Supreme Court of PA Affects Landscape for Bonded Projects: Just How Safe is the Safe Harbor Provision?

Ask most subcontractors and suppliers their biggest concern on a project and they will probably tell you it is (not surprisingly) getting paid. The concern is a valid one. Standing in the way of a material supplier’s payment, for instance, could be several tiers of contract payments from the owner to the general contractor to the subcontractor and all the way down to the material suppliers.

The stumbling blocks that could prevent the money from flowing down the contractual chain are many. A lender might be slow to release project funds to the owner. A contractor might become insolvent and unable to pay its subcontractors. A workmanship issue might hold up the payment process. Unfortunately, it could be just about anything. It is these kinds of payment risks that shape the negotiation of construction contracts and the development of laws that deal with these risks.

Pennsylvania Bond Law

For public projects in Pennsylvania, the Bond Law requires general contractors (GCs) to obtain bonding that guarantees the performance of the GC and payments to subcontractors and suppliers. Normally, when a contractor obtains bonding from a surety, the contractor (and often its individual owners) indemnifies the surety. In other words, if the surety is called upon to pay off a supplier’s payment bond claim, then the surety may later call upon the contractor (and anyone else who agreed to indemnify the surety) to repay the surety for the amount of payment made to resolve the bond claim.

So what happens in the not-so-uncommon scenario in which (1) the GC pays each of its subcontractors in full, (2) one of the subcontractors becomes insolvent and fails to pay its supplier in full, and (3) the supplier files a claim against the GC’s payment bond? If the surety pays that claim and then pursues the GC, the GC will have been called upon to pay twice for the same work. To some, particularly GCs, this fate probably seems unfair.

In Pennsylvania, the legislature passed a provision of the Procurement Code that protects GCs and sureties from this fate. It is commonly referred to as the “Safe Harbor Provision,” and it reads as follows:

Once a contractor has made payment to the subcontractor according to the provisions of this subchapter, future claims for payment against the contractor or the contractor’s surety by parties owed payment from the subcontractor which has been paid shall be barred. The Safe Harbor Provision is a classic example of how legislators try to balance the risk of nonpayment on public construction projects. On the one hand, the Bond Law provides protection to subcontractors and suppliers by requiring a payment bond to be in place. On the other hand, the Procurement Code’s Safe Harbor Provision provides protection to sureties and GCs when the GC has paid its subcontractor in full. These two statutory provisions and the conflicting interests they seek to protect were front and center in the recent case of Berks Products Corp. v. Arch Insurance Co. (Berks).

Berks

In Berks, Arch Insurance Co. (Arch) issued a payment bond for the GC on a public school project for the Wilson Area School District (the Project). The payment bond included the following language that ultimately determined the outcome of the case:

[T]he terms and conditions of this Bond are and shall be that if the [GC] and any subcontractor of the [GC] to whom any portion of the work under the Agreement shall be subcontracted, and if all assignees of the [GC] and of any such subcontractor, promptly shall pay or shall cause to be paid, in full, all money which may be due any claimant supplying labor or materials in the protection and performance of the work in accordance with the Agreement and in accordance with the Contract Documents… for material furnished or labor supplies or labor performed, then this Bond shall be void; otherwise, the Bond shall be and shall remain in force and effect.

In much simpler terms, this language says that the payment bond will no longer remain in effect if the GC and its subcontractor have paid all monies due and owing under their respective contracts/subcontracts. The Safe Harbor Provision says something altogether different. The Safe Harbor Provision says that a payment bond claim will not be permitted if the GC has paid its subcontractor in full (regardless of whether the subcontractor paid its suppliers). In Berks, the Commonwealth Court of Pennsylvania compared the language in the bond with the language in the Safe Harbor Provision and decided (1) the language in the bond was inconsistent with the Safe Harbor Provision and (2) the language in the bond waived the language in the Safe Harbor Provision. In other words, the Safe Harbor Provision did not protect Arch because the specific language of this payment bond said that payment was required by GC and the subcontractor for Arch to escape a payment bond claim from the supplier.

Life after Berks

Now that the Supreme Court has decided not to take Arch’s appeal, the Berks’ decision will likely receive mixed reviews throughout the industry that include groans from sureties and cheers from lower-tier subcontractors/suppliers.

Although we expect sureties doing business in Pennsylvania will re-examine and revise the language in their payment bonds to make sure it does not resemble the payment bond at issue in Berks, there are likely similarly-worded payment bonds in effect for ongoing construction projects that cannot be modified and through which sureties could have the type of exposure Arch had in Berks. Also, if Berks creates a perception that the Safe Harbor Provision is under attack, it could increase the cost to provide bonding, which may be passed on to owners.

In addition to the effect Berks will have on sureties, it is also likely to affect GCs, subcontractors, and suppliers. We expect suppliers will use Berks as authority to support future bond claims where the GC has paid its subcontractor in full but the subcontractor had not passed down payment. We expect GCs will become more vigilant in confirming that payments make their way down the contractual chain by way of verifications, releases, joint check agreements, and/or bonding requirements for their subcontractors.

Life after Berks will be complicated and interesting, and we will continue to report how it affects each tier of the construction industry.