Surety bonds

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.