Sustainable buildings and the surety.(FOCUS ON GREEN BUILDING)

ONE OF THE MORE VITAL, THOUGH OFTEN HIDDEN, types of risk transfer mechanisms on many construction projects is the surety. In fact, sureties act as a basic backstop against the possibility that a project will get derailed due to the inability of a contractor or subcontractor to fulfill the terms of the contract with the owner or higher-tier contractors. Sureties allow the owner to defray his or her risk for failure of contract performance and the concomitant delays and financial difficulties that ensue. To manage risk, large and complex projects require the services that a surety bonding regime can offer, while the largest projects, including infrastructure projects, cannot even be contemplated without adequate bonding.

Because surety bonds function to guarantee the fulfilment of contract terms, they play an important role in guaranteeing building performance. Their role is increasingly implicated in the sustainable building process through either the inclusion of contract provisions for green building rating system certifications or specific attributes of building performance reasonably inferable from the contract documents to deliver sustainability. A surety is usually a large financial institution that issues a bond to assure a set of contractual obligations. In the construction context, these are most often seen as bonds to assure the contract documents to deliver sustainability. A surety is usually a large financial institution that issues a bond to assure a set of contractual obligations. In the construction context, these are most often seen as bonds to assure the performance of a contractor or subcontractor--so-called "performance bonds"--or bonds to assure the proper and timely payment of lower-tier subcontractors to prevent work delays--so-called "payment bonds" To manage these types of performance and payment risks, almost all governmental projects on the federal, state and municipal level statutorily require the use of surety bonds as a result of the passage of the Federal Miller Act and the Little Miller Acts adopted by the states.

A surety bond is a three-party contract issued by a surety company in connection with a construction project. The three parties to the bond are the surety company, the owner and the contractor. The bond, in part, guarantees to the owner that the contractor will perform the construction project per the requirements of the contract. If the contractor fails to perform the contract, the owner may call upon the surety to step in and complete the project or correct project deficiencies. This usually occurs when the contractor does not meet the contractual requirements, performs defective work or does not have the financial wherewithal to complete a project. There are no requirements for surety bonds on private projects; however, savvy owners often require a private works contractor to procure a surety bond. This allows the owner to displace much of the financial risk onto the surety company if the contractor fails to perform.

A LEGISLATIVE EXAMPLE AFFECTING THE SURETY INDUSTRY

Sustainable building rating systems and benchmarks have been legislated in numerous states, municipalities and counties throughout the United States, Many federal agencies also require the use of sustainable building rating systems. As sustainable building becomes fixed into the statutory and regulatory framework, the surety's role is increasingly implicated by virtue of the fact that surety bonds are required on almost all federal, state and municipal projects. One example of legislative activity that has implicated the surety is the District of Columbia Green Building Act of 2006, which mandates the use of a surety product that does not currently exist in the marketplace.

The D.C. Act requires certain public and private projects to meet the U. S. Green Building Council's (USGBC) Leadership in Energy and Environmental Design (LEED) certification. The D.C. Act also requires that all applicants for construction of privately owned buildings governed by the Act provide a performance bond that is due and payable prior to receipt of a certificate of occupancy. The D.C. Act sets the penal sum(1) of the performance bond at an arbitrary rate of between two and four percent of the total construction price depending on the square footage of the building. The Act requires that the performance bond shall be forfeited to the District and deposited in the District's Green Building Fund if the building fails to meet the verification requirements of the Act.

While performance bond requirements of the D.C. Act may appear benign to the casual observer, their implications may be severe for the surety industry. These problems include: 1) assumptions and vague language by the drafters which suggest that LEED is an accredited standard, possibly resulting in the interpretation of LEED as a performance standard as opposed to a prescriptive requirement; 2) failing to define the parties to the bond (a fatal error in any contract); 3) misunderstanding sustainable building rating systems that require input and control of several parties to a construction project that may or may not be in privity of contract or under the control of the contractor; 4) automatic deposit of the penal sum of the bond into a green building fund held by the District without a determination of liability or certification; and 5) determination of the forfeiture of the penal sum of the bond by the same agency responsible for verification under the Act.

From a construction risk management perspective, these problems raise several questions. How can a surety, as secondary obligor, be required to guarantee the obligation of building certification when that obligation does not lie in the hands of any one party? What effect will these obligations have upon the many parties implicated by the bond? More important, is it equitable to legislate such a performance bond requirement for automatic deposit by a surety into a green building fund held by a District administrative agency that has the authority to determine compliance with the Act's requirements? Finally, will the District agency actually track the performance of the buildings in a meaningful manner, and if they are non-performing, what types of recourse are available to the District and the owner or developers?

This type of legislation involves a fundamental misunderstanding of the marketplace, the type of products available in the insurance and surety industry and how those products respond to today's construction needs. Performance bonds typically guarantee the performance of a quantifiable objective. Rather than legislate a performance bond to guarantee a quantifiable goal based on an objective standard for which the bond is written, the District has chosen to legislate a particular prescriptive rating system with attendant unknown risks. The surety product will more likely end up contributing to the District's green building fund and not the sustainable performance objectives of the District's projects.

Owners, stakeholders, contractors, risk managers, insurers and sureties must be keenly aware of the flurry of legislative activity and its implications for their interests. Much of the recent green building legislation is a result of advocacy for intangible outcomes with little analysis given to the overall performance of the public asset and little consideration for the industries that support and sustain the construction process such as insurers and sureties. The D.C. Act is just one of many examples of legislative activity that may have profound and unknown affects on these industries.

TRADITIONAL RISK DRIVERS

While the D.C. Act is an unusual example of a risk that may affect a surety or insurer, there are also more common risk drivers affecting the surety industry. Right or wrong, public owners may likely look to the surety as performance guarantor of sustainable building requirements or benchmarks in the event of the bonded contractor's default or some subsequent determination of non-performance. To the extent a bonded contractor defaults under his or her performance obligations on a project, such default will be exacerbated by the ill-defined performance standards of sustainable buildings. While the surety's performance liability for failed sustainable building standards and benchmarks has yet to be decided through litigation, the surety's representative should have a working knowledge of the major issues of sustainable buildings in order to address the owner's expectations.

In the surety industry, one of the greatest risk drivers that results in increased claim activity is mismatched expectations: a difference in what the owner expected to receive as a final product and what was actually delivered by the contractor. The owner and the contractor should be very clear in defining sustainability expectations, benchmarks and prescriptive requirements in the contract. This may require a collaborative effort at the outset of the project between the owner and the contractor to determine the reasons for the owner's decision to construct a sustainable building.

If the owner, for example, is primarily concerned about the marketing of the building as achieving a specific sustainable rating or complying with certain legislative rating requirements, the building's failure to meet that rating may result in claims for lost profits for building stakeholders and investors or result in statutory legal liability. Where the contract plans and specifications may incorporate rating requirements, the contractor and its surety should be careful to determine which requirements the contractor will be accountable for and which requirements fall outside the scope of the contractor's work and control.

If, however, the project owner is expecting that the use of a particular rating system will increase occupant health and productivity based on unfounded or questionable claims, the contractor should be careful that no warranties are being made with respect to those claims. Where the project owner is representing to the public and fully expects to obtain a specified level of energy savings through increased net operating income and reduced energy costs, the contractor must actively protect against unknowingly guaranteeing these performance attributes.

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