Who Benefits from Subcontractor Default Insurance? Not Project Owners.

The good folks at Bricker & Eckler, an Ohio law firm, recently blogged about a New York appellate decision concering subcontract default insurance (“SDI”), often referred to as “SubGuard” based on a Zurich SDI product of the same name.  The case involves a private owner who alleged it was misled by its construction manager (presumably at-risk) into believing that the SDI policy the CM had procured from the project’s largest subcontractor provided coverage to the owner in the event of that sub’s default.  Turns out the policy only named the CM, but not the owner, as an insured, and when the owner discovered it had no coverage after the sub’s default, it sued the CM for fraud, among other claims.

Neither the trial court nor the appellate court bought what the owner was selling.  The appellate court affirmed the trial court’s allowance of the CM’s motion for summary judgment, reasoning that the owner could not possibly have relied reasonably upon the CM’s representations regarding the scope of coverage under the sub’s SDI policy.  I agree with the court’s reasoning, and commend the details of the court’s analysis to your reading.

I blawg to argue that the court’s conclusion was supported not only by sound legal reasoning, but also by fundamental principles of construction risk management.  At the risk of sounding harsh, shame on the project owner for thinking that ANY product intended to guard against the risk of subcontractor default would inure to the benefit of a party two links up on the contractual chain.

I mean, c’mon, this is Construction Contracting 101, people!  An owner contracts with a prime contractor (i.e., a general contractor, construction manager at-risk or design-builder), who assumes responsibility for the entire work.  If the owner desires protection from the risk that the prime contractor will not be able to complete the work, then it must obtain that protection from — and pay the related premium to — the prime contractor.  If a subcontractor thereafter defaults, then that’s the prime contractor’s headache, and if the prime becomes so incapacitated by a sub’s default that it, too, can no longer continue prosecuting the work, then the owner is protected by whatever instrument it obtained from the prime contractor to guard against the prime’s project default.

Subcontractor default protection, on the other hand, inures to the benefit of the prime contractor, NOT the owner.  Whether we’re talking about subcontractor performance bonds, SDI policies or subcontractor letters of credit, these products serve as a hedge against the delays and costs a prime contractor might incur if a key sub goes AWOL or belly up during a project.  The risk being managed by these products is the risk that the prime contractor — NOT the owner — will be damaged in the event of subcontractor default.

Maybe I’m just cranky this morning, but I just don’t have a lot of sympathy for the owner in the Waterscape Resorts case.  Owners of private construction projects, regardless how experienced they may be in the construction industry, must understand the basics of risk management before they contract with a prime contractor for an improvement.  Simply put, if a private owner wants protection from the risk of project default, it must purchase that protection from its prime contractor, and should have zero expectation that any subcontractor default protection product the prime contractor is contemplating purchasing in order to manage its own risk will also shield the owner from damages arising from subcontractor default.

UPDATE (10/3/2013 12:00 p.m.): I just found a terrific 2009 paper presented by the Foundation of the American Subcontractors Association, Inc. and the National Association of Surety Bond Producers on the pro’s and con’s of subcontractor default insurance; you can find it here.