Construction Bonds. A CCM Research and Information Service Info Kit

Transcription

1 Construction Bonds A CCM Research and Information Service Info Kit July 2009

2 A CCM Research and Information Info Kit Introduction The following Construction Bonds InfoKit is provided as an informative publication to all CCM members. This InfoKit is divided into three sections: 1) Relevant Connecticut Legislation & General Information 2) Sample Municipal Construction Bond Regulations 3) Examples of Bonds For more information regarding this or any question please contact CCM Research and Information Service Department at (203) or All Rights Reserved. This publication may not be reproduced, stored or transmitted in any way for profit and is intended for the exclusive use of Connecticut Conference of Municipalities (CCM) Members and for the employees of its Members. This publication may not be shared, copied, or electronically stored for the use of any non-member municipality, entity, or individual. The Connecticut Conference of Municipalities reserves the right to grant exceptions to these limitations and will do so exclusively by means of prior written consent. CCM is not responsible for any errors or omissions that may appear in this publication. This publication is intended for general reference purposes only and is not intended to provide legal advice, opinions, or conclusions. If you have questions about particular legal issues, the application of the law to specific factual situations, or the interpretation of any statutes, ordinances, or case law referenced in this publication, CCM strongly recommends that you consult your attorney, certified public accountant, or other relevant party. June 2009, The Connecticut Conference of Municipalities The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 2

3 Table of Contents Section 1: Relevant Connecticut Legislation & General Information CHAPTER 847 LIENS, Sec Public buildings and public works. Bonds for protection of employees and materialmen. Performance bonds. Limits on use of owner-controlled insurance programs. Certain surety contract provisions.... Public Act (House Bill No. 5677) An Act Concerning Surety Bonds and Construction Contracts.. Public Act (Senate Bill No. 493) An Act Concerning Subcontractor Claims. Article: The Importance of Surety Bonds in Construction, The Surety & Fidelity Association of America (SFAA), National Association of Surety Bond Producers, and the Surety Information Office. Article: 10 Things You Should Know About Surety Bonding, The Surety & Fidelity Association of America (SFAA), National Association of Surety Bond Producers, and the Surety Information Office. Article: Contract Surety Bonds: Protecting Your Investment, The Surety & Fidelity Association of America (SFAA), National Association of Surety Bond Producers, and the Surety Information Office Article: Surety Bonds at Work, The Surety & Fidelity Association of America (SFAA), National Association of Surety Bond Producers, and the Surety Information Office Department of the Treasury's Listing of Certified Companies Section 2: Sample Municipal Construction Bond Regulations Updated, Willington (est. pop. 6,139).. Avon (est. pop. 17,333 ) Berlin (est. pop. 20,254) The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 3

4 Westport (est. pop. 26,508) Durham (est. pop. 7,397).. Bristol (est. pop. 60,911) New Britain (est. pop.70,664). Section 3: Examples of Bonds The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 4

5 Section 1 Relevant Connecticut Legislation & General Information The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 5

6 CHAPTER 847 LIENS Sec Public buildings and public works. Bonds for protection of employees and materialmen. Performance bonds. Limits on use of owner-controlled insurance programs. Certain surety contract provisions. (a) Each contract exceeding one hundred thousand dollars in amount for the construction, alteration or repair of any public building or public work of the state or a municipality shall include a provision that the person to perform the contract shall furnish to the state or municipality on or before the award date, a bond in the amount of the contract which shall be binding upon the award of the contract to that person, with a surety or sureties satisfactory to the officer awarding the contract, for the protection of persons supplying labor or materials in the prosecution of the work provided for in the contract for the use of each such person, provided no such bond shall be required to be furnished (1) in relation to any general bid in which the total estimated cost of labor and materials under the contract with respect to which such general bid is submitted is less than one hundred thousand dollars, (2) in relation to any sub-bid in which the total estimated cost of labor and materials under the contract with respect to which such sub-bid is submitted is less than one hundred thousand dollars, or (3) in relation to any general bid or sub-bid submitted by a consultant, as defined in section 4b-55. Any such bond furnished shall have as principal the name of the person awarded the contract. (b) Nothing in this section or sections 49-41a to 49-43, inclusive, shall be construed to limit the authority of any contracting officer to require a performance bond or other security in addition to the bond referred to in subsection (a) of this section, except that no such officer shall require a performance bond in relation to any general bid in which the total estimated cost of labor and materials under the contract with respect to which such general bid is submitted is less than twenty-five thousand dollars or in relation to any sub-bid in which the total estimated cost of labor and materials under the contract with respect to which such sub-bid is submitted is less than fifty thousand dollars. (c) No contract for the construction, alteration or repair of any public building or public work of the state or a municipality that requires a person to supply the state or municipality with a bond may include a provision that requires the person to obtain the bond from a specific surety, agent, broker or producer. No contracting officer may require that a bond be obtained from a specific surety, agent, broker or producer. (d) In the event that any political subdivision of the state enters into a contract described in subsection (a) of this section and fails to obtain delivery from the contractor of the bond required by this section, any person who has not been paid by the contractor for labor or materials supplied in the performance of work under the contract shall have the same legal right of action against such political subdivision of the state as such person would have had against a surety under the provisions of section Nothing in this section shall be construed to extend liability to the state for any person's right to payment or constitute a waiver of the state's sovereign immunity. The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 6

7 (e) (1) As used in this subsection, "owner-controlled insurance program" means an insurance procurement program under which a principal provides and consolidates insurance coverage for one or more contractors on one or more construction projects. (2) No contract for the construction, alteration or repair of any public building or public work of the state or a municipality may include a provision that allows or requires the state or municipality to maintain an owner-controlled insurance program, except for (A) a project approved pursuant to section 10a-109e, or (B) one or more municipal projects totaling one hundred million dollars or more (i) under the supervision of one construction manager, or (ii) located within the boundaries of a municipality if under the supervision of more than one construction manager. (3) Each contract or policy of insurance issued under an owner-controlled insurance program pursuant to this subsection shall provide that: (A) Coverage for work performed and materials furnished shall continue from the completion of the work until the date all causes of action are barred under any applicable statute of limitations. (B) Any notice of a change in coverage under the contract or policy or of a cancellation or refusal to renew the coverage under the contract or policy shall be provided to the principal and all contractors covered under the program. (C) The effective date of a (i) change in coverage under the contract or policy shall be at least thirty days after the date the principal and contractors receive the notice of change in coverage as required under subparagraph (B) of this subdivision, and (ii) cancellation or refusal to renew shall be at least sixty days after the principal and contractors receive the notice of change in coverage as required under subparagraph (B) of this subdivision. (4) Each principal or contractor shall disclose in the project plans or specifications at the time the principal or contractor is soliciting bids for the construction project that the project will be covered by an owner-controlled insurance program. (f) Whenever a surety bond is required in connection with a contract for the construction, reconstruction, alteration, remodeling, repair or demolition of any public building for work by the state or a municipality, that is estimated to cost more than five hundred thousand dollars and is paid for, in whole or in part, with state funds, the surety contract between the contractor named as principal in the bond and the surety that issues such bond shall contain the following provision: "In the event that the surety assumes the contract or obtains a bid or bids for completion of the contract, the surety shall ensure that the contractor chosen to complete the contract is prequalified pursuant to section 4a-100 of the Connecticut general statutes in the requisite classification and has the aggregate work capacity rating and single project limit necessary to complete the contract". The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 7

8 Public Act (House Bill No. 5677) An Act Concerning Surety Bonds and Construction Contracts (Signed by the Governor 5/8/2006) The law requires public works contracts for which a payment bond is required to include certain provisions establishing a payment schedule. This act requires a general contractor or subcontractor, regardless of whether a surety bond is in place, to deposit funds in an interestbearing escrow account on the written demand of its subcontractor if (1) a payment is not made according to the contract schedule, (2) 10 days have passed since the payment date, and (3) the subcontractor has sent a payment demand by registered or certified mail. Under prior law, the general contractor or subcontractor had to escrow funds under these conditions only if a surety bond was not in place. By law, unchanged by the act, the escrowed amount must be for the amount that the general contractor or subcontractor is liable, which is the amount of the claim plus 1% per month interest. The contractor or subcontractor may refuse to escrow funds if he contends that his subcontractor has not substantially completed the work according to the terms of the contract. EFFECTIVE DATE: October 1, 2006 Public Act (Senate Bill No. 493) An Act Concerning Subcontractor Claims (Submitted to Secretary of State 5/17/06) This act revises a subcontractor's or supplier's deadlines for filing payment claims against a general contractor's surety company under certain public works contracts and for suing a surety company to compel payment. The law requires public works contracts valued at more than $50,000 to require the general contractor to (1) pay the amount due subcontractors or suppliers within 30 days after being paid by the state or municipality if the work performed or material supplied was included in a requisition or estimate and (2) include in its subcontracts a requirement that a subcontractor pay its subcontractors within 30 days after being paid by the general contractor. These contracts must also require the contractor to furnish a payment bond from a surety company. A general contractor or subcontractor who has not been fully paid after 60 days has the right to file a payment claim with the surety company. Under prior law, the deadline for filing these claims was 180 days after the requisition for work or materials was submitted or, if the work or materials was not included in a requisition or estimate, 180 days after the work was performed or the materials supplied. The act instead makes the deadline for filing claims, other than for retainage, 180 days after the last date the claimant performed work or supplied materials. For retainage, the act sets 180 days after the payment due date as the deadline. Retainage is the amount withheld from progress payments conditioned on substantial or final completion of all work in accordance with a construction contract, but it does not include amounts withheld for failure to comply with construction plans or specifications. The act changes the deadline for filing a suit to enforce a claim in the same way that it changes the The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 8

9 deadline for making a claim against the surety. Prior law required a suit to be filed within one year after the requisition was submitted or, if the work or materials was not included in a requisition, within one year after the work was performed or the material was supplied. The act instead makes the deadlines one year after the last date that the claimant performed work or supplied materials or, if the suit is being filed solely for payment of retainage, one year after the payment due date. EFFECTIVE DATE: Upon passage The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 9

10 The Importance of Surety Bonds in Construction Historical Perspective Surety bonds have been a valuable tool for centuries. The first known record of contract suretyship was an etched clay tablet from the Mesopotamian region around 2750 BC. According to the contract, a farmer drafted into the service of the king was unable to tend his fields. The farmer contracted with another farmer to tend them under the condition they split the proceeds equally. A local merchant served as the surety and guaranteed the second farmer s compliance. Suretyship was addressed in the first known written legal code, the Code of Hammurabi, around BC. A Babylonian contract of financial guarantee from 670 BC is the oldest surviving written surety contract. The Roman Empire developed laws of surety around 150 AD that exist in the principles of suretyship today. While suretyship has a long history, it wasn t until the 19th century that corporate surety bonds were used. Recognizing the need to protect taxpayers from contractor failure, Congress passed the Heard Act in 1894, which required surety bonds on all federally funded projects. The Miller Act of 1935 (40 U.S.C. Section 270a et. seq.) was the last major change in public sector surety, and is the current federal law mandating surety bonds on federal public works. It requires performance bonds for public work contracts in excess of $100,000 and payment protection, with payment bonds the preferred method, for contracts in excess of $25,000. Almost all 50 states, the District of Columbia, Puerto Rico, and most local jurisdictions have enacted similar legislation requiring surety bonds on public works. These generally are referred to as Little Miller Acts. Risky Business How one evaluates and manages risk on construction projects and makes fiscally responsible decisions to ensure timely project completion is key to success. To gamble on a contractor whose level of commitment or qualification is uncertain or who could become bankrupt halfway through the job can be a costly decision. How can a public agency using the low-bid system in awarding public works contracts be sure the lowest bidder is dependable? How can private sector construction project owners manage the risk of contractor failure? Surety bonds provide financial security and construction assurance by assuring project owners that contractors will perform the work and pay specified subcontractors, laborers, and material suppliers. A surety bond is a risk transfer mechanism where the surety company assures the project owner (obligee) that the contractor (principal) will perform a contract in accordance with the contract documents. Types of Bonds There are three basic types of contract surety bonds: The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 10

11 The bid bond assures that the bid has been submitted in good faith and that the contractor will enter into the contract at the price bid and provide the required performance and payment bonds. The performance bond protects the owner from financial loss should the contractor fail to perform the contract in accordance with its terms and conditions. The payment bond assures that the contractor will pay specified subcontractors, laborers, and material suppliers on the project. Financial Security & Construction Assurance Although surety bonds are mandated by law on public works projects, the use of surety bonds on privately owned construction projects is at the owner s discretion. Alternative forms of financial security, such as letters of credit and self-insurance, do not provide the 100% performance protection and 100% payment protection of surety bonds nor do they assure a competent contractor. With surety bonds, the risks of project completion are shifted from the owner to the surety company. For that reason, many private owners require surety bonds from their contractors to protect their company and shareholders from the enormous cost of contractor failure. To bond a project, the owner specifies the bonding requirements in the contract documents. Obtaining bonds and delivering them to the owner is the responsibility of the contractor, who will consult with a surety bond producer. Subcontractors may also be required to obtain surety bonds to help the prime contractor manage risk, particularly when the subcontractor is a significant part of the job or a specialized contractor that is difficult to replace. Most surety companies are subsidiaries or divisions of insurance companies, and both surety bonds and traditional insurance policies are risk transfer mechanisms regulated by state insurance departments. However, traditional insurance is designed to compensate the insured against unforeseen adverse events. The policy premium is actuarially determined based on aggregate premiums earned versus expected losses. Surety companies operate on a different business model. Surety is designed to prevent loss. The surety prequalifies the contractor based on financial strength and construction expertise. The bond is underwritten with little expectation of loss. Prequalification of the Contractor Sureties are able to accept the risk of contractor failure based on the results of a thorough, rigorous, and professional process in which sureties prequalify the contractor. This prequalification process is an in-depth look at the contractor s business operations. Before issuing a bond the surety company must be fully satisfied that the contractor has, among other criteria: Good references and reputation; The ability to meet current and future obligations; The experience matching the contract requirements; The necessary equipment to do the work or the ability to obtain it; The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 11

12 The financial strength to support the desired work program; An excellent credit history; and An established bank relationship and line of credit. The surety company must be satisfied that the contractor runs a well-managed, profitable enterprise, keeps promises, deals fairly, and performs obligations in a timely manner. Surety bonds have played an important role in the construction industry s success, allowing the industry to sustain its position as one of the largest contributors to the nation s economic stability and growth. Contractor Failure Construction is a risk-filled enterprise, and even capable and well-established contractors can ultimately fail. According to BizMiner, of the 1,155,245 general contractors and operative builders, heavy construction contractors, and special trade contractors operating in 2006, only 919,848 were still in business in 2008 a 20.37% failure rate. Despite the surety s rigorous prequalification process and best judgment about the qualifications of the contractor, sometimes contractor default is unavoidable. However, when a contractor fails on a bonded project, it is the surety company that remedies the default not the project owner and not at taxpayers expense. In the unfortunate event that a bonded contractor does default, the surety has legal obligations to the project owner and the contractor. First, the owner must formally declare the contractor in default. Then the surety company conducts an impartial investigation before settling any claim. This protects the contractor s ability to pursue legal recourse in the event that the owner improperly declares the contractor in default. When there is a proper default, the surety s options often are spelled out in the bond. These options may include the right to re-bid the job for completion, bring in a replacement contractor, provide financial and/or technical assistance to the existing contractor, or pay the penal sum of the bond. The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 12

13 Bond Rates Surety bond premiums vary from one surety to another, but can range from 0.5% to 2% of the contract amount, depending on the size, type, and duration of the project and the contractor. Typically, there is no direct charge for a bid bond. In many cases, a performance bond incorporates the payment bond and a maintenance period. The contractor includes the bond premium amount in the bid and the premium generally is payable upon execution of the bond. If the contract amount changes, the premium may be adjusted for the change in contract price. Contract surety bonds are a wise investment protecting public owners, private owners, lenders, and prime contractors from the potentially devastating expense of contractor and subcontractor failure. Benefits of Bonds After analyzing the risks involved with a construction project, consider how surety bonds protect against those risks. Owners, lenders, taxpayers, contractors, and subcontractors are protected because: The contractor has undergone a rigorous prequalification process and is judged capable of fulfilling the obligations of the contract; Contractors are more likely to complete bonded projects than non-bonded projects since the surety company may require personal or corporate indemnity from the contractor; Subcontractors have no need to file mechanic s liens on a private project when a payment bond is in place, and because mechanics liens cannot be placed against public property, the payment bond may be the only protection these claimants have if they are not paid for the goods and services they provide; Bonding capacity can increase a contractor s or subcontractor s project opportunities; The surety bond producer and underwriter may be able to offer technical, financial, or management assistance to a contractor; and The surety company fulfills the contract in the event of contractor default. Any contractor whether in business for one year or 100, large or small, experienced or novice can experience serious problems. Through the years surety bonds have held fast as a comprehensive and reliable instrument for minimizing the risks in construction. The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 13

14 10 Things You Should Know About Surety Bonding Making the right choice to mitigate and manage risk on construction projects and selecting the most fiscally responsible option to ensure timely project completion are imperative to a successful project and a sound business. Gambling on a contractor or subcontractor whose level of commitment is uncertain or who could become bankrupt halfway through the job can be an economically devastating decision. Surety bonds offer the optimal solution: providing financial security and construction assurance by assuring project owners that contractors are capable, in the surety s opinion, of performing a construction contract and paying specified subcontractors, laborers, and material suppliers. 1. A surety bond is a three-party agreement where the surety company assures the obligee (owner) that the principal (contractor) will perform a contract. Surety bonds used in construction are called contract surety bonds. 2. There are three primary types of contract surety bonds. The bid bond assures that the bid has been submitted in good faith, that the contractor intends to enter the contract at the price bid and provide the required performance and payment bonds. The performance bond protects the owner from financial loss in the event that the contractor fails to perform the contract in accordance with its terms and conditions. The payment bond assures that the contractor will pay certain workers, subcontractors, and materials suppliers. 3. Most surety companies are subsidiaries or divisions of insurance companies, and both surety bonds and insurance policies are risk transfer mechanisms regulated by state insurance departments. However, insurance is designed to compensate the insured against unforeseen adverse events. The policy premium is actuarially determined based on aggregate premiums earned versus expected losses. Surety companies operate on a different business model. Surety is designed to prevent loss. The surety prequalifies the contractor based on financial strength and construction expertise. The bond is underwritten with little expectation of loss. 4. In 1984 Congress passed the Heard Act to protect federal projects from contractor default and protect subcontractors from nonpayment by contractors. The Heard Act was supplanted by the Miller Act in 1935, which basically requires performance and payment bonds in excess of $100,000 and payment protection for contracts between $30,000 and $100,000. A corporate surety company issuing these bonds must be listed as a qualified surety on the Treasury List. Also, almost all 50 states, the District of Columbia, Puerto Rico, and most local jurisdictions have enacted similar legislation requiring surety bonds on public works. These generally are referred to as Little Miller Acts. Owners of private construction also manage risk by requiring surety bonds. 5. Construction is a risky business. Of 1,155,245 contractors in business in 2006 only 919,848 were still in business in 2008 a 20.4% failure rate. Surety bonds offer The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 14

15 assurance that the contractor is capable of completing the contract on time, within budget, and according to specifications. Specifying bonds not only reduces the likelihood of default, but with a surety bond, the owner has the peace of mind that a sound risk transfer mechanism is in place. The burden of construction risk is shifted from the owner to the surety company. 6. Surety bond premiums vary from one surety to another, but can range from 0.5% to 2% of the contract amount, depending on the size, type, and duration of the project and the contractor. Typically, there is no charge for a bid bond if performance and payment bonds are required on the project. In many cases, performance bonds incorporate payment bonds and maintenance bonds. 7. The surety company s rigorous prequalification of the contractor protects the project owner and offers assurance to the lender, architect, and everyone else involved with the project that the contractor is able to translate the project s plans into a finished project. Surety companies and surety bond producers have been evaluating contractor and subcontractor performance for more than a century. Their expertise, experience, and objectivity in prequalifying contractors is one of a bond s most valuable attributes. Before issuing a bond, the surety company must be fully satisfied that the contractor has, among other criteria: good references and reputation; the ability to meet current and future obligations; experience matching the contract requirements; the necessary equipment to do the work or the ability to obtain it; the financial strength to support the desired work program; an excellent credit history; and an established bank relationship and line of credit. 8. Contractor default is an unfortunate, and sometimes unavoidable, circumstance. In the event of contractor failure, the owner must formally declare the contractor in default. The surety conducts an impartial investigation prior to settling any claim. This protects the contractor s legal recourse in the event that the owner improperly declares the contractor in default. When there is a proper default, the surety s options often are spelled out in the bond. These options may include the right to re-bid the job for completion, bring in a replacement contractor, provide financial and/or technical assistance to the existing contractor, or pay the penal sum of the bond. That owners have been shielded from risk is evidenced by the fact that surety companies have paid more than $10.5 billion due to contractor default since 1994, according to The Surety & Fidelity Association of America, Washington, DC. In 2008, the surety industry paid more than $13 million in losses on private construction and more than $1.5 billion since When bonds are specified in the contract documents, it is the contractor s responsibility to obtain them. The contractor generally includes the bond premium amount in the bid and the premium generally is payable upon execution of the bond. If the contract amount The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 15

16 changes, the premium will be adjusted for the change in contract price. Contract surety bonds are a wise investment providing qualified contractors and protecting public owners, private owners, and prime contractors from the potentially devastating expense of contractor and subcontractor default. 10. After analyzing the risks involved with a construction project, consider how surety bonds protect against those risks. Owners, lenders, taxpayers, contractors, and subcontractors are protected because: The contractor has undergone a rigorous prequalification process and is judged capable of fulfilling the obligations of the contract; Contractors are more likely to complete bonded projects than non-bonded projects since the surety company may require personal or corporate indemnity from the contractor; Subcontractors have no need to file mechanics liens on private projects when a payment bond is in place; Bonding capacity can help a contractor or subcontractor grow by increasing project opportunities and providing the benefits of assistance and advice of the surety bond producer and underwriter; Surety companies may prevent default by offering technical, financial, or management assistance to a contractor; and The surety company fulfills the contract in the event of contractor default. The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 16

17 Contract Surety Bonds: Protecting Your Investment How do you evaluate and manage risk on your construction projects? How do you ensure that your projects are completed on time, on budget, and to contract specifications? How do you ensure that contractors and subcontractors successfully meet their obligations? One way is with bid, performance, and payment bonds. Specifying surety bonds ensures capable and qualified contractors and subcontractors and protects you from financial loss in the event of contractor failure. How Do Surety Bonds Work? With a surety bond, the surety company and its financial resources stand behind the contractor, which enables the contractor to enter into a contract. You receive a bond from a financially responsible surety company licensed to transact surety. Surety bonds provide protection by screening out unqualified contractors. Before contractors can obtain a surety bond, they undergo a rigorous prequalification process, called underwriting, to determine whether they are capable of performing a given contract. When a surety underwrites performance and payment bonds, it stands behind the contractor s promise to: perform the work according to the contract s terms and conditions, and pay certain subcontractors, laborers, and material suppliers. The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 17

18 Types and Benefits of Contract Surety Bonds Bid Bond Assures that the bid has been submitted in good faith, the contractor intends to enter into the contract at the price bid, and the contractor will provide the required performance and payment bonds. Performance Bond Protects the owner from financial loss should the contractor fail to perform the contract in accordance with its terms and conditions. Payment Bond Assures that certain subcontractors, laborers, and material suppliers will be paid in the event of contractor default, and prevents subcontractors from filing mechanics liens on the project. Prequalification The fundamental concept of contract surety is that contractor default is preventable. Surety companies spend a great deal of time and expense in the underwriting process to qualify a contractor before issuing a surety bond. This effort keeps contractor defaults to a minimum. Since surety companies back their promises with their own assets, they conduct a careful, professional, and rigorous prequalification review of the contractor. Because surety companies and bond producers have been evaluating contractor and subcontractor performance for more than a century, they possess the expertise, experience, and objectivity to effectively prequalify the contractor and assure project completion. The surety bond premium is a fee for this expertise and financial backing. Because a contractor s bonding capacity affects his or her ability to acquire work, the contractor provides more comprehensive information to the surety than to the owner. The surety company and producer have access to detailed financial information; ongoing analysis of the contractor s strengths and weaknesses; and information on past, current, and future work. The surety bond underwriter has the formidable task of assessing the strength of a construction firm based on a prediction of profits on uncompleted jobs and the analysis of the contractor s cost systems, billing patterns, timeliness of completion, and likelihood of profitability. Surety professionals make informed decisions to prequalify the contractor. Their unique relationship with a contractor allows them to evaluate each element and determine whether the contractor can complete the job. It is more economical to have a surety professional perform the prequalification than for an owner to maintain a staff or hire a consultant for this purpose. The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 18

19 What Surety Professionals Analyze Financial Strength Ability to Perform Reputation With Annual & interim financial statements Investment strategies Cost control mechanisms Work in progress Cash flow Net worth Working capital Bank & other credit relationships Prior experience on similar projects Equipment Personnel Past, current, and future workload (bonded & non-bonded) Continuity plan Organization Management plan Project Owners Subcontractors Suppliers Lenders Subcontractors Subcontractors have a significant impact on the profitability of your projects. Two significant risk factors are their ability to fulfill their contractual obligations and their right to file mechanics liens. Performance and payment bonds offer substantial protections from both. Subcontractors who are unable to perform can bring your project to a halt, particularly if the subcontractor is responsible for a significant portion of the contract or is a specialty contractor that is difficult to replace. The general contractor is responsible for its subcontractors. However, when the general contractor requires key subcontractors to obtain performance bonds, you are assured of qualified subcontractors on your project. Subcontractors deserve the protection of a payment bond. No matter how qualified the subcontractors are, if the general contractor fails to pay them you run a significant risk of project delays and mechanics liens. However, when you specify a payment bond, certain subcontractors, laborers, and suppliers are assured payment in the event of contractor default. The surety company investigates claims made on the payment bond and pays subcontractors directly when the contractor is found in default of the payment bond. As Northland College experienced, a claim of non-payment may even occur after the project is complete or nearly complete, even if the owner has already paid the contractor for the work. Keeping key subcontractors on the job can help keep a project moving toward timely completion. Cost The cost of a performance bond is a one-time premium, which typically ranges from 0.5 2% of the contract amount, depending on the size and type of the project and the contractor s bonding capacity. There is often no charge for the bid bond, and the payment bond may be issued at no The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 19

20 additional charge when issued in conjunction with a performance bond. The contractor generally includes the bond premium amount in the bid. Contract Amount Bond Premium $100,000 $1,200 $2,500 $1 Million $7,700 $13,500 $10 Million $56,950 $81,000 $50 Million $206,475 $341,000 Rates may vary depending on the size and type of the project and the contractor s bonding capacity. These rates are approximate and are intended to provide examples of the range of rates an owner might expect. A Contractor s History Is No Guarantee When Northland College in Ashland, Wisconsin decided to build the $12 million Larson-Juhl Center for Science and the Environment, the Board of Trustees didn t require performance or payment bonds. According to Harold Vanselow, Vice President of Finance and Administration, the college s Board of Trustees chose the construction company because of its history with the college. It had been in business for more than 100 years and the owner s great-grandfather laid the first stone for the first building of the college when it was built in A former owner of the construction company was at one time a trustee himself, and the company had successfully performed other projects for the college. By all accounts, it appeared the college made an informed decision on choosing a contractor. Vanselow stated that, The project continued on schedule and on budget, and the college made all payments to the general contractor in full, and on time. It came as quite a surprise when, after the project was nearly complete, seven subcontractors filed liens totaling nearly $900,000 because the contractor hadn t paid them. Because the Board of Trustees was so eager to develop a great science facility, it did not recognize the value of a bond. The Board believed the $70,000 - $100,000 bond premium could be better used on equipment and supplies for the new building. Now the college must find a way to settle $900,000 in liens on the completed project. Realistically, a contractor with a 100-year history of work on college projects who has successfully completed similar projects for similar contract amounts, and who had a good The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 20

21 reputation with the owner doesn t sound like much of a gamble. But the risk in construction often lies in the uncontrollable, unpredictable, and unknown. According to one of the subcontractors on the job, the company was having financial difficulties because of some problem jobs a few years earlier. Surety professionals make informed decisions when prequalifying a contractor for a bond. They look at the financial strength of the contractor, the management structure and ability, the volume and makeup of other work the contractor is performing, as well as the character and reputation of the contractor. This unique relationship with a contractor allows the surety underwriter and surety bond producer to evaluate each element and guarantee that the contractor can complete the job for the owner. Reputation alone does not complete contracts and a solid contractor can become an insolvent contractor very rapidly if one or more of the elements changes. The small fee for prequalification and the surety s financial guarantee of the project are very valuable products to an owner. The relationship that an owner has with a contractor is arm s length while a surety s relationship is a day-to-day partner. A surety has much greater insight as to a contractor s abilities to perform than any owner could possibly have. Specifying a Bond To require a bond on a project, simply state the requirement in the contract specifications. It is the contractor s responsibility to contact a surety bond producer and obtain the necessary bonds. The surety bond producer, also called an agent or broker, guides the contractor through the prequalification process and helps him or her develop a business relationship with a surety company. When the contractor submits a bond, read the bond form carefully and understand its provisions. Make certain all data is entered correctly and that it is signed and dated. Bond form language is important in determining the surety company s responsibilities and liabilities. The bond form should: Stipulate the parties to the bond; Indicate the surety company s maximum financial obligation known as the penal amount of the bond; State the surety company s obligations under the bond; Include the construction contract and specifications by reference; Provide a brief description of the project; and Give the location of the project. It Pays to Know the Surety Company Before you accept a bond, it is important to verify that it is from a reputable surety company. Contact your state Insurance Department or visit its Web site to confirm that a surety company is The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 21

22 licensed to do business in your state. As with any product, know what you are purchasing and take a few minutes to know with whom you are dealing. The Southgate Recreation and Park District in Sacramento, CA learned this lesson the hard way. A developer donated 146 acres to the park district adjacent to 1,100 acres he intended to subdivide. The stipulation was that the park district would build a golf course within four years or the land would revert to the developer. It sounded like a good deal for everyone - the park district would receive valuable land, the public would have a golf course, and the developer would receive a tax break and increase his property s value. A feasibility study estimated golf course construction at $3.9 million. The low bid was $3 million and the next lowest bid was $4 million. With such a huge gap, the park district should have questioned whether the low bidder submitted a responsible bid. However, lured by savings of $1 million, the park district awarded the contract to the lowest bidder. When the secondlowest bidder notified the owner that the contractor s surety company was questionable, the park district did nothing. Soon after the project began, the contractor experienced financial problems. He was spread too thin on other projects, was unable to pay subcontractors and suppliers, and soon filed bankruptcy, leaving the owner with an unfinished project and $500,000 in subcontractors claims. The park district soon learned that the surety company was just a shell and the bonds were illegal and unenforceable. Had the park district heeded the warning signs and checked with the state Department of Insurance, it would have learned that the surety company was neither licensed nor approved to do business in the state. It is unlikely that a responsible, licensed surety company would have bonded the original contractor. Said a California Department of Insurance spokesman, If there was more due diligence on the front end, this type of thing could be avoided. While the case is still in litigation, that free land and $1 million bid spread may end up costing the park district several million dollars. Contractor Failure Prevention and Response Surety underwriters and surety bond producers are a valuable resource to contractors, using their experience and knowledge to help contractors avoid extreme risks and overcome challenges. Most major surety companies have construction attorneys, accountants, and engineers to help viable contractors through temporary problems. The surety company can proactively respond in many different ways, and not just when a contractor defaults on a project. The surety underwriter is trained to make impartial judgments about whether a contractor can perform the contract, and does not expect a loss. However, losses do occur. Contractors may default if there are drastic financial changes in the economy, unforeseen changes in job site conditions, or death or illness of a key employee. Usually, it takes a combination of events to force a contractor into default. When that happens, the professional expertise of the surety company and surety bond producer is there. With the surety company s technical knowledge, The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 22

23 practical experience, and resources and the cooperation of the contractor and owner, losses can be minimized and the job completed to the satisfaction of all parties. A minimal number of defaults signifies that surety companies have been successful in screening out unqualified contractors from the bidding process. If inadequately financed or incompetent contractors are allowed to bid, particularly in the lowest bidder award system, the number and cost of defaults will increase. The surety is paid for prequalifying the contractor and assuring that the contractor will perform. One of the most difficult variables to account for in the prequalification process is the interdependent nature of construction. The difficulties listed above may occur on other projects being performed by the contractor, which ultimately affects all projects on which the contractor is working (including yours!). These setbacks may occur with a subcontractor or supplier and eventually cause problems on your project. This is why it is important not only to have the prequalification process conducted by the surety, but also to have its financial backing in the event default occurs. Why Contractors Fail Accounting & Management Issues Inadequate financial, accounting, and project management systems Change in ownership and/or personnel Change in scope of business Rapid over-expansion (volume and/or territory) Labor & Material Issues Subcontractor failure Non-bonded subcontractors/selective bonding of subcontractors Labor and/or material shortages Cost escalations Work Environment Issues Onerous contract terms and conditions Unexpected economic downturn Inclement weather Default is an unfortunate, and sometimes unavoidable, circumstance. To reduce the likelihood of contractor default: 1. Review the contract documents. Establish terms of the agreement, provide clear explanation of the contractor s obligations, and define what constitutes default. 2. Provide the contractor with a high-quality working set of plans and specifications. 3. Pay the contractor on time. 4. Maintain adequate insurance. 5. Communicate with the surety company to inform it of progress and any potential problems. 6. Notify the surety company of changes in the contract. The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 23

24 Claims The surety company has legal obligations to you and the contractor. It first must investigate a claim before taking action in order to protect the contractor s legal recourse in the event of improper declaration of default. On the other hand, the surety must keep in mind its obligations to you. To expedite the claims process, define default in the contract and communicate with the contractor and the surety company. Once notified of a default, the surety company independently investigates notices of disputes or claims and provides you with its assessment. Since this investigation must be impartial and responsible in order to meet state standards as well as their own company service requirements, claims investigations are thorough and can be timeconsuming. When the surety finds the contractor to be in default, it is obligated to respond to you and perform in accordance with the terms of the contract -- subject to the limitations and understandings contained in the performance bond. In addition to this obligation, the surety may exercise its option to proceed in discharging its bond liability, if any, without risking a claim by the contractor for interference with the contract. There are things you can do to manage the process: Verify validity of the bond before awarding the contract; Notify the surety of changes in the contract; Know who to contact at the surety company; Notify the surety as soon as you recognize problems occurring on the project; If possible, allow the contractor time to cure the default before termination; If default occurs, notify the surety company in writing and ask for a specific response; Be reasonable and diligent in providing notice of default; Request a face-to-face meeting to discuss the complaint; and Provide records and correspondence to the surety company; If the surety company s investigation finds that the contractor has defaulted on the project under the performance bond, the surety company, in most cases, may: Re-bid the job for completion; Arrange for a replacement contractor chosen by the surety company; Retain the original contractor and provide trained personnel and/or financial assistance; or Reimburse the owner (pay the penal sum of the bond). If the investigation reveals that the contractor is not in default, the surety company is not obligated to perform. The Connecticut Conference of Municipalities Information Kit Construction Bonds Page 24