When You Build… Bond

Introduction

Surety bonds have been used to guarantee the performance of contracts since the beginning of time. The Bible, the Magna Carta and The Merchant of Venice all make reference to the use of suretyship to assure that someone will carry through on promises. Since the late 19th century, surety bonds have been written in the United States by private corporations – and today they are an essential part of everyday business transactions. Construction surety bonds (bid, performance and payment) are the catalyst that enables our existing open, competitive bidding system-mandatory for public construction-to function smoothly.

While surety bonds traditionally have been required in conjunction with public contracts, they are just as essential in private construction. When a company undertakes a building project, risk managers are expected to analyze all the perils that can result in a loss. Yet, in many instances, no attempt is made to protect against the failure of the contractor to perform. This can be far more costly than all other hazards combined.

This pamphlet is designed to acquaint both public and private owners and their lenders, attorneys, architects and risk managers with the fundamentals and benefits of construction surety bonds.

Using a Question and Answer format, it demonstrates how surety bonds provide the owner with protection against loss, starting with a surety’s thorough prequalification review of the contractor. In today’s economic environment, anyone who plans to build, to provide funds for a building project, to provide legal advice for it or to analyze the risks such a project entails, should consider requiring construction performance and payment bonds for protection. It is only prudent.

Surety Bonds

Question: What is available to protect building project owners against the failure or default of a construction contractor?

Answer: Construction surety bonds.

Question: What are construction surety bonds?

Answer: A construction surety bond is a three-party instrument where the surety joins with the contractor to guarantee to the owner that the contractor will comply with the terms and conditions of the contract. Generally there are three separate bonds. The first, the bid bond, guarantees that the bidder actually will enter into the contract at the bid price and provide the required performance and payment bonds. The performance bond protects the owner from financial loss due to the contractor’s failure to adhere to the terms and conditions of the contract. The payment bond guarantees that the contractor will pay certain labor and material bills associated with the project.

Question: Who benefits from these bonds?

Answer: Construction surety bonds provide direct protection to owners of building projects as well as laborers, subcontractors and suppliers. At the same time, they either directly or indirectly benefit lenders, architects, engineers, attorneys, risk managers and contractors themselves.

Question: How do they provide protection?

Answer:

  1. For the owner, performance and payment bonds guarantee that the contractor will perform the contract and pay certain labor and material bills incurred on the job. They also give the additional security of knowing that the contractor has satisfied the surety’s comprehensive prequalification review.
  2. For the lender, the bonds provide assurance that if the contractor is paid for the work, the project that secures the loan will be built in accordance with the terms of the contract.
  3. For the architect or engineer, the bond provides confidence that, in the judgment of the surety, the contractor is capable of translating the plans into a finished product.
  4. For the owner’s attorney, the bonds provide the security of knowing that the owner will be protected if the contractor fails to perform.
  5. For the risk manager, the bonds provide the satisfaction of knowing that the owner is protected against one of the major construction perils – contractor failure.
  6. For the contractor, bonds help to screen out unqualified contractors and irresponsible competition, because reputable contractors will not object to providing surety bonds. 

Surety Companies

Question: Who provides the bonds?

Answer: Surety bonds are provided by licensed surety companies which are willing to commit their assets in support of their contractor clients.

Question: How are surety companies able to offer this protection?

Answer: Surety companies possess requisite financial strength to provide credible guarantees on construction projects. Since surety companies back their guarantees with their own assets, they do not write bonds imprudently. Before surety companies issue bid, performance, and payment bonds for a contractor, they conduct an extensive prequalification review of the contractor.

Prequalification

Question: What is a prequalification review?

Answer: A thorough review of the contractor’s finances, previous experience, and capacity to perform the specifications of the contract.

Question: If a private owner is prequalifying contractors, why pay a surety to do the same thing?

Answer: An owner’s prequalification process is likely to be more limited in scope than a surety’s. Generally, a surety has a close, long-lasting, personal relationship with the contractor, its employees, attorney, banker, accountant, and other advisers. Therefore, the surety has access to detailed financial information, continued analyses of organizational strengths and weaknesses, and information on current problems facing the contractor. Most of this is unavailable to an owner. The surety is in a much better position to make a solid and informed decision on whether the contractor is qualified to do a particular job, because of its depth of knowledge of the contractor client.

Bottom line, when an owner without a bond makes a mistake in choosing a contractor, the owner bears the cost of the error in judgment. When the owner is protected by a contract surety bond, financial risk is transferred to the surety.

Question: Doesn’t this close relationship sometimes cloud a surety’s objectivity?

Answer: While this possibility exists, it must be remembered that a surety pays for its judgmental errors with its own money. This tends to maintain a surety’s objectivity.

Cost

Question: What is the cost of construction surety bonds?

Answer: Rates for construction surety bonds vary, but they typically range from one-half to one percent of the contract price. The premium rate decreases as the contract size increases. Considering the protection afforded, surety bonds are an excellent, low-cost investment.

Question: Well, the price seems reasonable enough, but what does an owner get besides a piece of paper?

Answer: The owner receives guarantees from a financially responsible surety company licensed to transact suretyship. Construction Surety Bonds . . .

  1. Guarantee that the bonded contract will be performed to contract specifications.
  2. Guarantee that certain laborers, suppliers and subcontractors will be paid even if the contractor fails to pay them. This often results in lower prices and expedited deliveries.
  3. Relieve the owner from the risk of financial loss arising from liens filed by unpaid laborers, suppliers and subcontractors.
  4. Smooth the transition from construction to permanent financing by eliminating liens.
  5. Reduce the consequences of a contractor diverting funds from the project.
  6. Provide an intermediary – the surety – to whom the owner can voice complaints and grievances.
  7. Lower the cost of construction in some cases by facilitating competitive bids. 

Benefits

Question: Are the services of the surety worth the price of the bond?

Answer: Certainly, that decision is up to you. However, consider the savings that will result from bonding a project by reducing or eliminating:

  1. Staff time needed to prequalify contractors.
  2. Costs added by subcontractors and suppliers to offset the risk of not being paid.
  3. Costs added by general contractors for administration of payment affidavits or lien rights procedures.
  4. Costs and complications to owner as a result of having to withhold money from the contractor as a means of imposing discipline or solving problems such as:
    1. Disputes and slow-downs
    2. Potential of contractor alleging owner’s breach of contract
    3. Undelivered materials
    4. Ill will
    5. Possible litigation.
  5. Direct and indirect costs to owner arising out of contractor default:
    1. Cost to owner of having to make good on a contractor’s unpaid bills which can include tax liens
    2. Staff time and administrative costs associated with processing requisitions and payment affidavits.

Question: What happens if liens are filed upon the bonded construction project by laborers, material suppliers or subcontractors?

Answer: The project owner may call upon the surety to arrange for the release of the liens. It may accomplish this in a variety of ways, but generally will provide separate bonds to release the liens.

Question: Can bonds be written only on projects which are let out for bid?

Answer: No. Construction surety bonds provide the same protection to owners on negotiated contracts as on competitive bid contracts.

Question: How can a lender directly benefit from a construction surety bond?

Answer: Generally, a lender benefits from a dispute-free project. Additionally, it is possible to name the lender as an additional obligee (beneficiary) of a contract bond giving the direct rights under the bond. In such cases, surety companies will require a clause in the bond stating that the surety shall not be liable unless the owner and/or the lender makes all payments and performs all other obligations as provided in the contract.

Question: Are contractors going to object to a requirement for bid, performance and payment bonds?

Answer: Reputable contractors support the use of bonds as a legitimate part of the prequalification process. They recognize that bonding tends to screen out unqualified contractors and encourages fundamental fairness in bidding and award procedures. Furthermore, contractors generally are proud and protective of their ability to obtain bonds and of the bonding credit line extended to them by their sureties.

Contractor Default

Question: How does a surety respond when a contractor is in default?

Answer: A surety has a variety of ways to respond depending upon the specific facts of the case. Each case requires individual treatment. The following representative cases illustrate the services a surety provides to an owner when a default occurs.

Case 1

Because of severe winter weather problems, the construction of a basketball stadium for a major university was only 28% complete while 68% of the scheduled time had elapsed. Additionally, the construction company, which had experience building other major sports arenas, was close to defaulting because of financial difficulties.

With the basketball season less than a year away and construction at a standstill, the surety intervened and arranged for the university to work with a new contractor. The work schedule was revamped and additional subcontractors and general contractors were hired to carry out various aspects of the contract. The total number of craft workers grew from 310 to 590 working two shifts for six (and sometimes seven) days a week.

A combination of prompt intervention, commitment of resources and considerable financial support got the project back on track and the doors to the arena open in time for the season opener-which the home team won! Loss to the surety was approximately $9.5 million. Without the bond, this loss would have been incurred by the owner.

Case 2

A large steel company decided to embark on a $50 million construction project. Having selected a contractor who appeared to be reliable, performance and payment bonds were not required. However, the contractor was not as reliable as everyone believed and eventually defaulted. After the contractor was removed from the job, workers from the steel company completed the project at an additional $12 million. Paying a modest premium for a $50 million performance bond would have been better than suffering a $12 million loss and the disruption caused by having to reassign company workers to complete the contract.

Question: How long does it take to process a bond claim?

Answer: When a contractor defaults, the surety will usually want to start its own investigation immediately and respond as quickly as possible. Ordinarily, the surety will want to keep the project moving since delays merely increase costs. The size and complexity of the default, the duration of the project and the point at which the default occurred, all have a direct bearing on the time it takes to complete a settlement. Other factors, such as the condition of the contractor’s records, terrain, climate, type of project and other work the contractor might have undertaken also have a bearing on the bond claim process. It is in everyone’s best interest to have the project continue and proper claims paid as soon as possible.

Owner’s Obligation

Question: What is the owner’s obligation under a surety bond?

Answer: An owner only has to perform his or her part of the contract to receive the protection of the bond. It should be emphasized that a bond will protect the owner’s legal rights under the contract by assuring that there will be a responsible party available in the event of contractor default.

Obtaining Bonds

It appears that requiring bonds on private construction projects is a prudent practice for any owner. How does one go about arranging for them?

Answer: The owner simply includes the requirement for bid, performance and payment bonds in the contract specifications. Obtaining bonds and delivering them to the owner is the responsibility of the contractor who will consult with an independent bonding agency.