by Elizabeth Graff Dorfman, Associate

In recent years, state and federal spending has tightened as public officials attempt to address budget deficits without increasing taxes.  As a result, the public funding available for infrastructure projects is declining, despite a growing need for new or upgraded facilities or maintenance to existing infrastructure.

To meet the nation’s enormous needs, and to overcome these very real fiscal constraints, the public and private sectors are increasingly joining together to identify, finance, and build infrastructure projects of the type that have historically been solely the province of the public domain.  State and local governments have recognized the benefits that can be realized from private involvement in infrastructure development by enacting legislation authorizing Public-Private Partnership agreements.  A Public-Private Partnership or a PPP, generally involves a contractual relationship between a private entity and a public agency for the construction of a public infrastructure project.  In a PPP, the private entity takes on a larger than traditional role in the construction, planning and financing of the project, depending upon limitations imposed by statute and the project’s goals.  The private entity may also play a significant role in the operation and maintenance of the Project after completion.  While this larger role provides many benefits to the private entity, such as expanded business opportunities and lengthy and continual revenue sources, the inherent structure of such partnerships poses unique issues for bonding companies.

This article is intended to provide guidance to the surety in its negotiation of bonds for PPP projects by reviewing common provisions in PPP agreements that may shift greater risk to the contractor and surety and by suggesting strategies for insuring that the surety’s interests are appropriately protected.

New Risks for the Contractor and Implications for the Surety – The PPP Agreement

Public-Private Partnerships are established by contract and further defined by statute.  In addition to federal legislation permitting PPPs, a number of states have, by statute, created a vehicle for the formation of PPPs.  See D. Joseph Darr, Current Trends in Public-Private Partnership Laws, THE CONSTRUCTION LAWYER (Summer 2008).  Generally, PPP statutes confer power to state agencies to form partnerships with private entities for the planning, construction and operation of state infrastructure projects.  These statutes set forth the general requirements of the terms and conditions of partnering agreements, as well as the powers and duties of a private entity contracting with the public entity.

The structure and function of PPPs present greater responsibilities and pose greater risks for the private contractor than traditional projects and, therefore, pose a corresponding increase in risk to the bonding surety.  These risks depend largely on the type of contract the parties decide to enter, such as Design-Build or Design-Build-Operate-Maintain.  See Nicholas J. Farber, Avoiding the Pitfalls of Public Private Partnerships: Issues to be Aware of When Transferring Transportation Assets, 35 Transp. L.J. 25 (Spring 2008).  Under these contracting paradigms, some factors impacting the surety’s risks and resulting liability include: (a) the method of financing – PPPs often involve multiple sources of funding, including public bonds or guaranteed loans, shareholder equity and direct user charges (for example, revenue from tolls) and the ability to control and insure adequate funding, including the sources of such funding, are risk factors to be evaluated by the surety; (b) the term of the PPP Agreement – typically, PPPs are utilized for complex, costly infrastructure projects, and as a result, the costs of the facility are financed, in part, by projected revenue during the operation phase of the contracts, which typically have extended durations of up to 30 years; (c) obligations to operate or maintain the facility — many PPP agreements require the contractor to assume responsibility for post-completion operation, maintenance and quality control of the Project facility, which because of the extended performance period increase the risk to both the contractor and the surety.  Additionally, from the surety’s perspective, questions arise regarding the surety’s liability for continued maintenance and warranty work, especially when many bond forms, as discussed in further detail below, obligate the surety to perform all of the contractor’s obligations in the event of default.

The Surety’s Obligation – The Bond/Guaranty

Although the surety must be cognizant of the terms and conditions of the Partnering agreement, and, to the extent possible, participate in its negotiation, the surety’s ultimate consideration should be the terms of its obligation as set forth in its bond.  For PPP projects, many public entities require the surety to execute bonds that function like letters of credit or guaranties that impose unconditional obligations on the surety to tender payment for any breach of contract by the principal.  Moreover, the terms and conditions of these agreements often preclude the surety from asserting many of the rights and defenses commonly afforded under typical bond forms like the AIA A312 performance bond.  Sometimes, these agreements seek to subordinate any surety rights until after the obligee has been fully compensated or performance fully rendered.  Thus, both the Partnering agreements between the contractor and the public entity and the bond form governing the surety’s obligations must be negotiated to protect the rights and defenses of the contractor and the surety.

The following is a brief summary of provisions that may be contained in a form obligation or bond proposed by a public entity on a PPP project.  The surety should be aware of these types of provisions and, to the extent possible, negotiate to eliminate or modify their terms.

• Broad Liability

The surety can expect the form of obligation suggested by the public entity to contain sweeping liability provisions and clauses that waive fundamental surety rights and defenses and provide for “unconditional guarantees” of performance.  Often, these “unconditional guarantees” are not dependent upon the public entity’s performance of its obligations, as is the case under typical bond forms like the AIA A312 bond, which requires that there be no owner default.  Additionally, these forms might identify the surety as the “primary obligor” who agrees to fully and promptly perform, observe and pay on demand each and every obligation of the contractor.  These types of provisions convey added risk to the surety, as it becomes essentially a co-obligor, responsible without regard to the normal surety defenses attendant with the tripartite surety agreement.  The surety should always carefully review the scope of such agreements and, if possible, modify or limit the breadth of these types of liability clauses to protect its interests.

• Demand for Performance and Related Dispute Provisions

Consistent with the public entity’s goal to insure immediate protection from any contractor default, and related financial security for any such default, the bond or guarantee forms required by public entities often are more akin to letters of credit, providing few, if any, conditions precedent to the surety liability.  Indeed, some bond forms may provide that the surety’s unconditional obligation extends to payment of all monies owed by the contractor.  The surety’s unconditional obligation to pay any and all claims for payments owed, which could include claims for liquidated damages, effectively eviscerates many surety defenses related to, for example, owner’s breach, impairment of suretyship, waiver, or any other defense.

Through negotiation, sureties have been successful in altering these types of bond forms to include, at a minimum, expedited dispute resolution prior to any requirement for immediate payment of the obligated funds.  Sureties are also well-advised to include a catch-all reservation of rights provision that limits the surety’s exposure to that of the contractor.  Sureties would also consider a mechanism by which the surety can retain its right to assert defenses, depending upon other contractual provisions, prior to the tender of performance, if it so elects.

• Waiver

Many bond forms include waiver of notice provisions.  These provisions might address routine waivers, such as waiver of notice related to changes to the Partnering agreement.  They might also include more fundamental waivers, such as waiver of the surety’s rights to set-off and recoupment, waiver of notice of the contractor’s default, waiver of notice of the contractor’s failure to perform its obligations, or waiver of notice of any failure or delay on the part of the public entity to enforce its rights under the Partnering agreement.  These latter provisions could potentially undermine impairment of suretyship arguments, and certainly prejudice the surety’s ability to ameliorate any potential contractor breach or default, thus increasing the surety’s risks for liability.

Perhaps even more troublesome for the surety are the “catchall” provisions wherein the surety agrees to waive notice of any other circumstance that might constitute a legal or equitable discharge.  Such provisions could eliminate fundamental surety defenses including impairment of the surety’s rights, that ordinarily result in a partial or full discharge of liability.  The surety should be cognizant of the implications of such waiver provisions, and where possible seek to modify or eliminate these provisions.

• Subrogation

Finally, many of the bond forms used on PPP projects purport to eliminate, or at least subordinate, the surety’s rights of subrogation until after the public entity has been completely indemnified through full payment or completion of performance.  Clearly, the surety’s rights to contract funds and its entitlement to subrogation are fundamental rights that should be protected.  These clauses have not been judicially tested, and the method and manner of enforcement remain questionable.  Nonetheless, as the surety’s subrogation rights are essential surety rights, such provisions should be stricken or modified.

Conclusion

For several years, public-private partnerships for construction infrastructure projects have been on the rise.  The expanded role of private entities on these projects is not without certain risks, especially for the bond surety.  These sureties must consider the statutory requirements applicable to the bonded project, seek to participate in the negotiation of the underlying agreement and, most importantly, be cognizant of the broad risk-shifting provisions contained in some proposed bond forms.  Careful and vigilant negotiation by the surety of the terms of its obligation on a PPP project is essential to the protection of fundamental surety rights and defenses.

The information or opinion provided in this article is the author's own and not necessarily that of Watt, Tieder, Hoffar & Fitzgerald, LLP. The author is solely responsible for the information and opinion that he or she has provided. The information contained herein does not replace seeking specific legal counsel to directly address individual client needs.