Surety bonds have existed in one form or another for millennia. Some may view bonds as a useless business expense that significantly reduces profits. Other companies consider the bonds as a passport that only allows qualified companies to access offers for projects that they can achieve. Construction companies in search of important public or private projects understand the basic necessity of obligations. This article provides information on some of the basics of bonding, a closer look at how surety companies assess bail applicants, bail costs, warning signs, defaults, regulations federal and state laws affecting bonding requirements for small projects and the dynamic critical relationship between a principal and the guarantor.
What is the bond?
The short answer is the bond is a form of credit wrapped in a financial guarantee. This is not an insurance in the traditional sense, hence the name of suretyship. The purpose of the guarantee is to guarantee that the principal will discharge his obligations towards the creditor and, if the mandator does not fulfill his obligations, the surety puts himself in the place of the principal and provides the financial compensation for allow the execution of the contract. obligation to fulfill.
There are three parties to a bond,
Principal – The party who assumes the obligation under the bond (eg General Contractor)
Obligated – The party benefiting from the bond (for example, the owner of the project)
Security – The party issuing the security guaranteeing the bond covered by the bond will be executed. (For example, the underwriting insurance company)
How do surety bonds differ from insurance?
The most distinctive feature between traditional insurance and bonding is perhaps the principal's guarantee to the surety. Under a traditional insurance policy, the policyholder pays a premium and receives the benefit of compensation for any claim covered by the insurance policy, subject to its terms and policy limits. With the exception of circumstances that may involve the advancement of police funds for claims that were subsequently deemed unhedged, the insurer has no recourse to recover its loss. paid to the policyholder. This illustrates a real risk transfer mechanism.
The estimate of losses is another major distinction. As part of traditional insurance forms, complex mathematical calculations are performed by actuaries to determine the projected losses on a given type of insurance underwritten by an insurer. Insurance companies calculate the probability of payment of risks and losses for each category of business. They use their loss estimates to determine the appropriate premium rates to charge for each business category that they subscribe to to ensure that there will be enough premiums to cover the losses. , pay the expenses of the insurer and also generate a reasonable profit.
Strange as it may seem to non-insurer professionals, surety companies take on a risk zero losses. The obvious question then is: why do I pay a premium to the bond? The answer is: Premiums are current fees charged for the ability to obtain the financial guarantee from the guarantor, as required by the creditor, to guarantee the realization of the project if the principal does not comply. its obligations. The surety assumes the risk of recovering any payment that it makes to the creditor of the principal's obligation to indemnify the surety.
Under a bond, the principal, as a general contractor, provides an indemnity agreement to the surety (insurer) who guarantees the refund to the surety in the event that the surety has to pay under the suretyship. . Since the principal is still primarily liable under a bond, this arrangement does not provide real protection against the transfer of financial risks to the principal, even if it is part of who pays the guarantee premium to the guarantor. Since the principal indemnifies the guarantor, the payments made by the guarantor are in fact only an extension of credit that must be repaid by the principal. As a result, the principal has a direct economic interest in the way a claim is settled.
Another distinction is the actual form of the bond. Traditional insurance contracts are created by the insurance company and, with some exceptions for the amendment of endorsements, insurance policies are generally non-negotiable. Insurance policies are considered "membership contracts" and, since their terms are essentially non-negotiable, any reasonable ambiguity is generally interpreted against the insurer. The bonds, on the other hand, contain the conditions required by the creditor and may be the subject of negotiations between the three parties.
Personal Compensation and Guarantees
As we have seen previously, a fundamental component of the bond is the compensation of the principal in favor of the guarantor. This requirement is also called personal guarantee. It is required of private business executives and their spouses because of the typical co-ownership of their personal property. The principal's personal assets are often required by the guarantor to be pledged in the event that a guarantor is unable to voluntarily repay the loss caused by the granter's breach of its contractual obligations. This personal guarantee and this guarantee, while potentially stressful, strongly encourages the principal to honor his bond obligations.
Types of bonding obligations
Surety bonds exist in several variants. For the purpose of this discussion, we will focus on the three types of obligations most commonly associated with the construction industry: bid obligations, performance bonds and payment obligations.
The "criminal sum" is the maximum limit of the economic exposure of the bond to the bond and, in the case of a performance bond, it usually corresponds to the contract amount. The penal sum may increase as the nominal value of the construction contract increases. The criminal sum of the bid bond is a percentage of the amount of the contract bid. The penal amount of the payment security reflects the costs associated with the supplies and the amounts to be paid to the subcontractors.
Tender Obligations – Provide the owner with assurance that the contractor has submitted the offer in good faith, with the intention of performing the contract at the price of the offer, and that it has the ability to obtain the required performance requirements. It provides downward economic insurance to the project owner (Bond) in the event that a contractor is awarded a project and refuses to sue, the project owner would be obliged to accept the next highest bid. The defaulting contractor would lose up to the maximum bid bond amount (a percentage of the bid amount) to cover the cost difference for the project owner.
Performance Obligations – Provide economic protection against the surety to the creditor (project owner) in the event that the principal (contractor) is unable or does not fulfill his obligations under the contract.
Payment Obligations – Avoids the risk of project delays and mechanics' privileges by providing the creditor with assurance that material suppliers and subcontractors will be paid by the guarantor in the event of default by the principal to his obligations payment to these third parties.
How are surety bonds guaranteed?
Bond underwriters have a complex responsibility and continue to assess leaders looking for a bond. Companies that rely on bonding to win projects fully understand the importance of establishing a solid relationship with their bonding companies. The bond underwriters are required to submit the principal to a rigorous underwriting process before issuing a bond and will continue to monitor the progress of the principal's projects in order to identify any sign of warning. from a potential defect. The information requested from companies requesting a bond is perhaps the most detailed of any "insurance" application process. Companies that will need obligations are well advised to maintain a current portfolio of required documents in order to facilitate and speed up the underwriting process.
The Subscription Questionnaire or Application Form that the Principal completes is completed with the following information required by the Underwriters:
- Most recent audited annual financial statements,
- Unaudited financial statements since the beginning of the fiscal year, including cash flows,
- Audited financial statements for the last three years,
- List of bank credit lines and other forms of credit relationships,
- Letter of reference from the bank or lender,
- An inventory of all work in progress,
- Accounting and cost control,
- Up-to-date personal financial statements (unaudited) of individual directors
Information about the proposed project, plans, etc.
Summary of any previous experience with similar projects,
Manpower required for the project, quality of the subcontractors,
Material needed for the project,
Project Management Plan,
Summary of all past and pending projects, bonded and unsecured,
Summary of potential future projects,
CVs of individual directors
Reputation and relationships:
Owners of projects,
Cost of bonds
The rates of each surety company differ, but there are general rules:
Bidding requirements are usually provided at a nominal cost or on a complementary basis, as the guarantor seeks to purchase the performance bond if the contractor is awarded the project.
The bonus or performance bond fees may vary from 0.5% of the final contract amount to 2.0% or more. The two main factors affecting prices are the amount of the bond because higher amounts usually have lower rates and the quality of risk. For example, a performance bond in the amount of $ 250,000 could have a rate of 2.5% resulting in a fee of $ 6,250 compared to a $ 30 million bond at a rate of 0%. , 75% that would cost $ 225,000.
Even experienced entrepreneurs sometimes operate under the misconception that bond costs are fixed at the time of issuance. In fact, a bond premium or commission will often adjust to the final value of the contract. The final value is generally, but not exclusively, greater than the original contract amount due to work modification orders during the construction process. It is important for entrepreneurs to realize the potential for a negative surprise represented by an increase in the cost of their obligations. This should occur initially during the bid preparation process and, to the extent possible, during the contract negotiation process, contractors should consider the feasibility of dealing with any further increase in the cost of the obligations that would result. the increase in contract values due to change orders made by the developer.
The main purpose of a surety is to filter out entrepreneurs who may be well meaning, but just not completely qualified in every aspect of their business to undertake certain projects. Bond underwriters are always looking for warning signs before issuing the bond and after issuing it.
Factors that concern bond underwriters include:
Poor project management and accounting systems
Excessively fast expansion
Changes in key management
Significant change in historical business direction
Quality issues with subcontractors
Shortage of manpower and / or supplies
Failure to require subcontractors to guarantee their own bonds
Unreasonable project contract conditions
Delays due to catastrophic weather
Unfavorable macroeconomic conditions
What happens in case of failure of a contractor?
Upon notification, and if after conducting a thorough investigation and the surety determines that the principal has failed, it may:
Provide the defaulting contractor with additional resources or economic assistance to carry out the project, or
Select a replacement contractor to complete the project, or,
Organize a bidding process to complete the project,
Pay to the creditor (owner of the work) the "criminal sum" of the performance bond
The surety is required by law to conduct a diligent investigation of a potential defect so as not to prematurely or incorrectly declare a contractor in default. Once the surety has paid a loss under the bond, it will seek a refund from the principal, including the exercise of its rights to the letters of credit, receivers or personal property that secured the bond.
Regulations and statutes
The Miller Act
The Miller Act promulgated by Congress in 1935, replaced the 1894 Heard Act and applied to federal government construction projects whose contract value exceeded $ 100,000. This law provides for exclusive recourse for suppliers of labor and materials who have not received full payment within ninety days from the date of the last service of the sub-office. dealing or the injured supplier. The payment bond covers sub-contractors and first-level suppliers and second-tier contractors. Top-level contractors may submit claims in the form of a dispute directly under the payment bond, while second-level contractors must formally notify the prime contractor of their intention to submit a claim in the form of a dispute. ninety days after their last service or unpaid material supply.
A claim for any unpaid balance is obtained by filing a lawsuit, between ninety days and one year from the date of the last service was provided. The lawsuit must be brought on behalf of the United States in favor of the party bringing the action. The lawsuit is filed with the federal court of the jurisdiction where the contract was executed.
Payment Protection in the Construction Industry Act, 1999
This federal law came into force in August 1999, amending the Miller Act in several ways, including replacing the following provision with the mathematical formula that originally capped the maximum amount of the obligation at 2, $ 5 million despite the size of the project:
The amount of the payment bond is equal to the total amount payable under the terms of the contract, unless the contracting officer awarding the contract makes a written decision supported by specific findings that a bond payment of this amount is not practical, in which case the amount of the payment bond is set by the contracting officer. Under no circumstances will the amount of the payment deposit be less than the amount of the performance bond.
Federal Acquisition Regulations ("FAR")
Located under Title 48 of the United States Code of Federal Regulations, the FAR regulates the federal government's processes for the purchase of goods and services. Part 28 of the FAR entitled Obligations and Insurance has the corresponding specifications. Below are some relevant excerpts from Article 28 of the FAR which detail the requirements for payment protections of construction contracts:
Implementation and payment guarantees and alternative payment protections for construction contracts. 28.102-1 General
(a) The Miller Act requires performance and payment guarantees for any construction contract in excess of $ 100,000, except that this requirement may be waived-
(1) By the contracting officer for the bulk of the work that must be performed in a foreign country after ascertaining that it is impossible for the contractor to provide such a bond; or
(2) Otherwise authorized by the Miller Act or other law.
(b) (1) In accordance with USC 3132, for construction contracts over $ 30,000 but not exceeding $ 100,000, the contracting officer must select two or more payment protections following, paying particular attention to the inclusion of an irrevocable letter of credit as one of the alternatives chosen:
(i) A payment bond.
(ii) An irrevocable letter of credit (ILC).
(iii) A tripartite escrow agreement. The prime contractor opens an escrow account in a federally insured financial institution and enters into a tripartite escrow agreement with the financial institution, as an escrow agent, and all the suppliers of labor and materials. The escrow agreement establishes the terms of payment under the contract and dispute resolution between the parties. The government makes payments to the escrow account of the contractor and the escrow agent distributes the payments in accordance with the agreement or triggers the dispute settlement procedures if necessary.
(iv) Certificates of deposit. The contractor deposits certificates of deposit of a federally insured financial institution with the contracting officer, in an acceptable form, executable by the contracting officer.
(v) A deposit of the types of securities listed in 28.204-1 and 28.204-2.
(2) The contractor must submit to the government one of the payment protections chosen by the contracting officer.
(c) The Contractor must provide any warranties or other payment protection, including any necessary reinsurance agreement, before receiving notice to continue work or to be authorized to commence work.
28.102-2 Amount required.
(a definition.) As used in this sub-section-
"Initial price of the contract", the award of the contract; or, for requirement markets, the price to be paid for the total estimated quantity; or, for contracts of indefinite duration, the price to be paid for the minimum quantity specified. The original price of the contract does not include the price of the options, with the exception of options exercised at the time of contract award.
b) Contracts over $ 100,000 (Miller Act) –
(1) Surety. Unless the contracting officer determines that a lesser amount is sufficient for the protection of the government, the criminal amount of the performance bonds must be equal to:
(i) 100 percent of the original price of the contract; and
(ii) If the contract price increases, an additional amount equal to 100% of the increase.
(2) Payment obligations.
(i) Unless the contracting officer makes a written decision supported by specific findings that a payment bond of this amount is impractical, the amount of the payment security must be to be equal to:
(A) 100 percent of the original price of the contract; and
(B) If the contract price increases, an additional amount equal to 100 percent of the increase.
(ii) The amount of the payment security must not be less than the amount of the performance bond.
(c) Contracts exceeding $ 30,000 but not exceeding $ 100,000. Unless the contracting officer determines that a lesser amount is sufficient for the protection of the government, the criminal amount of the payment bond or the amount of the alternative payment protection must be equal to :
(1) 100% of the original price of the contract; and
(2) If the contract price increases, an additional amount equal to 100% of the increase.
(d) Provide additional protection for payments. If the price of the contract increases, the government must obtain any additional protection necessary by asking the contractor
(1) Increase the criminal sum of the existing bond;
(2) obtain additional security; or
(3) Provide additional alternative payment protection.
e) Reduce the amounts. The contracting officer may reduce the amount of collateral to maintain a bond, subject to the conditions of 28.203-5 (c) or 28.204 (b).
In 2004, Congress passed a provision requiring an inflation-based readjustment of threshold requirements related to the acquisition every five years. The last adjustment took place in 2007, which raised the minimum threshold of mandatory obligations for federal projects from $ 25,000 to $ 30,000.
"Little Miller Acts"
Each state, the District of Columbia and Puerto Rico have passed laws governing bonding and bonding security requirements for state government construction projects. These laws contain provisions specifying the threshold amount of the contract under which surety bonds are not required. Below, we provide relevant excerpts from the Little Miller Acts adopted in New York, New Jersey and Connecticut.
New York Little Miller Act:
New York Consolidated Laws, State Finance Law, Section 9, Contracts, Section 137 states in part:
Provided, however, that all performance bonds and payment guarantees may, at the discretion of the head of the state agency, corporation or public interest commission, or his attorney, be exempted from the completion of a specified work in a contract for the pursuit of a public improvement for the State of New York for which bids are solicited when the full amount the contract is less than one hundred thousand dollars and provided, in addition, that in the event that the contract is not subject to the multiple contract award requirements of Article One hundred and thirty-five of this Article, these requirements may be waived when the head of the state agency, public utility company or commission finds that this is in the public interest and when the total amount of the awarded or to be awarded is less than two hundred thousand dollars.
New Jersey Little Miller Act:
New Jersey Revised Statutes, Title 2A, Administration of Civil and Criminal Justice, Chapter 44, Sections 2A: 44-143 through2A: 44-148 states in part:
(2) Where this contract is to be performed at the expense of the State and is entered into by the Director of the Division of Building and Construction or State Services designated by the Director of the Building Division and from the construction, the director or the State services may: a) establish for this contract the amount of the deposit at a percentage not exceeding 100% of the amount of the offer, on the basis of the Assessment by the director or the risk department presented to the state by the type of contract, and other relevant factors, and (b) waive the surety requirement of this section entirely if the contract is for an amount not exceeding $ 200,000. (3) Where such a contract is to be performed at the expense of a Contracting Unit or School District, the Council, the Officer or the Contracting Representative on behalf of the School Board or School District, shall The Contracting Unit or the School District may: a) establish for this Contract the amount of: the security deposit at any percentage, not exceeding 100%, of the bid amount, depending on the amount of the deposit; assessment by the board, officer or risk officer presented to the contracting unit or school district according to the type of contract and other relevant factors, and (b) waive to the bonding requirement of this section entirely if the contract is for an amount not exceeding $ 100,000.
Connecticut Little Miller Act:
General Acts of Connecticut, Title 49, Mortgages and Privileges, Chapter 847, Links, Articles 49-41 to 49-43, in part:
Second. 49-41. Public buildings and public works. Obligations for the protection of employees and materialists. Deposits. Limits on the use of insurance programs controlled by the owner. (a) Each contract of an amount in excess of one hundred thousand dollars for the construction, alteration or repair of any public building or work of the State or of a municipality shall include a provision that the person responsible for the performance of the contract must provide the State or the municipality no later than the date of the award, a surety of the amount of the contract which will bind the award of the contract. contract to that person, with one or more satisfactory guarantees for the contracted official, for the protection of persons providing labor or materials for the continuation of the work provided for in the contract for use of each of these persons, provided that no such security is required to be provided (1) in connection with a general offer in which the estimated total cost of labor and materials the contract for which this general offer is present is less than fifty thousand dollars, (2) in respect of any sub-offer in which the total estimated cost of labor and materials and the contract for which such a sub-offer is submitted is less than fifty thousand dollars, or (3) in relation to any general offer or sub-offer submitted by a consultant, as defined in article 4b-55. Such security shall be provided by the name of the person who is awarded the contract.
(b) Nothing in this section or sections 49-41a to 49-43 inclusive shall be construed to limit the power of any contracting officer to require a performance bond or other security in addition to the security referred to in paragraph (a). of this section, except that no such officer shall require a performance bond in respect of a general offer in which the estimated total cost of labor and materials under the contract for which this general offer is presented is less than twenty-five thousand dollars. or in respect of any sub-offer in which the total estimated cost of labor and materials under the contract for which the sub-offer is submitted is less than fifty thousand dollars.
The crucial importance of a strong relationship between principal and suretyship
A bond underwriter is responsible for assessing the overall ability of the director to complete a project based on: their financial situation, historical performance, current workload, ability to manage, and reputation with other stakeholders.
Differences of opinion occur periodically between the principal and the surety as to his willingness to provide surety capacity. School directors see it as an indirect attack on their ability to do business. The underwriters consider that their decision is in the principal's interest because, by denying bonding capacity, an underwriter can prevent a principal from compromising his or her personal assets. When such situations arise, the insurance broker should pay particular attention to the subscriber's concerns and work with the principal to provide any additional information that may mitigate or mitigate the subscriber's concerns.
Establishing a strong bonding relationship requires ongoing diligence, openness and active dialogue between the principal and the surety. La meilleure façon de bâtir la confiance qui est si importante dans la relation est peut-être de fournir des rapports convenus sur l'état d'avancement des travaux en cours, y compris les états des profits et pertes de chaque projet cautionné (et non cautionné), celui du propriétaire. l'activité de paiement, les ordres de modification non approuvés et les états financiers périodiques de l'entreprise. Un courtier d'assurance proactif organisera une réunion annuelle en personne à la fin des états financiers vérifiés. Les participants comprendraient le directeur, le garant, le directeur financier du directeur et éventuellement l'auditeur externe. Cette réunion offre une occasion de développer davantage la "relation papier" et est un lieu pour discuter franchement des problèmes potentiels et des perspectives d'avenir.
Bien que cela puisse sembler contre-intuitif, les directeurs qui avisent une caution des problèmes potentiels créent également un niveau de confiance élevé. Fournir de manière proactive les informations requises envoie un signal fort à la caution concernant le caractère commercial et la gestion du mandant, et fournir également à la caution les plans d'affaires de la société pour les douze à vingt-quatre prochains mois permettra de gagner la confiance et la flexibilité du souscripteur lorsque ces situations surviennent et peuvent obliger le preneur ferme à faire preuve de plus de souplesse afin que le mandant puisse atteindre ses objectifs commerciaux. Les sociétés de cautionnement peuvent fournir des ressources précieuses aux directeurs pour les aider à surmonter les défis commerciaux temporaires avant qu'un défaut ne se produise. Ces ressources comprennent: les avocats de la construction, les ingénieurs et les comptables.
Le département américain du Trésor publie une liste des cautions approuvées. the Liste du Trésor est situé à: http://www.fms.treas.gov/c570/c570.html.
Des entreprises de construction hautement efficaces maîtrisent l'art et la science de la gestion de relations de cautionnement réussies. L'engagement d'un professionnel de l'assurance expérimenté qui peut travailler efficacement avec le personnel financier et opérationnel interne et externe pour gérer le processus de garantie des obligations en temps opportun est un élément essentiel pour maintenir l'accès à des lignes de cautionnement stables.