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Subcontractor default insurance (SDI) has been gaining in popularity among general contractors. SDI is insurance that covers certain losses related to a subcontractor’s material breach of a subcontract.

Contractors favor SDI for several reasons, but primarily because it addresses subcontractor performance risk and potential loss of profits that result when they have to quickly step in to remedy a subcontractor’s breach. Additionally – and this is rarely mentioned – contractors who properly manage their subcontractors and avoid making claims under an SDI policy are eligible to receive a retro premium from the SDI insurer. Because contractors include the SDI premium as part of their estimated project costs, any retro payment they receive goes directly to their bottom line.

The risk of subcontractor default has historically been addressed through subcontractor payment and performance bonds. Shortly after SDI policies were introduced, many contractors were quick to change horses and begin using SDI.

Sureties assert that bonds are better than SDI because, among other things, they: 1, have a more rigorous underwriting process; 2, do not require deductibles; 3, provide a direct remedy for lower-tier parties if the bonded subcontractor is unable to pay them; and 4, incentivize the owners of a subcontractor to favor bonded projects over unbonded projects because their personal assets (or other collateral) are at risk under their indemnity agreements with the surety.

The most common complaint about bonds has been that sureties are slow to pay claims. Because a surety’s liability is joint and several with the subcontractor under the bond and the subcontractor is obligated to defend the surety in any lawsuit, sureties typically tender disputed claims to the allegedly defaulting subcontractor. Except when it is clear the subcontractor cannot pay, sureties typically pay claims only after the dispute is resolved and the subcontractor cannot satisfy a final judgment. In other words, the dispute resolution process must play out before a claim is paid, and in many cases that can take several months or years.

Proponents of subcontractor bonds historically have not advertised quick resolution of claims as a selling point – until recently. The expedited dispute resolution (EDR) bond has the coverage of a traditional bond with an abbreviated investigation and dispute resolution process. While a speedy resolution may be desired in some cases, this approach raises several concerns:

• EDR bonds use arbitration as the initial form of dispute resolution. The laws concerning arbitration generally require that the parties to the arbitration agree, in writing, to arbitrate their disputes. If the dispute involves other parties who have not agreed to arbitrate, it may be difficult to fully resolve all issues in the EDR bond arbitration.

Here is an example. In an EDR bond arbitration, the general contractor asserts a delay claim against subcontractor A and its surety. In its defense, subcontractor A alleges that subcontractor B caused part of the delay. However, if subcontractor B is not bound to arbitrate disputes with the general contractor, subcontractor A, and subcontractor A’s surety, the general contractor may not be able to fully resolve the delay claim in the EDR bond arbitration.

• One related issue is that the general contractor may need to file a separate lawsuit or arbitration against subcontractor B. This may result in increased legal fees, because it is more costly for the general contractor to separately pursue subcontractor A in one dispute resolution forum (expedited arbitration) and subcontractor B in another forum.
• Another related issue is that, if there are separate forums, there is a risk of inconsistent results. In the example above, it is possible that the arbitrator in the EDR bond arbitration against subcontractor A could decide that subcontractor B is responsible for delay. At the same time, it is also possible that in the general contractor’s separate action against subcontractor B, the decision maker could determine that subcontractor A was responsible for the delay. This worst-case scenario would not happen if the general contractor, subcontractor A, subcontractor A’s surety, and subcontractor B resolved their disputes in the same forum at the same time.
• To compete with SDI, EDR bonds must provide for a speedy resolution, usually in the range of 30 to 60 days. However, speed often comes at a cost. One of the most time-consuming aspects of litigation is the discovery phase, during which the parties discover facts. In complex construction disputes, the discovery phase can take months or longer. Condensing months’ worth of discovery into days means that it is highly likely that the arbitrator will make a decision based on limited (and perhaps inaccurate) information. More likely than not, this will favor the subcontractor – and its surety – because the general contractor has the burden of proving its claim.
• Some EDR bonds entitle the parties to a de novo appeal of an arbitration decision in court. A de novo appeal allows the court to review the evidence and law without deference to the arbitrator’s ruling. Depending on the jurisdiction, an appeal could result in significant delay, thus defeating the purpose of expediting the dispute resolution process.

As the above points illustrate, there are potential pitfalls with EDR bonds. As with any new product or service, parties who use EDR bonds should carefully consider both their advantages and disadvantages.

Sean Gay is an attorney in the Stoel Rives LLP construction and design practice group. Contact him at 503-294-9239 or [email protected].