exists in most states for state-funded construction projects. And private project owners increasingly are requiring performance bonds from their contractors.
A performance bond provides financial protection for project owners in the event that a contractor fails to bring a project to successful completion. Performance bonds are issued in specific amounts (usually to cover the full project cost) and for a specific length of time, by the end of which the job should be completed.
Each performance bond is a legally binding contract among three parties:
- The “obligee” (the project owner requiring the bond),
- The “principal” (the contractor required to purchase the bond), and
- The “surety” (the company guaranteeing the bond).
How Do Performance Bonds Protect Project Owners?
If the principal fails to complete the project due to insolvency or some other reason, the obligee can file a claim with the surety and seek compensation for monetary damages up to the full amount of the bond. The principal is legally obligated to pay any claim the surety’s investigation finds to be valid.
Some performance bonds include an “extend or pay” provision to provide further protection if the principal has not completed the project as of the bond’s expiration date. Specifically, the obligee would require the surety to extend the term of the performance bond to provide continuous protection for the obligee until the job is completed successfully. And the principal would be required to pay the additional premium for the extended coverage. Otherwise, the obligee will file a claim for damages before the bond expires.
What is Extended Pay and Can it be Challenged?
Contractors understand that purchasing a performance bond and paying valid claims for noncompletion or contract default is a cost of doing business in the construction industry. They understand that a project owner should not bear the cost of a contractor’s failure. However, there are instances in which an obligee invokes an extend or pay provision when the blame for the contractor’s inability to complete a project on time actually rests with the project owner.
Not every failed project can be attributed to something the principal did wrong or failed to do. Sometimes, the obligee is at fault, for example by making design changes after construction begins that cause delays beyond the principal’s control. In such cases, a principal might try to get a court to issue an injunction to prevent the obligee from invoking an extend or pay provision, but there currently is no case law on this issue.
The problem for the principal in trying to challenge an obligee’s extend or pay request is that it’s up to the surety, not the principal, to determine whether to honor it. Agreeing to provide a performance bond containing an extend or pay provision exposes the surety to the risk that the provision will be invoked. In other words, the surety knows what they’re getting into when they enter into the surety bond agreement.
There are two conditions under which the courts may intervene to prevent a project owner from succeeding in demanding payment under an extend or pay clause:
- When the project owner is responsible for delays and noncompletion of the job, which makes the claim fraudulent, or
- When the extend or pay demand is in violation of a provision of the underlying construction contract if that contract, prohibits a demand from being made.
How Common Are Extended or Pay Provisions?
Most construction performance bonds are issued for a specific period of time, often to coincide with the completion date specified in the underlying construction contract or to provide protection against construction defects for a certain period following project completion—usually no more than a couple of years. Some performance bonds must be renewed after 12 months to provide continuous protection for the obligee until the project is completed successfully. Consequently, extend or pay provisions are relatively uncommon.
Also, sureties are reluctant to take on the additional risk that an extended or pay provision entails. Still, some obliges insist on including one in the surety bond agreement. If this is the case when you are seeking a performance bond, be sure to discuss the implications with the surety, and make an informed decision.
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