Public-private partnerships (P3s) are gaining momentum throughout the United States as an efficient way to design, build, finance and maintain government construction projects. Under a P3, the government entity generally issues an RFP to engage a concessionaire for the project. The concessionaire then secures funding for the project while holding the right to use the project property for the duration of the construction, operations and maintenance period outlined in the agreement.
The public sector retains ownership and ultimate control of the public asset in a P3. The concessionaire secures funding for the project and enters into agreements with the government agency, which provides availability payments based on construction, operations and maintenance milestones. These payments can be structured to meet the government’s budgetary constraints, allowing projects to be delivered in a shorter time frame while government funding is spread over multiple years and operating budgets.
Government funding shortfalls are the most important reason for public and private partners to pursue a P3. Public entities also believe risk transfer is an important part of the P3 model. Some U.S. sureties also are providing pay-on-demand bond forms that read like an irrevocable letter of credit (ILOC) for owners that do not recognize the value of the accelerated adjudication process in the most recent bond forms.
Generally, the private sector assumes the financing, construction and operational risk, while the public sector retains ownership and sets the standards for the construction and use of the asset.
The concessionaire typically engages a design-build contractor to complete the construction phase of the project. The security requirements for the design-build contractor ideally are structured to meet the needs of the concessionaire and its lender, as well as provide protection for subcontractors and suppliers on the P3 projects.
Performance Bond With Dispute Resolution
Because subcontractors and suppliers are unable to perfect a lien on P3 projects, surety bonds that include a performance bond with an accelerated dispute resolution process or liquidity feature, as well as a payment bond for the protection of the subcontractors and suppliers, remains the security of choice for the benefit of all project participants. If letters of credit are used in lieu of surety bonds for the security of the contractor’s performance, the subcontractors and suppliers will have no recourse against the bank that issues the letter of credit, leaving them exposed to the contractor’s default risk.
Two of the top three sureties have been leaders in the P3 surety market, developing performance bonds that include an accelerate dispute resolution process that meets the liquidity needs of the concessionaire and its lender, while providing payment bonds that give downstream protection to subcontractors and suppliers.
One surety has developed a hybrid performance bond that includes a pay-on-demand feature for a percentage of the bond penalty with the balance of the bond coming under the accelerated adjudication process. The accelerated adjudication process guarantees a decision to the obligee within a short period of time through the use of alternate dispute resolution processes outlined in the bond form.
Conditional Surety Bonds
Conditional surety bonds used on P3 projects also benefit the design-build contractor. The built-in adjudication process included in the bond form reduces the contractor’s exposure to a liquidity crisis. When an ILOC is called, the bank must immediately pay, and the amount paid promptly converts to bank debt. Contractors and their banks are not given an opportunity to dispute the reasons for the default, and the contractor’s liquidity is impacted even when the contractor has a legitimate defense to the claim. With a surety bond, the surety must weigh the merits of a surety bond default versus the contractor’s defenses.
The surety has to follow legal duties, including timely response to the demand, evaluation of the contractor’s defenses to the default and responding in good faith to the claimant. The surety must respond under the terms of a bond for all valid claims, including paying for damages up to the penalty of the bond, financing the defaulted contractor to completion or hiring a replacement contractor.
However, the surety cannot force the contractor to perform if the contractor has valid defenses to the default. The surety claim process has the advantage of preserving the contractor’s liquidity throughout the course of a dispute on a bonded contract until the facts are reviewed and a bond coverage determination is reached. With the accelerated dispute resolution features of the surety products now used on P3 projects, all parties will receive the benefit of prompt dispute resolution and payment of valid claims in a timely manner.
Letters of Credit
Sureties also recognize some owners or lenders will simply avoid conditional payment surety bonds at all cost and will demand letters of credit in lieu of bonds. For those instances, a few sureties are looking to provide bank syndication guarantees where the sureties become a participant on bank letters of credit guarantying up to 50 percent of the ILOC in a reinsurance agreement with the bank. To do so, sureties are participating on a quota share basis while sharing in the bank’s collateral package, helping contractors expand their ILOC capacity through the use of the surety market.
Sureties also are becoming more sophisticated creditors through intercreditor agreements that clearly define the first and second security positions for the banks and bonding companies, helping the surety expand capacity with these new products.
Given the choice of security requirements, the surety market continues to provide the product with the best combined benefit for contractors and their obligee in today’s evolving construction and surety markets.
James Bly is managing director of subcontractor default insurance and surety analytics for Alliant’s Construction Services Group. He also sits on the board of the Construction Financial Management Association and serves as its national at-large director. For more information, email firstname.lastname@example.org.