Surety Agencies and the Construction Industry
S.S. Saucerman / May 2016
Richard’s company went out of business today. Richard was the general contractor for the museum restoration project, and all morning Anne, the owner’s rep for the museum, tried in vain to reach him. There was no answer at his office, and his cell phone went straight to voicemail. She tried again and again, but still no luck. Something was wrong. She could feel it. There hadn’t been a worker on site for three days, and rumors were starting to surface—scary rumors. And now no one was answering the phone—no voice mail, nothing. The restoration was a $3.5 million project, and now it was a ghost town only half complete. Anne fought off a sick feeling in her stomach long enough to call her boss—who called the primary board members, who called their lawyers, who scrambled for answers. Five days later, the worst was confirmed: Richard had filed for bankruptcy—the bad kind, and nobody would be returning to the museum project.
Belly Up: The Stark Reality
When a contractor defaults on a building project, there are no winners. The contractor has lost his livelihood, reputation and future ability to be trusted. The project client suddenly finds his substantial investment in dire risk and dozens of subcontracting firms, suppliers and workers are abruptly out on the street. It’s a bad situation. Even worse, it turns out that Richard’s plight isn’t unusual.
According to an Associated General Contractors of America publication, roughly one-half of all the construction firms in business today will be out of business six years from now. Dun & Bradstreet reports that (on average) over 9,000 construction firms fail every year—piling up billions of dollars in unbacked liability and tremendous ill will toward the building and construction industry. You know what I’m talking about.
How many of you have seen, read or heard crooked contractor stories in the media? Me too. And the public—our clients—read the same newspapers and listen to the same programs we do.
So with so much volatility (and mistrust) permeating the construction world, it is little wonder bonding companies exist. No astute, responsible business person is going to gamble on a contractor (often unknown to them) disappearing in the middle of one of their building projects when there can be several million dollars in play and at risk. These successful business leaders didn’t rise to where they are now without learning to protect their investments. Bonding companies are simply another way to do this. Bonding companies, sometimes referred to as surety companies or sureties, offer what is commonly labeled “surety bonding.” The surety bond provides financial security and insurance to the construction client on building construction projects by assuring these clients that the contractor they’ve hired will perform their work properly and pay their workers, subcontractors and suppliers according to contract.
A surety bond is not insurance for the contractor. Rather, it gives the client (and the consuming public) something to fall back on should a contractor default take place. The surety company allows its financial resources to be used to back up the commitment that the contractor has made to the owner. If the contractor defaults, the surety steps in to finish the job and sort out the mess. For this service, the contractor (and eventually the owner, through accepting the contractor’s bid) pays the surety company a fee, not unlike paying an insurance premium. These fees often fall into a range of between half a percentage point to 2 percent of the construction contract amount, but your fee may vary.
There are commonly three types of bonds used in the building construction industry: the bid bond, the performance bond and the payment bond.
The bid bond is financial insurance (to the owner) that the bid has been submitted in good faith and that the bidding contractor intends to enter into a contract at the price they’ve quoted. The bid bond also helps to ensure that the bidder will provide the owner with a performance and payment bond (assuming it’s required) in a timely fashion once an agreement is sealed. The performance bond protects the project owner from financial loss should the contractor fail for any reason to perform the actual work in the field as set forth in the building contract documents.
Who Needs to Be Bonded?
There has been a notable yet unrelenting shift in the construction bonding universe in recent years. Not long ago, the only companies generally asked to provide a bond were either general contractors, construction management firms or large prime contractors. This isn’t the case today. And I believe I can point to two reasons why.
First, today more commercial construction projects are being bid as separate prime contracts. This is when the building client themselves (or often, a CM hired by the client) solicits separate bids—broken down by trade—on a potential building project. This is in place of the single, lump-sum bid received in the past from (normally) the general contractor, which encompassed all trades of work required for the project. So where there use to be only one number to consider, now there can be dozens including one each for (in example) masonry, steel, concrete, carpentry and flooring. Once all the bids are collected, each division of work is awarded and the prime contractor for the project (often the CM) oversees the work.
Second, if you are a subcontractor, you may now find you are more often being asked to provide a bond for your particular scope of work under a general contractor—in addition to the bond already secured by the GC. This is due partly to some bonding companies requiring their clients (in this case, the GC) to collect bonds on all of their subcontractors over a certain contract dollar amount (perhaps $100,000) to simply act as a “second tier” of protection—and a possible secondary avenue for recovery—should things go south. In other cases, it may just be that the GC or CM themselves have decided to further protect their own interests by requiring lower-tier bonds of their subcontractors.
What Construction Projects Are Bonded?
For private construction projects (those projects not funded by government entities), the decision on whether or not to require bonding of the contractor is purely discretionary and individual. The owner can basically decide if he wants to bond the project or not. If an owner has worked with and is familiar with a particular contractor, he may feel confident and comfortable enough to forego the bonding requirement.
Yes, this does leave the owner open to default by the contractor so it really can be described as an exercise in trust. But there’s also the financial side. Remember, bonds cost money—sometimes a lot of money. And it’s naïve to believe that this cost isn’t passed along to the owner in the form of a line item in the contractor’s bid (it certainly is in my bids). By eliminating the bonding requirement, the owner saves himself some immediate—albeit risky—cost on the project.
Bonding for federal or government funded work is different. Often, there is no option. Since 1935 (in the United States), the Miller Act has required performance and payment bonds on all public works projects in excess of $150,000. In addition, additional state and/or local mandates may require bonding or other forms of security for building projects. To determine if bonding is required or not for the job you are bidding, you can often check “Division 1, General Requirements” of the specification manual (assuming it’s in standard Construction Specification Institute order) that commonly accompanies many architectural plan packages. This chapter will often describe/explain your insurance and bonding responsibilities.
What Is a Bonding Company’s Role When Default Occurs?
In the event of default, a surety company may step in to perform all or some of the following:
- Insure the bonded project is completed according to the terms of the contract.
- Insure the bonded project is completed for the then determined contract price.
- Insure laborers, suppliers and subcontractors are paid.
- Help to relieve the owner of financial loss via liens filed by those listed above.
- Insure a minimal break in construction schedule continuity.
- Aid in reducing the possibility of the contractor diverting funds for his benefit at the last minute.
- Act as intermediary between the owner and defaulting contractor during a very stressful period.
How Can I Obtain a Bond?
If you live in or around metropolitan areas, there are likely several bonding companies close by. Check around, perhaps through contractor acquaintances or associations, for the names of good firms. If your community is anything like mine, you’ll probably hear some names repeated more than once. That’s a good place to start. Once you develop a short list of potential bond providers, schedule appointments to discuss your needs. Warning: Be ready to leave your ego at the door. Bonding is serious business, and a good surety company will expend great due-diligence to pre-qualify you. They will want to know your personal history, work record, and they will ask for references. They will want proof you are a responsible, reliable, reputable character, and they will be deeply interested in your financial situation, so be sure to have on hand financial statements, balance sheets, income/cash flow information, accounts receivable/payable, overhead expenses and any outstanding liabilities such as delinquent tax bills.
It’s not a simple process—and not for the thin-skinned. It’s also quite selective. Younger, less experienced contractors can find themselves facing considerable odds in acquiring a bond, often simply due to the fact that they haven’t had time to build up a strong enough track record for a surety to take a chance on them. The downside for the contractor is that this can materially affect a younger company’s ability to acquire work by limiting the amount of jobs they’re able to bid. Caught in a proverbial Catch-22 situation, the frustrated, young business person will ask, “How will I get experience, build a reputation and mold a credit history when I have this huge strike against me?”
Well, I’d like to give a comforting response, but unfortunately the truth is more sobering. All one can do when starting out in the contracting world is to substitute hustle and energy for experience. There will almost certainly be greater effort involved. But if the right person remains positive, perseveres and builds a solid reputation one small step at a time (from whatever bits and pieces the market may offer), there will come a day when all the pieces fall into place. It’s a cold, clinical business world out there and, like everything in life, there are no easy fixes. But remember the big picture. Keep in mind that what seems to you to be roadblocks and hurdles to obtaining bonding status is inherently part of what the surety effort was intended to be when first introduced: a critical ‘checks and balances’ system that protects the buying public from potential loss through contractor fraud and/or incompetency.
Are There Alternatives to Bonding?
There are alternative forms of financial security available to the construction client such as bank letters of credit, self-insurances/collateral and/or (less sophisticated but arguably effective) a thorough and rigorous pre-screening process of all participating contractors/suppliers before the project ever begins. Of course, the ultimate alternative to bonding is trust, but lamentably, we simply no longer live in a world that affords us such optimism.
Perhaps there will be a better way in the future but for now, the best assurance any building construction client can possess in knowing the contractor they’ve hired will fulfill their obligation is through bonding. And peace of mind is a good thing.
Where to Go for More Help
One nice thing about an industry as large as the insurance and bonding industry is that there is no shortage of places you can go for information or help. If you want to learn more about surety bonding and how it can apply to your own needs, here are just a few organizations online to get you started:
And there’s much more out there. One last thing: If you’ve been turned down for a bond and have exhausted your local sources, a route you may want to explore is the Small Business Administration. The SBA guarantees (in the form of backing) surety bonds for small contractors that might not otherwise qualify for bonding. Note that this is not the bond itself. Rather, it’s a guarantee—an underwriting—that may allow you to obtain a bond from one of your local bonding companies. It also applies to bid bonds, payment bonds and performance bonds.
For more information on the SBA and how it might help your business, visit sba.gov. Yes, there will still be a vetting process—and you will likely face some serious paperwork, but the effort may well prove well worth it.
S.S. Saucerman is a full-time commercial construction estimator and project manager for a large upper-Midwest general contractor. He is also an established freelance writer and author whose work spans 20 years. In addition to construction and writing, Saucerman also taught building construction technology part-time for 11 years at Rock Valley College in Rockford, Ill.