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November 2008 >>
Contractor in Default? What to Expect from a Surety Bond Provider
A tight credit market with high fuel costs and a looming recession is making it more challenging for many businesses to stay financially fit. Business bankruptcies for the first quarter of 2008 rose 81 percent from the first quarter of 2007. As a result, more owners and contractors may be confronted with defaults.
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or example, a general contractor with too much work may become stretched beyond its financial and organizational capabilities, forcing it to notify the surety it can no longer complete the project.
The facts and circumstances giving rise to every contract default and performance bond claim are unique and complex, and the surety’s rights and obligations in such situations generally are governed by the terms of its performance bond or applicable law. Accordingly, it is difficult, if not impossible, to predict precisely how a surety will address every performance bond claim. However, sureties commonly take four options under a performance bond. Understanding these options will help owners and contractors better navigate the claims process.
Completion by Another Contractor
One of the most difficult decisions a surety must make when the principal defaults on a bonded contract is whether the surety should forfeit the penal sum of the bond or complete the contract. This decision is often based on the terms of the underlying contract and the circumstances surrounding the default. Additionally, the surety should obtain an account of the contract funds, determine the status of the project and consider, among other things, the following questions:
- What is the balance due on the contract, and will the owner cooperate in making further progress payments in the event the surety elects to complete the project?
- What are the costs of completion and will the subcon-tractors cooperate if the surety decides to complete the project?
- Are there any outstanding labor or material claims for which the surety may be obligated under the bonded contract, or is there any payment bond it may have executed in connection with the project?
- If the surety steps into the shoes of the contractor, is it prepared to be obligated to complete all of the contractor’s performance requirements under the bonded contract? In this event, the surety’s obligation would no longer be limited to the penal sum of the performance bond.
- Do the costs of completion, plus any outstanding obligations that may be payable by the surety, exceed the penal sum of the performance bond? If this is the case, the surety normally will leave completion of the job to the owner in order to limit its liability and not exceed the penal sum of the performance bond.
- Has the contract obligee/owner breached the terms of the bonded contract, thereby releasing the contractor/principal and the surety from having any liability to the obligee/owner?
There are no firm rules for when a surety should or should not complete a contract. Generally, if after making a complete analysis of the cost of completion and other potential obligations, the surety determines a sufficient balance exists in the contract price to finance the completion of the work, the surety may elect to complete the work through a qualified contractor. If there is doubt whether sufficient funds are left in the contract to reimburse the surety for the costs it incurs to complete the project, then the surety may elect to allow the obligee to com-plete the work. This option would limit the liability of the surety to the penal sum of its bond.
Completion by Owner/Obligee
The surety likely would allow the obligee to complete the work in the event the costs to complete the project exceed the balance of the contract funds held by the owner/obligee. In this circumstance, the surety normally requires the owner/obligee to obtain several written bids for the completion of the work. The surety would then tender to the owner the difference between the lowest bid and the balance of contract funds held by the owner/obligee, subject to the penal limit of the performance bond.
The surety also may, through its own sources, have contractors bid the cost to complete the work. In the event the surety receives a lower bid for completion of the work, the surety would tender that bid to the owner/obligee. If this option is followed and the owner accepts the lower bid submitted by the surety, the owner would contract directly with the low bidding contractor for completion of the work. When the owner enters into a contract with the new contractor for the completion of the work, the surety may pay the owner the amount by which the cost to complete exceeds the contract balance.
Financing the Contractor
When a principal appears to be in some financial difficulty, the surety may, in certain instances and at its sole discretion, elect to finance the principal. The objective behind this approach is to help the principal complete the work it is required to perform under the bonded contract, pay firms that have furnished labor or materials in connection with the bonded contract, and avoid a complete failure by the contractor.
This may be a viable option if the contractor’s business is fundamentally sound, its management team is of high quality and it mitigates the surety’s exposure under its bonds.
In order to make such a decision, the surety must evaluate the principal’s current financial condition and its prospects for future success. This evaluation requires a careful analysis of the principal’s financial statements, the status of its work on the bonded project (including the availability of contract funds to offset the surety’s exposure), and the expectation of profitability on other existing work.
Denying Liability
After evaluating all the relevant facts, the surety may advise the obligee it has no liability under the performance bond. Or, if the surety has not received sufficient information to evaluate the merits of the obligee’s claim, the surety may request additional information from the obligee to determine whether the claim is valid.
As economic conditions continue to create a challenging business environment, the surety’s pre-qualification of contractors will help avoid these claim situations.
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Friday, September 3, 2010