Bid bonds, payment and performance bonds — what you need to know
All public projects require surety bonding by statute and federal and state regulation, such as the federal Miller Act. This is designed to protect taxpayers, as well as payments to subcontractors and suppliers, as they cannot place liens on public projects. Private work not requiring government-mandated protection may also require bonding based on owner or lender requirements. This guarantees the contractor will deliver on the project according to the contract requirements, and all invoices will be paid, ensuring the owner a lienfree, completed project.
While there are many different types of bonds, the following are the basic ones used in the construction industry:
Bid Bonds are required at the time proposals are submitted, ensuring the selected contractor will enter into the contract at the price submitted. The bid bond is typically in the amount of 5 percent to 10 percent of the total bid. If the selected bidder later chooses not to enter into the contract, the bid bond amount, or the difference between their bid and the next lowest bidder’s price, may be forfeited.
Performance & Payment Bonds guarantee two things. The Performance bond ensures that the contractor will complete the project according to agreed upon contractual plans and specifications. The Payment bond guarantees all subcontractors and suppliers will be paid, and that the owner is able to accept a lien-free project.
Think of surety as similar to the relationship between a loan cosigner and a lender. Surety bonds guarantee that the contractor will complete the project and satisfy all obligations; if they don’t, the surety must. Therefore, a surety bond is not unlike a credit function, and the bonding company must be comfortable with the risk of an obligation, or simply not provide a guarantee. It’s not a matter of price. It is a matter of confidence in the contractor’s ability to meet all contractual obligations.
The surety factors several key elements to support the decision-making process: the contractor’s financial strength; resources, capabilities and past performance. The surety additionally considers potential risk and the risk mitigation approach, prior to issuing a guarantee.
Putting a bonding program in place
As a surety bond broker, Gallagher plays a critical role advising contractors on how the surety will view their company, with a goal to make the contractor more qualified to the bonding company. Developing a relationship between the contractor and the surety is critical to a long-term partnership. Think of Gallagher as a matchmaker or marriage counselor, and hopefully never a divorce attorney. Our relationships with sureties, and Gallagher’s understanding of their requirements, help us nurture a relationship that can grow and support the contractor’s surety requirements over the long haul.
Contractors need to expand their bonding credit as they grow their businesses. Gallagher’s approach is to ensure the surety is included in the contractor’s business plan and approach, and not focused solely on current project projections and financial ratios.
Gallagher encourages the surety and contractor to meet often, tour project sites, share strategic business plans, and analyze challenges, both positive and negative. Ultimately, the goal is to develop a pathway that establishes a partnership. Gallagher helps to establish this contractor/surety bond. The sureties are a valuable resource and can offer advice and assistance to the construction industry. They should be treated as such and not as a vendor.
Because Gallagher works within the financial and risk side of construction, we have established long-standing relationships with construction-focused CPA’s and legal firms. Qualified legal and accounting firms can often assist contractors in areas that have a direct impact on their ability to qualify for surety bonds.
The importance of due diligence
There is potential financial risk involved for the contractor in entering into a construction contract. For example, when a developer or owner is challenging to work with and withholds payments unreasonably, significant financial problems for the contractor may occur. The contractor remains obligated to pay their labor, subcontractors and suppliers. At Gallagher, we also see instances when a contractor wishes to bid a project with an unfamiliar developer or owner. The first step is to research the owner relative to how other contractors have fared with this firm. If the record shows, for example, a pattern of non-payment or bad working conditions, we will advise our client and assist them with the best action plan — whether to move forward or not proceed.
Once a contractor has executed a contract, and they have secured a surety bond for a project, the last thing a bonding company wants to do is get involved in a claim. In contrast to insurance, where claims are normal and expected, bonding companies underwrite to a zero-loss ratio. If they have to get involved in a claim, they will return to the contractor and all indemnitors for reimbursement for any payments they have made on their behalf.
What if the project you are interested in is just too large or you want part but not all of the risk?
Joint ventures are an excellent option. In the case of a significant project a firm chooses to bid, the scope may be outside manageable capabilities of a single bidder. Gallagher can assist in introducing other contractors that could be a good fit to perform and be responsible for a portion of the work. A quality team, sharing qualifications and workload, can be critical to achieve surety bonding.
Partnerships do not come without potential risk. A joint venture is an entity. Suppose there are two partners and one goes bankrupt? The other is still 100 percent responsible for completing that project. It’s Gallagher’s responsibility to ensure all entities in a joint venture project are cognizant of the liability. Even if they agree to split the work and revenue/profits in a specific way, each player is obligated to the developer / owner who holds the contracts. Finding the right partners can reduce the risk significantly. Gallagher’s Construction Practice has proven expertise in this area.
Gallagher can additionally help contractors find qualified subcontractor partners. This enables the general contractor to better qualify for bonds, as well as protect against potential subcontractor risk.
The value of getting in early
Gallagher’s professional bond brokers review contracts before initiation. We identify terms and conditions bonding companies may have concerns about and may create unreasonable risks to the contractor. Finally, Gallagher can help clients negotiate those terms and conditions, enabling a surety company to support the project. By entering at the start of a project, we ensure the bonding company is current, understands the goals and objectives and can support the overall effort.
The stakes are high
According to surety.org, between 2014 and 2016, there was a 29.3 percent failure rate among building, heavy/highway and specialty trade contractors. This figure underscores why surety bonds are mandatory on all public and many private construction projects. Their report says it best…
Construction is a risky business, and contractors fail for many reasons. Having a surety partner often helps a contractor prevent and avoid those risks. When a contractor does fail, however, having surety bonds in place ensures that the owner and the subcontractors on the project do not bear the full risk of that failure.