The housing subdivision developer has defaulted, leaving its contractors with unpaid bills and the local government without the finished roads, sidewalks, water and sewer lines that the developer has to have constructed for the subdivision. Who can make good on the developer’s commitments – why not the surety who issued the developer’s subdivision bond? Because of the housing market collapse and developer’s defaults, sureties are now confronted with claims rarely seen in the past. Contracts and local governments are likewise coming to grips with the coverage and limits to subdivision bonds.

Effect of Real Estate Boom on Residential Subdivisions

Extensive subdivision development on land lacking public utilities and services began in earnest in the early 1970’s. With the upsurge in the real estate market, developers experienced feelings of euphoria and began “investing” in real estate subdivisions. Many were convinced that housing prices always go up “in the long run” and acquiring lender support was almost effortless, as banks were clamoring for this business.

Obtaining bonding to secure public improvements required by public agencies (in exchange for approval of tentative and final tract maps for the subdivision development) was no less difficult. Because the developers were typically backed by reputable banks and the real estate market appeared to be on a continuous incline, sureties were not reluctant to issue the performance and payment bonds local governments often required of developers.

End of the Honeymoon Period

What many did not realize, however, was that often these developers were first-timers with little to no experience with the platting process, contracting with financial institutions, hiring competent contractors, dealing with home builders, or lacking sufficient capitalization to weather a downturn. Now, in the wake of the nation’s real estate bust, thousands of developers have been unable to complete subdivision developments, thereby resulting in defaults, foreclosures, and overall residential distress. As a result, sureties are facing a growing number of subdivision bond claims from contractors and public agencies alike, demanding that the sureties cure the defaults of their bonded developers.

Lessons Being Learned

Subdivision bond claims are not the same as claims on public works bonds, and those within the housing development industry must recognize the differences.

• Statutory Purpose

The law relating to subdivision bonds is entirely a creature of legislation. For example, in California, the subdivision of land is controlled and governed by the Subdivision Map Act (Government Code § 66410, et seq.), which was intended to regulate and control the design and improvement of subdivisions with consideration for their relation to adjoining areas.

In order to assure consistency of subdivision design and improvements with local standards concerning public health and safety, local agencies are permitted to require that subdividers satisfy certain conditions for approval in exchange for the agency’s approval of the tentative and final tract maps for the subdivision. Some of the conditions include the installation of public improvements, such as streets, sewers, and water facilities, according to specifications established by the local agency. Moreover, if the subdivision improvements are not completed at the time the final tract map is recorded (which is often the case), the local agency can require the subdivision to enter into a subdivision improvement agreement to assure the completion of such improvements by a given deadline.

• Subdivision Bonds

To assure the completion of the required subdivision improvements, the public agency may require the developer to post security, usually in the form of corporate surety bonds. Again using California as an example, public agencies are not afforded the option of requiring security from the developer, but, instead, are required under the Subdivision Map Act to obtain sufficient security. The purpose is to assure that proper improvements are made so that the area does not become an undue burden on the taxpayers. Further, if the public agency accepts subdivision bonds as security, it must require both a performance and payment bond. The amount of security required to secure the completion of the subdivision improvements is determined by the public agency, but typically equates to the cost to complete the bonded improvements.

• Differences Between Subdivision Bonds and Public Works Bonds

Although subdivision bonds are somewhat similar to traditional public works bonds, there are important differences which often create disagreement as to whether subdivision bonds are considered “true” public works bonds.

First, with a typical public works bond for a local or state government project, the surety secures the performance of the contractor, whereas, under a subdivision bond, the surety secures the obligations of the developer, which may not necessarily be the contractor. If the developer has separately retained a contractor to build the required improvements, and the contractor subsequently defaults, there is no privity of contract between the surety and the contractor. Indeed, often is the case where the developer experiences cashflow problems, fails to pay the contractor, and, as a result, construction comes to a halt. Because of this unique situation, sureties often find it necessary to monitor the progress of the builder directly to assure the timely completion of the obligations secured by the subdivision bonds.

Second, in a typical public works bond, the public agency is named as the obligee. In the event of a default, a balance of contract funds may be available to put towards completing the remaining work. Under a subdivision bond, however, the surety does not have access to such funds because the public agency was never under any obligation to pay the developer for the cost of the improvements. The consideration that the public agency gave was the approval of the tentative and final tract map and, thus, the right to develop the subdivision. In some states, if the developer defaults before construction has even started, courts have held that the public agency is still permitted to make a demand against the surety under the subdivision bonds. See e.g. City of Merced v. American Motorist Ins. Co. (2005) 126 Cal.App.4th 1316.

The Supreme Court of Virginia reached a similar conclusion in Board of Supervisors of Stafford County v. Safeco Insurance Company of America, 226 Va. 329, 310 S.E. 2d 445 (1983). In the Virginia ruling, the developer had provided a subdivision bond to assure construction of roads, water lines and sewer lines in four sections of a subdivision. At the time of the developer’s default and bankruptcy, the only work done on the project was limited to on-site cleaning and grading for roads. No work was ever started on installation of water or sewer lines. The County sought recovery for the yet to be constructed improvements. The Virginia Supreme Court held in favor of the County, ruling it was not necessary for the County to prove a financial loss as a prerequisite to recovery from the surety on the subdivision bond. In response to the surety’s argument that the County had not shown an intent or need to perform the bonded improvements, or that it was feasible to complete the bonded improvements, the Court wrote that it was not the surety’s responsibility to see to the application of the bond proceeds.

Third, the primary distinction between subdivision bonds and other bonds is the scope of coverage. Unlike public works bonds, a subdivision bond guarantees only the public improvement portion of the entire development. Further, the surety is generally not relieved until the improvements are finally completed and the governing authority has the improvements. Sureties are finding that few (if any) public agencies are inclined to accept improvements in piecemeal fashion but, instead, will wait until all of the required improvements are completed before performing an inspection for acceptance. The reason for such reluctance is that, once the improvements are accepted, it typically becomes the responsibility of the public agencies to maintain and repair any defects (resulting after any warranty period or latent defect issue). In California, sureties are generally liable during this interim period for any damages caused to the improvements before the public agency’s acceptance. City of Sacramento v. Trans Pacific Industries, Inc. (1979) 98 Cal.App.3d 389, 397.

Finally, the limitation period between public works and subdivision bonds differs greatly. While typical public works bonds appear to provide broader coverage, the limitations period for making a claim on such bonds is typically limited to one or two years from the date of acceptance or completion of the project. For subdivision bonds, however, the limitations period often runs from the date the notice of completion or cessation of labor is recorded. Further, the nature of a subdivision development often requires the developer to seek extensions of time to complete the improvements. Most subdivision bond forms include language that allows the public agency to grant such extensions without notifying the surety. As such, the surety’s exposure under a subdivision bond might be extended to several years after the bond was first issued.

Conclusion

Subdivision bonds have unique aspects and different potential consequences for all involved in housing division development and construction. Now that general building in the private sector has plummeted and developers and their projects collapse, everyone should expect more subdivision bond claims as one of the effects of the once hyperactive housing market.

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.