The Dotted Line: How to navigate 'the 3 Cs' of construction bonding
The following is the second installment of Construction Dive's "The Dotted Line" series, which takes an in-depth look at different construction contract types each month with expert input. Read the first installment exploring guaranteed maximum price contracts here.
"Payment and performance bonds required." Those words can signal a giant dead end for some contractors who would like to bid on public work or large private projects but haven't yet waded into the bonding world. However, the bonding process doesn't have to be mysterious or sweat-inducing as long as companies are equipped with the right information.
The most common types of construction bonds are performance and payment bonds, which are kinds of surety bonds. A payment bond guarantees the owner that the contractor will pay all the supplier and subcontractor bills associated with the project, and the performance bond is the owner’s assurance the project will be completed in a timely manner and with high quality.
Those who have bumped into bonding requirements on past jobs might have seen a "bid bond" requirement. This is a bond that guarantees the owner that the contractor will be able to meet the requirements of the contract for the amount of the submitted bid. But if a company has bonding capability for performance and payment bonds, these aren’t usually a problem to secure.
Surety, but not insurance
But before delving into what surety bonds are, let’s first address what they are not. Even though surety bonds are obtained from an insurance company, they are not insurance.
"I think a lot of the reason it gets confused with insurance is our delivery method," Bill Reidinger, senior vice president of surety at Assurance, told Construction Dive. "It's through insurance agencies, but it's really a credit instrument that’s provided by an insurance company."
With general liability insurance, for example, if there is a valid claim against a policy, the insurance company will pay it. The repercussions might be a more expensive policy with increased premiums, but the insurance company absorbs the lion's share of the cost. That isn't the case with performance and payment bonds. Any claims the surety pays become the contractor’s responsibility to pay in full. If the company can’t pay, then the surety will seek reimbursement from the principals of the company.
"They're a financial partner," Mary Devolt, chief financial officer of Englewood Construction, told Construction Dive. "They’re putting skin in the game."
This partnership is why the process to obtain payment and performance bonds can be so rigorous. Reidinger said that because these types of bonds can be likened to a line of credit, the qualification process is similar to the experience of trying to obtain a bank loan.
Three Cs of bonding
Bob Raney, executive vice president of construction services, bond and specialty insurance at Travelers, said financial considerations, like how much money someone has in the bank and credit history, are important in the bond qualification process; but so is someone's project history.
"Bonding can be wrapped up with the three Cs — character, capacity and capital," Raney told Construction Dive.
- An examination of the "character" element looks at a contractor’s proven project track record, which means the surety will be on the lookout for prior contract defaults and evidence that the company has met its prior contract obligations, Raney said.
- The "capacity" portion of the equation reviews contractor resources. This is where the surety determines if a contractor has the skill, experience, employees and equipment to perform the work.
- "Capital," according to Raney, means how the contractor’s balance sheet looks, as well as credit history, cash flow and working capital.
Be prepared for scrutiny
Devolt said the financial aspect of the surety company’s review can often be the most time-consuming part, which is why contractors need to start building a relationship with a surety as early as possible and start practicing some serious financial housekeeping.
"Clean up your internal and reporting systems, make sure your (financial) ratios look good and start forming that relationship before you all of a sudden decide you want to go after a $20 million bond," Devolt said.
In addition, Devolt said contractors shouldn't be be surprised by the extent of detail the surety will want to see. She said smaller companies might have in the past gotten away with a simple compilation of their books to demonstrate financial strength, "but maybe now they need to have a review or maybe they need to have an audit. It just depends on their level."
Devolt said that no matter the company size, contractors should expect scrutiny. Since the Great Recession, owners and their lenders are looking for that extra security a bond provides, she noted. In addition to most public projects where payment and performance bonds are required, Englewood’s private owners are increasingly demanding them as a risk management tool. As a result, Devolt said Englewood has bonded approximately $16 million in 2015, a substantial uptick from previous years.
Reidenger said, "I think everyone was just a little bit on edge after the economic downturn and the collapse of many of the construction firms that they were doing business with."
Given such a demanding qualification process and the relative high cost of surety bonds, it's no wonder some owners and contractors are exploring alternatives. For general contractors, a suitable alternative might be a letter of credit from their bank to the owner. In fact, Reidinger said, surety bonds are an American invention, and letters of credit are commonplace internationally.
Reidinger said that when a contractor provides an owner a letter of credit, usually 10%-25% of the contract amount, the owner "has the ability to pick up the phone and draw down on the letter of credit, and the bank has to send them cash."
"The problem with that approach," he added, "is it puts a financial strain on the contractor. He loses the ability to borrow money for working capital because of funds set aside for the letter of credit."
Bonding concerns during work
After the initial bonding process is settled and work is underway, bonding questions are far from over. Projects bring the possibilities of disputed change orders, weather delays, antagonist relationships between a project manager and the owner's rep, and countless troubling scenarios.
For example, if a contractor hasn't paid a few subcontractors for extra work they did because they're waiting for the owner to pay them, then the subs — who have already complained about payment to the owner’s rep — are now grumbling about filing a claim against the project payment bond. And the owner is talking breach of contract because the subcontractors won’t do any more work unless they get paid.
Attorney Mark Johnson, a partner at Snell & Wilmer, said it's smart to put into the project contract a clause that says upper-level management will get involved in the negotiation of disputes.
"You'd be surprised how many times in a project the dispute really boils down to a personality dispute between the owner's onsite project personnel and the contractor's onsite personnel," Johnson told Construction Dive. "They butt heads every day for months and months on end, and they get themselves locked into positions, and sometimes they’re lost in the jungle and not looking at the big picture."
Johnson said parties to private projects have the luxury of being able to come up with their own dispute resolution "as long as they're both willing to comply with it." The options on a public project, he said, are statutorily dictated, and the parties often have little leeway when it comes to the available ways to work things out.
However, Johnson added, if the parties can manage to keep the contractor out of default and on the project, "it's going to be cheaper for all parties."
Nevertheless, if the owner or a sub does file a claim against either the payment or performance bond, Reidinger said companies shouldn't expect a quick fix.
"It would probably go to litigation before the bonding company would step in and start writing checks," Reidinger said. "It would have to go down the path of dispute resolution before they would get involved at all, even on the payment side of it."
He added, "While (the surety) guarantees run to the owner and suppliers and subs and lien holders on the job, their real business partner is the contractor that they provided the bonds for... At the end of the day, if the contractor loses the dispute resolution and cannot make the financial restitution it needs to, then (the surety) will be there to respond."
Advice for companies seeking a bond for the first time
So given the complexities of obtaining surety bonds and the possibilities for serious financial consequences if things take a turn for the worse, what advice would the experts give someone who is thinking about going for it anyway?
Devolt said her best piece of advice is for a contractor to turn to trusted advisors, such as attorneys or bankers, who are familiar with surety bonds.
"They need to understand the industry," she said.
Reidinger said it’s critical that whoever the contractor reaches out to be well-versed in the industry and be able to advise on how to not only grow bonding capacity, but how to grow the company as well.
"It’s very important that they’re working with a person who understands the business and is able to help them reach their goals," he said.
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