n Part 1, we briefly discussed the Detroit Bankruptcy and the need to review how contractors were getting paid.
In Part 2, we discussed what effect a direct payment from a failing municipality has on a contractor.
Here, we are going to discuss the effects of the bankruptcy and how we believe it will affect the industry. Unfortunately, it's our opinion that the bankruptcy by Detroit will be followed by many other municipalities (bucking the historical trend of zero bankruptcies). This will, of course, have a devastating effect on the contractors that are directly involved. Our point here is to figure out what will happen to the rest of those not directly affected.
In the last few years, bid bonds have really exploded in the industry. It's our opinion that bid bonds will really increase in usage, including commercial contracts. This is because the contractors will be at an increased chance of default, even if they look financially stable at the time of the bid. That's because revenues could be coming from a governmental project, which could default. Further, revenues could be coming indirectly from a governmental project (say through a general, or land project, which gets its money from the government or through governmental bonds or tax incentives).
Yep, these are going to get more expensive. We believe that performance bonds will become the standard moving forward. The rationale behind this is that the owner is going to want some assurance that their project will not be derailed by events outside their control. So, in order to mitigate the risk of an outside event, they will require a performance bond so that they can get someone else to finish the project if the original party cannot.
Payment bonds will also become more prevalent, although we do not believe as prevalent as performance bonds. In our experience, many owners get comfort through the terms and conditions of the contract and do not fully recognize the risk of a subcontractor going unpaid and having that derail the project. Instead, they rely on the terms of the contract with the general contractor (hey, they AGREED to pay the sub) instead of getting a bond to ensure the payment of the subcontractors. The more sophisticated owners will start using payment bonds, which will trickle down through the industry.
Surety bonds: it's going to be an interesting few years as we work through these issues.