General contractors obtaining payment bonds on public or private projects must take steps to protect themselves from having to pay twice for the same work in the event a subcontractor fails to make downstream payments. Consider this scenario:
A bonded general contractor makes progress payments to its unbonded subcontractor for work performed. The subcontractor signs lien waivers for the payments and receives the payments, but fails to pay its subcontractor and material supplier. Instead, the subcontractor diverts the monies elsewhere and goes out of business or even files for bankruptcy in the middle of the job. The unpaid lower tier subcontractor and supplier give proper written notice of their claims for nonpayment against the general contractor's payment bond and threaten to stop work. When payments are not made quickly, the lower tier subcontractor and supplier quit work and bring suit on the general contractor's bond. Ultimately, the general contractor's payment bond surety pays the lower tier claimants. Under its indemnity agreement with the general contractor, the surety then demands reimbursement from the general contractor for all amounts paid to the claimants. The result: the general contractor has paid twice (and then some) for the same work. The general contractor cannot defend against the lower tier bond claims by proving that it had paid its subcontractor for the work.
How could the general contractor have avoided this result? There are several protections available.
First, the general contractor could have required that its subcontractor obtain payment and performance bonds. A subcontractor payment bond would be for the protection of the subcontractor's lower tier subcontractors and suppliers and would protect the general contractor's bond from lower tier claims. The performance bond would protect the general contractor when the subcontractor defaulted in performing the subcontract agreement. However, not all subcontractors are financially qualified to obtain suitable bonding. Moreover, the cost of obtaining bonds is usually included in the subcontractor's price to the general contractor which increases the cost of the work.
A second protection is to require the subcontractor to produce releases of claims and liens from each of its subcontractors and suppliers as a condition of payment. In this manner, the general contractor can monitor the flow of funds and make sure that payments to the subcontractor are making their way downstream to the appropriate parties. This process requires that the general contractor know the identity of the subcontractor's lower tier subcontractors and suppliers. The general contractor should insert in its subcontract agreement provisions requiring its subcontractors to identify all lower tier subcontractors and suppliers, to obtain releases from all such parties as a condition to receipt of a progress or final payment, and to allow the general contractor the right to determine for itself the degree to which the lower tier subcontractors are being paid.
A third protection is a joint check agreement. In this arrangement, the general contractor, subcontractor and lower tier subcontractor or supplier enter an agreement whereby the lower tier party will receive payments by checks issued by the general contractor and payable jointly to the subcontractor and the lower tier party. The subcontractor will then endorse the check and forward it to the lower tier party for endorsement and deposit. This process allows the general contractor to monitor the billings from the lower tier party and make payments on them with a check payable to both the subcontractor and lower tier party.
Ultimately, the prudent bonded general contractor will assess each of its subcontractor candidates for financial strength and reliability, taking into account the type of project, scope of work and amount of the subcontract involved, and then take steps that will best protect the general contractor from claims by lower tier parties against its payment bond.