Today’s construction market is the toughest in years. Contractors are moving from private to public works and these sectors have significant differences. These include the bidding process, listing of subcontractors, owners with different agendas, high liquidated damages and higher levels of inspection. On public works contracts subcontractors and suppliers have no lien rights, so in 1935 the Miller Act was passed to cover federal projects, and all states have similar requirements.
A surety bond is required for all public works projects, which assures that a contractor will complete a project in accordance with contract terms including paying subcontractors and suppliers. Private owners should require bonds on their projects to protect them from a contractor’s failure to perform and pay subcontractors and suppliers.
“A bond not only protects the owner but also the subcontractors and suppliers on the project,” says John M. Garrett, CPCU, president of GMGS Insurance Services. “Private owners should be very wary of any contractor who cannot provide a bond.”
Smart Business spoke with Garrett about the surety bond process and what happens if you don’t have a surety bond in place.
What items will be examined during the surety bond process?
The surety decision is based on a review of net worth, working capital, experience and reputation of the construction company and its owners relative to the amount of credit granted. The surety will perform a complete credit analysis, looking at items such as prior projects, reputation with owners and bank line (how large it is, usage and security on the line). Does the lender have accounts receivable? Sureties have priority on accounts receivable on bonded projects, which many bankers don’t realize. This can lead to a reduction or disappearance of the bank line when engaged in public works.
Sureties will also look at the contractor’s litigation history. Net worth that is driven by assets such as heavy equipment book or market value might be suspect. The value of equipment could be impinged by the requirements in California to upgrade and the current economy. Sureties will also insist on full, personal indemnification. This includes indemnity of all the significant owners, indemnification of the owners’ spouses, cross indemnity of all entities and indemnity of any trusts. The surety must ensure that the contractor is fully committed to his or her company and all its obligations. Surety is a credit relationship, not insurance. If there is a loss, the surety expects to recover from the contractor.
The cost of a surety bond depends on the size, because the rate goes down as the size of the bond increases. It is about 1 percent, sometimes higher, depending on the quality of the contractor. The cost of the bond is paid by the owner.
How do you prepare for the current challenges in the construction market?
You should partner with a qualified accounting firm. The surety will insist on having a firm involved that can present a comprehensive financial statement including a work in process statement that ties into the balance sheet and profit and loss statement. You can anticipate a review level statement will be the minimum level requirement and a full audit likely as you expand the program. You also need to partner with a qualified construction law firm that is familiar with the public works environment. These attorneys understand how litigious this environment is and can advise you on the ramifications of construction litigation issues.
You should have a professional surety agent on your team, one who is a member of the National Association of Surety Bond Producers. They have been involved in the surety and public works environment for years and can offer invaluable counsel.
Given that you must list your subcontractors on bid day you should require in your scope that major subcontractors also provide bonds. If you do not do this at bid time, you cannot require it later.
Are these bonds always required?
Bonds are required by federal and state law on public works projects. Surety bonds protect the suppliers and subcontractors because they have no lien rights. However, it does not protect the general contractor. Given the budgetary shortfalls of the current economy, public entities may not be able to pay contractors for a project. You should be careful when entering into a project to make sure the entity has the sufficient funds, particularly if change orders might be involved. In California if general contractors do not get paid, they still have the obligation to pay the subcontractors and suppliers. This obligation extends to the surety.
What can happen if you don’t have a surety bond in place for a project?
If the contractor or subcontractor defaults, your contract price can escalate because you have to bring another contractor or subcontractor in to complete the project. You may end up paying for work, supplies and materials twice, thus increasing your project costs.
A surety will ultimately step in if the contractor or subcontractor defaults. The surety will determine if there’s a valid claim, examine the situation and decide how to proceed. There are several actions the surety can take:
- Bring in another contractor or subcontractor to complete the project
- Have the owner/contractor bring in other contractors to complete the project
- Negotiate with the owner/contractor to buy out the damages
- Continue to finance their principal through the work
Sureties generally prefer to keep the existing contractor on the project and finance it through completion, assuming that they still have a viable contractor.
John M. Garrett, CPCU, is the president of GMGS Insurance Services Inc. Reach him at [email protected] or (949) 559-3362.