What is a Contract Bond?
Last Updated: August 12, 2017 Contract bonds, which are used extensively in the construction sector by general contractors, are an assurance from a surety to a job’s owner (known as the obligee) that a basic professional (known as the principal) will not fail in their obligations under a construction agreement.
A good resource is the Associated General Contractors of America. They provides a bunch of really good information for their members on these types of bonds.
Contract surety bonds is really a generic terms that includes a whole variety of bonds, including bid bonds, performance bonds and payment bonds, etc. We have other blog posts that explain those bonds.
Other types of contract bonds
Of course, there are a variety of bonds that don’t fall within the contract surety bond umbrella, which include supply bonds and subdivision bonds. Some unusual bonds are class and supply bonds. There are also retention release bonds, and off site material bonds.
What is the typical cost (or rate) for a contract bond?
Prices are determined through calculations that are based as a percent of the penalty in case of default (the maximum that the guarantee is accountable for). This ranges from around one percent to five percent, with the most credit-worthy contracts paying the least. Unlike insurance, the rates are not based on a general assumption of loss. Instead, the rate is determined with the underlying assumption of no loss (of course, there are always unforeseen instances that force costs on the surety).
So, What Happens if you break the bond?
Well, the surety is going to look to you to make them whole pursuant to the terms of the contract (see the Indemnity paragraph below). In these cases, the insurance company will be looking first to get the work done, second to minimize any losses, and then third to get their money back from you.
The bond commonly consists of an indemnity agreement where the principal specialist or others concur to indemnify the guarantee if there is a loss. The Small Business Administration may guarantee surety bonds. In a piece of great news, the 2013 eligible amount was tripled to $6.5 million that they will guarantee.
Contract Bond sample
Here is a Sample Contract bond.
There are several good Contract Bonds Checklists that you can get. Here’s an Owner’s checklist for payment and performance bonds.
Contract Bond Agency
Swiftbonds is a world-class contract bond agency and you can get a bond from us here.
On our Performance Bond page, we started explaining bonds and left off right after collateral security.
Here, we continue with real property as collateral.
One of the most frequent pieces of collateral is a mortgage (or deed of trust) on a piece of real property. Many times, this type of security is not acceptable or not acceptable in and of itself. The biggest reasons are that it is not easily turned into cash (which they really want in case of a bond that’s requiring payment; remember, they do not have a reserve set aside) or there is another lien holder on the property, such as a first lien holder or a mechanics lien. This, in addition to the legal burdens arising from real property (getting an appraisal, filing in the right court, etc), makes bond underwriters a bit leery of real property only as security. Again, you just have to spend some time finding the right surety company.
Property, Plant and Equipment
The final piece of collateral security is construction equipment or PPE (property, plant and equipment). Many surety companies have accepted this as collateral for a surety bond. I am always happy to oblige them on that so that I can get my clients a bond. However, I find it a bit puzzling. That is, every construction company that I know of sells off their equipment when times get tough. Thus, in nearly every bond that comes due, the construction company has done everything in its power to stave off that default. That includes selling off the equipment, which leaves the surety company with nothing. Now, a surety could protect themselves by filing a UCC-1, but many don’t. Actually, most don’t. They forget or don’t think it’s all that important, at least until there’s an imminent default.
Timeframe of a Bond
Unlike a typical insurance policy, which usually lasts for a definite period of time – usually a year – most surety bonds do not have a stated timeframe. Instead, they last as long the underlying contract or job lasts. These are known as “continuous” bonds as there is not a termination based on an arbitrary timeframe, such as the end of the calendar year or the death of a person under a life insurance policy.
There are some surety bonds that do last for a defined period of time. These are usually fidelity bonds written for certain professions, such as a notary bond.
Most of you are familiar with a contract bond, which stays around until the contract has terminated. These bonds can last many years, especially in developments that have multiple stages. Other situations that exist are delays, whether due to developer delays, government delays (such as changes in permits, zoning, etc) or financing delays. Don’t even get me started on legal delays, such as when there’s suspected foul play. For example, one retirement community complex was delayed for over five years because the insurers were fighting over who had to pay the bill when the complex was destroyed by arson.
There are other bonds, such as an executor’s bond in a probate estate that does not terminate until the estate is settled. Contrast that with a litigation bond, which only lasts a year (even though most litigation lasts much longer).
One note: although the bonds last for a long period of time, the premiums are usually paid annually. So, even though you don’t have to go through the underwriting process again, you still have to pay. Most of you will get a receipt each year after the premium is due, similar to a certificate of renewal. However, although most surety companies treat these certificates are the same, or similar to, a certificate of renewal, they are not. It’s just a receipt of payment as the original issuance of surety is still valid.
The Surety Association of America
The Surety Association of America was formed in 1908, which helped the industry to standardize practices. Prior to the Association, each surety company was left to determine its own rates, fees, commissions and underwriting criteria. This wild west of surety rules led to numerous difficulties among the companies.
Thus, the Surety Association was created to help create stability in the underwriting process and lead to a more consistent system of rates and underwriting criteria focus points. Since its inception it has helped develop a system of more consistent rates and ratings criteria. It’s received consistent and vocal support from the surety bond community; despite multiple ups and downs over the years. Like any association, its members do not always get along, but the association itself has provided a great base from which to help the majority of members.
One of the unknown benefits of the Surety Association is that it keeps the surety bond industry largely out of the hands of state insurance regulators. Thus, the ability to have a large central organization keeps the bond companies in line while not giving too much power to local regulators – which would substantially raise compliance costs and other costs to bonds. Instead, the Surety Association has helped the system move forward without the large and costly bureaucracy that standard insurance companies must operate under.
The Towner Rating Bureau
The Towner Rating Bureau has helped determine a standardized cost structure for most surety bonds. This central agency is also a great factor in keeping the surety bond companies under a framework from which to operate and not utilize certain imbalances, whether through information, market gaps or other inefficiencies to exploit the marketplace. Instead, the Towner Rating Bureau has been a great focal point in keeping out the government and, again, driving up costs.
Like the Surety Association, the Towner Rating Bureau is a key to the ability of bond companies to thrive in the marketplace while keeping costs (relatively) low for construction companies. Thus, commerce has been able to move along at a reasonable pace and at a reasonable price for the bulk of the 20th, and now 21st, centuries. Given a standardized practice of pricing, the bond companies are not able to exploit the working companies that create a large part of the American infrastructure.
So, How Do You Get a Bond?
One of the frequent questions that we get is “how do I get a bond?” That question is, unfortunately, a myriad process of learning, understanding and paperwork. However, we do all the learning and understanding part and a big bunch of the paperwork.
The process can range from the very simple (we try our very best to keep it simple) to the very, very complex. We’ll try to explain the basics behind the bond process from your perspective. Let’s start with a look at the history (you can go review the British history and US Surety roots here) behind surety.
A bit of understanding about surety bond history
As you know, the surety bond industry is a modern mammoth in its size and depth of offerings. It does not just include the construction industry, but includes lawyers, notaries, bank executives, banks, etc. Thus, the underwriting of each of these types of bonds starts with the character and position of the person being underwritten. Given the high costs to, say, a lawyer for defaulting on a bond (risking their law license and entire future earnings), they are highly likely to not default. Compare this to a financial institution that could risk default if the gain is multiple hundreds of millions of dollars versus a bit of a loss of reputation.
In the old days, the application for a surety bond was a comprehensive and detailed set of information, which included the bulk of the applicant’s life, including many details that seemed not to be related to the risk being written (such as questions about their marriage, etc.). These documents asked for the basics: name, age, place of birth, residence history, assets – both real property and personal property, investments, current job and previous occupations, references, etc. These detailed applications had the effect, strangely, of driving off job applicants and otherwise reliable workers as the questions were either overwhelming or deemed too intrusive (that is, many people were offended and left their jobs).
It’s been reported that the archives of surety bond companies before the digitization of documents was reported to be in the millions of pages. A lot of very personal information was contained in these files – just so they could get a bond.
In the modern age, computers have eliminated the need for a large amount of document retention. However, the very low storage costs of digital files means that the information can be kept indefinitely and cheaply. More importantly, surety bond companies no longer have to rely on paper applications. Instead, they have access to a ton of digital information from which to rely in writing a bond.
For credit-based bonds, they only have to rely on the credit rating agencies who do their own gathering of data. Side note: it’s hard to imagine the large amount of data that a credit agency has access to. They gather, on a regular and ongoing basis, information about nearly all of us, whether it appears from a credit-based application (like getting a credit card or a home) or a public record (like a fraud conviction or bankruptcy).
For non credit-based bonds, they also have access to other sources of information. Yes, they still use the credit information from the big three credit agencies (Experian, TransUnion and Equifax). But they also use a variety of other sources, such as governmental sources, newspapers and your own information. That is, social media has become a large part of the data gathering machine. So, it’s always a good idea to do a search of yourself and make sure that there isn’t anything out there that should not be).
Rejection – And we’re not talking about the Junior Prom
We have, unfortunately, worked with plenty of clients that have been rejected for a surety bond. Although we work crazy hard to get them a bond, sometimes the surety bond underwriters just will not issue the bond. The question is, simply, why? Although the question is easy, the answers are myriad.
First, remember that each bond company has its own sets of guidelines and rules that they follow. Although they are somewhat similar, they are not the same. Some companies place a high premium on credit quality and some place a high premium on collateral while some focus on cash flow. The general range of rejections are:
- A conviction of fraud, theft, or other dishonest act of the person being bonded (or of a principal of a company being bonded)
- Drug and alcohol addiction (this is especially true in service industries, such as a notary bond)
- Fraud, theft or other dishonest acts that are done by known associates of the contractor (or of the job that is being bid on by the contractor)
- Gambling. Yes, it is true. Gambling is a big red flag.
- Large personal debts that haven’t affected the credit rating yet. For example, we worked with a company that had really good cash flow. The owner had good credit as he had made lots of money each year for many years in a row. However, he had a huge house and took lots of very, very expensive trips and drank expensive wines. Thus, he had no savings. What’s worse, he had to take out a loan each year to pay taxes. Here’s a case where he couldn’t get a bond, even though he made several million dollars per year.
- Poor, or nonexistent, references. In this day and age, nearly everyone has someone that will vouch for their character. Having a poor reference shows a lack of self-awareness and personal judgment.
- Related to poor references is a poor online reputation. As we mentioned before in the underwriting process, a person can go through a web background check. We constantly recommend to people to Google themselves and see if there is any bad information out there and then to get it removed.
- Finally, we get bond rejections when a contractor does not fully disclose everything. We ALWAYS recommend disclosing everything. We can work through a bad situation, but we have almost no defense when an underwriter rejects and, when we call to ask why, they say that our contractor did not disclose a pertinent fact.
This is continued on our Bid Bond page, here.
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