Underpayment by the Owner
An owner “underpays” his contractor when he submits a progress payment for less than the full amount to which the contractor is entitled. Not only does an underpayment affect the contractor, but it also has very real consequences for the surety. If the contractor defaults, which may be likely if he does not receive his full payment, the surety is then obligated to step in. Generally, the surety may choose to provide resources to the contractor to allow for the completion of the job in the face of the underpayment. When this happens, the surety gains rights, as an equitable subrogee, to the monies owed the contractor.
The surety may also decide to substitute another contractor for the defaulting one or pay the amount levied as a result of the default. A risky alternative for the surety would be to do nothing on the reasoning that there was no default by the contractor. However, the surety will bear the responsibility for its inaction should it be determined that there was, in fact, a default.
If the contractor is justified in stopping its work on the project as a result of the owner's underpayment, the owner may be held to be in material breach of the parties' construction contract. Therefore, withholding funds should be undertaken cautiously. Additionally, the surety would be discharged from its obligations on the performance bond leaving the owner with less protection.
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