Surety Bond News

As of January 1, 2009, the Public Utilities Commission of California may require a performance bond as a precondition of getting certain certificates and permits for telecommunications companies. AB 2578 allows this, also stating that the bond has to be sufficient to allow the collection of restitution, penalties, and fines for enforcement actions taken against the company.

The SBA has increased their maximum bond amount for a second time this year. In February, we wrote an article on the stimulus bill which spoke of an increase from $2 to $5 million.

Technically, the ceiling is still at $5 million (see: SBA FAQ). The changes allow up to $10 million only when “the contracting officer certifies that the guarantee is in the best interests of the government”. However, most news agencies are reporting it as a flat increase.

The SBA surety program is quite paper intensive as is. Certainly, there will be more paperwork to show the contracting officer agrees that it is in the best interests of the government.

One of the main differences in underwriting using the SBA program is how they calculate working capital. Under the SBA program a bank line of credit is considered working capital, which is not the case with normal surety underwriting. This allows contractors to qualify for bond lines that are larger than they could obtain through traditional avenues. Unfortunately, the credit crunch has caused banks to reduce or close line of credits previously available to contractors. Such changes to our financial system have had a direct impact on bond lines provided through the SBA program.

This leaves me to wonder, would there be more benefit in reviewing the current SBA procedures rather than increasing the maximum bond amount? Sure, it wouldn’t look as good in the news headlines, but it might have more of an impact with the contractors they are trying to assist.

As a contractor, the notion of a claim arising can be a troublesome thought. However, if a claim does arise it is important to know how the process is managed. Here is a basic breakdown of how claims are handled for performance bonds and payment bonds.

Performance Bond Claims:

As you may already know, a performance bond is in place to protect the obligee against financial loss should the principal fail to perform their obligations as outlined in the bonded contract. When a claim is filed, the process of investigating the validity of the claim can be timely and judicious. The surety must collect the necessary information from the obligee and principal in order to come to a decision that is fair to both parties. Cooperation and constant communication between the surety, obligee, and principal are fundamental to quickly resolving a claim.

If they determine that the claim is valid, there are a variety of resolutions they may employ.

The most common resolution is called the “Tender Option�. Under this option, the surety and the obligee agree on a replacement contractor to complete the work. The replacement contractor’s price may exceed the remaining balance of the contract, in which case the surety would pay any overruns.

Another common resolution is called the “Takeover Option�. Here, the surety hires construction professionals to complete the job. They could either hire a construction manager to finish the job using the original subcontractors. Or, more commonly, the surety simply hires a completion contractor. Under the Takeover Option, the surety and obligee usually puts a Takeover Agreement in place, since the surety is taking over responsibility for seeing that the project is completed.

Another option that is more reluctantly considered is for the surety to elect not to be directly involved in the completion work. The surety, of course, is still liable for excess cost beyond the remaining contract balance. However, the obligee would initially finance the completion and seek reimbursement later.

Other resolution options exist, though not as commonly applied. Sometimes the surety and obligee might agree on an upfront cash settlement. Other times they may decide to have the original contractor complete the work under additional monitoring.

Payment Bond Claims:

A payment bond guarantees payment for labor and material used for the bonded contract if the principal defaults. This bond would ensure that the suppliers and subcontractors will be paid. Once again, when a claim is filed, the surety must gather information from both parties in order to make a determination. They may request certain documentation including, but not limited to purchase orders, invoices, payment records, and delivery slips. They may also require the completion of certain forms and affidavits.

If it is determined that the principal has in fact defaulted on payment, the surety would pay the claim and pursue the principal for reimbursement.

The claims process can vary from situation to situation. Sometimes the principal admits that they cannot meet their obligations and a claim can be processed and resolved quickly. However, most times the surety must investigate the claim. Be sure to stay in constant contact with the surety throughout the entire process and provide them any requested documentation promptly. With proper communication by all parties, along with reasonable expectations, a claim should be resolved in a fair and timely manner.

The Miller Act (1935) is a federal law that requires contractors performing public work projects (addition or general repairing of any governmental building or public works facilities) to produce a performance bond as well as a labor and material payment bond in any contracts that exceed $100,000. Since government construction projects are unable to protect themselves from non-payment with a traditional lien, the Miller Act was created to protect the subcontractors as well as the suppliers when dealing with projects owned by the federal government. The corporate surety company that is willing to issue these two bonds must be registered as a qualified surety by the United States Department of Treasury, which is issued on a yearly cycle.

The requirement of the payment bond is to protect public money by guaranteeing payment from the prime contractor. It takes the risk off of the shoulders of the subcontractors and placing it directly onto the surety company that has issued the bond. Subcontractors as well as the suppliers of material for the project who have a direct binding contract with the prime contractor are protected by the Miller Act. Other subcontractors as well as material suppliers who have contracts with the subcontractors contracted with the prime contractor are also protected under the Miller Act. Any other parties who find themselves outside of these two tiers of contracts are considered too distant to make a claim against the payment bond.

Performance bonds also protect the government, guaranteeing the completion of the project that has been awarded. Generally, the amount that is required to satisfactorily protect the government by the contracting officer is one hundred percent of the total contract price.

Turning back the clock…..and bond agents working for a living.

Do you recall the late 90′s and way early in 2000 when getting approved for contractors Performance & Payment bonds were as easy as having a pulse? “Oh, you’re breathing? You’re approved!” That time period was an interesting but a rather frightening time in the surety industry. All the bonding companies began to become more and more competitive in this dog eat dog industry, so much that sureties were giving things away to contractors! Waving your spouse from the agreement? SURE! waiving personal indemnity all together for that matter! Dropping rates down to $6 per thousand….the list goes on.

Since the sureties have exceeded losses in the past couple years more than the losses they had throughout the whole past decade, has forced them to re-group themselves. Underwriting has taken an entire swing the other way and is incredibly conservative in all spectrums of underwriting. Aggregate bond lines have been sliced in half, rates have doubled, the re-insurers even writing surety have dropped to a measly 10 and all of this is all a snowball effect of one thing affecting another. However, In the end, it does change the industry in a positive way.

For one thing, it means that any contractor OR sub-contractor with a Performance bond in hand for the guarantee of their contract, likely, truly is qualified to get that job done-AND will get it done per the terms of their contract.

The obligee (who is requiring the bond) won’t feel the reluctance in accepting a bond as they may have in the soft bond market previously due to the soft underwriting that was occurring. Previously, many contractors still defaulted on jobs, and did so more willingly with no personal indemnity on the line.

Now, there is a rigorous underwriting process that each contractor must face. And there should be! Applying for a bonding line of credit and or Performance bond is just like applying for a line of credit from your bank. It is CREDIT. In this case, it’s not simply just to pay back a loan but to actually perform on a contract. Of course, with this type of guarantee the bonding company must make, their research into each contractor is complete.

This makes performance bonds not only a stronger tool for the owner that accepts them, but it sure does make us agents work for a living!