An unqualified subcontractor can have a major impact on a construction project. Surety bonds can serve as an effective tool for shifting the risk of subcontractor failure to a surety company.
Surety bonding is a careful, rigorous process by which the surety company prequalifies the subcontractor and supports that judgment by issuing performance and payment bonds. Performance bonds ensure the subcontractor is qualified to perform the work and protect the prime contractor from ultimate financial risk should the subcontractor default or fail to perform the job according to the terms and conditions of the contract. Payment bonds ensure specified laborers and suppliers associated with the project will be paid.
Benefits to Contractors
Transferring the risk of subcontractor default to the surety company is just one benefit of surety bonds. When prime contractors require performance and payment bonds from their subcontractors, they receive increased assurance of having qualified subcontractors. This pre-bid requirement eliminates problems that may occur with unqualified subcontractors and may elevate the quality of subcontractor bids. Contractors are protected from paying twice for the same work items if the subcontractor fails to pay its subcontractors and suppliers. Also, surety companies generally view prime contractors with established subcontractor bonding programs more favorably.
Prequalification is one of the most important services provided by the surety industry. The surety evaluates the subcontractor’s business operations, financial strength, experience, reputation, subcontract documents, exposure and progress on other contracts (bonded and non-bonded), size and location of the work and ability to perform that work—among many other factors.
Most surety companies require indemnity from the contractors and subcontractors they bond. This may include the owner’s personal indemnity in addition to the guarantee of the contracting entity. A troubled subcontractor is more likely to complete bonded jobs because business assets, and possibly personal assets, are on the line. This factor alone may provide the prime contractor with the leverage to keep the subcontractor performing on the job.
Availability/Capacity
Surety bonds are available for all types and sizes of qualified contractors and subcontractors. Prior to bidding, prime contractors can require a bid bond from the subcontractor’s surety guaranteeing the subcontractor will provide subcontract bonds on the project. If the surety does not provide the bonds, the bid bond is used to pay damages.
Occasionally, subcontractors may not have enough surety capacity to provide a bond on an entire contract. They may ask the prime contractor to purchase the materials and equipment and execute a labor-only contract to be in a position to provide a bond. This type of situation must be considered carefully, as there may be reasons the surety company is unwilling to write a larger bond.
The same is true of phased contracts in which a bond may be issued for each phase of the project. Receiving a bond on the first phase of a contract is no guarantee a bond will be available for subsequent phases.
Help With Problems
Most surety companies monitor the progress of the subcontractor by routinely sending out job status inquiries to the prime contractor. Prime contractors should complete and return these inquiries. When a surety company is aware of a problem early on, it may be in a position to help the subcontractor and prevent the problem from becoming a major disaster.
The job status inquiry gives the prime contractor a reasonable way to communicate with a subcontractor’s surety. The prime contractor has a right—and in some cases, a duty—to communicate with the surety company about unsatisfactory performance of the subcontractor. The prime contractor should initiate communication the moment serious subcontractor performance problems surface.
The subcontractor’s performance obligations should be defined in the subcontract documents. Occasional disputes about responsibility for scope of work are not uncommon, but do not necessarily constitute default. Although a surety is not an arbiter of these disputes and has no contractual ability or legal standing to resolve them, most sureties will respond to the prime contractor and subcontractor when they are notified of potential problems or receive a negative status report that could materially affect the overall project.
The earlier the surety knows about a problem, the sooner it can get involved. The surety may be able to offer assistance to resolve the situation before a formal default is made. If default is unavoidable, the prime contractor should file a written declaration of default to the surety company.
Bonding Policy
Construction is a risky enterprise. Each phase of a project requires several independent parties working together toward the common goal of project completion. Other factors such as management, labor and material problems also can lead to subcontractor failure. The possibility of subcontractor failure is always present. According to BizMiner, 24.4 percent of the trade contractors (SIC 1700) in business in 2004 were no longer in business in 2006. When a subcontractor fails, the ramifications on the entire project can be devastating.
Many sureties may encourage prime contractors to bond subcontractors, especially on large or complex projects or when a few subcontractors represent proportionally large or critical segments of the work. Sureties encourage such policies because they reduce the risk of subcontractor failure negatively affecting the completion of the prime contract.
Many general contractors bond all subcontractors on their projects, while others do not. The first step in establishing a bonding policy is to set a threshold at which bonds must be required. Thresholds may be set as a dollar amount, or as a percentage of a contract. Once a bonding policy is established, the prime contractor should notify its subcontractors, surety bond producer and surety underwriter.
Other considerations when establishing a universal bonding policy include:
- type and complexity of work;
- duration of subcontract;
- bid spread;
- subcontractor’s size, reputation, experience with type of project or geographic area, and role as a key part of the contract;
- government regulation requirement; and
- multiple project exposures with the same subcontractor.
A well-thought-out bonding policy for subcontractors provides the prime contractor with many benefits, including the prequalification services of the surety, the effects of indemnity, the positive impact on a contractor’s own surety relationship, and the ultimate performance and payment protection offered by the bonds.
The surety industry is committed to validating surety bonds and ensuring they are written by trusted, respected corporate surety companies. Contractors and subcontractors can access several resources to verify the legitimacy of sureties and validate a surety bond.
1. State Insurance Departments
The insurance department of the state in which the surety company is domiciled is responsible for licensing and performing periodic examinations of the company, and often will have the most information about a surety company. Insurance departments usually are located in state capitals and may have offices in other large cities. For more information, visit the National Association of Insurance Commissioners at
www.naic.org/state_web_map.htm.
2. U.S. Department of the Treasury
To write bonds for federal government construction projects or other federal obligations, a corporate surety must have a certificate of authority issued by the U.S. Department of the Treasury. The department conducts a financial review of the surety and sets a single bond size limit for the surety. The Treasury Department maintains a list of surety companies it has authorized to write surety bonds on federal government projects. The Treasury Department Circular 570, or T-List, is available at
www.fms.treas.gov/c570/index.html.
3. Rating Organizations
A.M. Best Company analyzes and rates insurance companies. Each year it publishes Best’s Insurance Reports, Property-Casualty, which includes detailed profiles and financial information on almost every insurance company operating in the United States. A.M. Best gives each company an alphabetic rating and a financial size category. (The rating pertains to the entire insurance company and not just the surety operation.) This book is available in many public and financial libraries or may be purchased from A.M. Best. Up-to-date information and prices on A.M. Best’s publications are available at www.ambest.com. Other rating organizations include:
4. Surety Bond Authenticity Program
The Surety & Fidelity Association of America maintains a list of surety companies that can assist in verifying the authenticity of a surety bond and the surety’s authorization of the bond’s execution. For a free copy of participating surety companies, send a self-addressed envelope to The Surety & Fidelity Association of America, 1101 Connecticut Ave. NW, Suite 800, Washington, DC 20036. The Bond Authenticity Program is available online at www.surety.org under "About the Industry."
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Friday, September 3, 2010