Here is a great article on some of the typical misunderstandings when it comes to bonds. You can find it at: http://www.constructionexec.com/Issues/July_2013/Risk_Management.aspx?pageNum=1
Common Misunderstandings About Bonds
By Carl Dohn
Despite the benefits of pre-qualification services, contract completion protection and payment protection, misconceptions persist about performance and payment bonds. A proactive approach to communication and a cooperative approach to claims are critical to realizing how bonds can function as successful risk transfer mechanisms.
Prequalification Process and Benefits
While companies that issue insurance policies and surety bonds are regulated by state insurance departments, the two products function in very different manners. Sureties issue bonds to construction firms that the surety determines to be able to perform the contract successfully.
Before issuing a bond, the surety conducts a thorough underwriting analysis, also called prequalification, to determine whether the contractor (the principal) is capable of performing the bonded contract. It also indemnifies the surety against any loss sustained from issuing the bonds. In the same way that bankers do not loan money to borrowers that are incapable of repaying them, sureties do not issue bonds on behalf of contractors and subcontractors believed to be incapable of fulfilling their obligations. Typically, the surety’s prequalification process includes a credit analysis, financial statement review, workload analysis and business plan review.
General agreements of indemnity (GAIs) function as security to the surety for claims that might be made against the bonds. The GAI usually is executed by a corporate indemnitor (the principal) and individuals who serve as indemnitors, all of whom agree to indemnify the surety for losses (as defined in the GAI) incurred by the surety as a result of issuing bonds for the principal. Because of the obligations owed to the surety by corporate and individual indemnitors, contractors are more likely to complete bonded projects than unbonded projects.
The surety’s rigorous prequalification process assists the obligee, the potential claimant and the principal by ensuring only companies considered to be qualified by the surety receive contract awards. When a surety declines to issue bonds on behalf of a contractor, it determines the risks presented by a particular job are beyond the contractor’s capacity or capabilities. Surety prequalification is a significant benefit to a project owner that may not have the expertise to prequalify potential bidders.
In addition to prequalifications, there are many other benefits that accompany a surety’s performance and payment guarantees. The surety typically issues a program to a contractor and stays up to speed on the contractor’s performance on multiple projects. If the surety determines a contractor is having difficulties, it may provide management assistance and advice to a principal through in-house engineers and certified public accountants. It also is possible for a surety to provide additional capital to a failing contractor to prevent a default from occurring and take control of the contractor’s bonded contract funds. This often happens without the obligee or potential claimants even knowing a problem existed.
Claims and Communication
Unlike a two-party property and casualty insurance policy, a surety bond is a tri-party agreement. A surety has obligations to the principal/indemnitors and to the obligee/claimants. Obligees and claimants often fail to understand this dynamic of the surety relationship, which leads to the incorrect assumption that a surety must immediately perform the contract or pay on a bond claim. They also may incorrectly assume they have no obligations other than to submit a claim. By the time an obligee declares a default and notifies the surety, it often has tolerated poor or slow performance on the part of the principal and expects the surety to fix the default immediately, which is not realistic. The surety must investigate to determine if the claim is proper, assess the status of the work, present a plan for completion, and determine what amounts, if any, are to be paid to subcontractors and suppliers on the project. In short, the surety must determine if the bond claim is valid; if the principal is not liable, the surety is not liable.
An obligee’s early and open com-munication with the surety improves the claims process. A surety’s ability to quickly respond to a default is related directly to whether the obligee kept the surety informed of the status of the project, how quickly the obligee provides needed information, and the level of cooperation from the principal and the obligee. Similarly, a payment bond claimant that provides needed information and cooperates in the investigation impacts the speed at which a surety can respond.
Just like many owner-contractor agreements, surety bonds have specific notice requirements for claims. Courts strictly enforce notice requirements, so obtaining appropriate legal counsel is recommended.
Some bond forms and state statutes set a time limit for the surety to respond to a claim; more often than not a surety is afforded a “reasonable” amount of time to respond to a claim. Depending on the complexity of the project, the status of the project, and how cooperative the principal, obligee and claimants are in providing documents and information to the surety, the claim process may take a few days, weeks or even months.
Alternatives to Performance and Payment Bonds on Private Projects
Sometimes construction parties consider alternatives when bonds are not statutorily required. It is important to note that such alternatives often do not provide either of the primary functions of a surety: the pre-qualification process or performance and payment guarantees.
An example is a letter of credit (LOC), which is essentially a promise by a bank (issuer) to pay a third party (beneficiary) on behalf of a second party (applicant). While performance bond sureties have no obligation to perform unless a default has occurred, banks that issue LOCs typically must pay the beneficiary upon demand without regard to the merits of a dispute concerning the underlying transaction. The issuer of the LOC is not required to investigate the alleged default and must pay the owner, absent fraud or forgery (or non-complying presentation). With a LOC, the owner does not receive the benefit of the surety prequalification process, nor does it receive the services of the surety in completing the contract or administering the payment claims. Further, an LOC does not provide an unpaid subcontractor or supplier with any recourse. The unpaid subcontractor or supplier must pursue its contract rights against the contractor or pursue lien rights if available.
A LOC has no guarantee of project completion because the performance of the underlying contract has no bearing on the bank’s obligation to pay on the LOC. The LOC is typically 10 percent or less of the construction contract, while the surety bond typically is issued in the full amount of the construction contract. Again, the amount of the LOC does not assure project completion and the task of administering the contract’s completion is the owner’s responsibility. In addition, if lien rights exist on the project, the owner bears the burden of sorting through the payment claims of subcontractors and materials suppliers. Because the LOC proceeds likely will be needed for project completion, the owner must decide whether it will pay potential claimants directly or with the risk of liens on the project.
While most bond forms are seemingly simple documents—often no more than two or three pages—the rights and responsibilities of all parties to a surety bond can be complex. As with all contracts, it is crucial to read the bond carefully to determine the respective rights and obligations of the parties and to consult with knowledgeable legal counsel.
Carl Dohn is an account executive at Dohn & Maher Associates, Palatine, Ill., and immediate past president of the National Association of Surety Bond Producers. For more information, visit www.dohn.com or www.nasbp.org.