THE USE OF CONSTRUCTION BONDS IN THE USA FLANDERS INVESTMENT & TRADE MARKET SURVEY

THE USE OF CONSTRUCTION BONDS IN THE USA FLANDERS INVESTMENT & TRADE MARKET SURVEY

In the United States, the use of construction bonds is common in construction projects. It is issued by an insurance company or by a bank. Insurance bonds: types of construction bonds 1 Difference between an insurance and a bond An insurance is a two party contract, between the insured and the insurance company, designed to compensate the insured against unforeseen adverse events. The policy premium is actuarially determined based on aggregate premiums earned versus expected losses. A surety bond is a three party contract whereby the surety assures the project owner (obligee) that the contractor (principal) will perform a contract in accordance with the contract documents. When a contractor requires its subcontractors to obtain bonds, the contractor is the obligee and the subcontractor is the principal. The surety prequalifies the contractor based on financial strength and construction expertise. Since the bond is underwritten with little expectation of loss, the premium is primarily a fee for prequalification services. Bid bond Most obligees require deposing of a bid security in the form of a bid bond. The bid bond assures that the bid is 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 amount of the bid security is usually 10%. But can range from 5% to 25% or more. Final bonds Final bonds are made up of a performance bond and a payment bond. In some cases they may also include a maintenance bond or a warranty bond. These bonds must always refer and be part of the terms and conditions of a specific contract. A contract bond is not a stand-alone document. The premium is based upon the final contract amount and covers the performance bond, payment bond and usually about one year of maintenance or warranty bond. Performance bond The performance bond protects the owner from financial loss should the contractor fail to perform the contract in accordance with its terms and conditions. 1 Sources: South Coast Surety, www.southcoastsurety.com Surety Information Office, www.sio.org The use of Construction Bonds in the US February 2016 2

Payment bond The payment bond assures that the contractor will pay specified subcontractors, laborers, and materials suppliers associated with the project. In public works contracts, the parties covered by the payment bond are specified in the Civil Code. Maintenance bond A maintenance bond guarantees the owner of a completed construction project for a specified time period against defects and faults in materials, workmanship and design that could arise later if the project was done incorrectly. It lasts typically no longer than one year. Warranty bond The warranty bond assures that the contractor will correct any deficiencies in material or workmanship for a specified period of time, usually one year from the date of completion. Often this obligation is considered part of the performance bond and a separate bond may not be issued. Cost of bonds Surety bond premiums vary from one surety to another, but can range from 1% to 3.5% of the contract amount, depending on the size, type, and duration of the project and the contractor. This amount will be higher for new contractors who cannot provide the necessary financial papers. Typically there is no direct charge for a bid bond, and in many cases, performance bonds incorporate payment bonds and maintenance bonds. The bond premium is usually paid up front. Existing clients can get credit (30 days). When bonds are specified in the contract documents, it is the contractor s responsibility to obtain the bonds. 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 changes, the premium will be adjusted for the change in contract price. Payment and performance bonds typically are priced based on the value of the contract being bonded, not necessarily on the size of the bond. For contractors working on several projects at the same time, it is possible to get an aggregate bond that covers several projects. The premium will be based on what it costs to finish the project, not on the total project cost. Every surety is filed with the State Government. 4

How to begin The surety bond producer The first step is to contact a professional agent or broker that works for a Surety Insurance Agent. They are also known as a surety bond producer because they specialize in contract surety. The surety bond producer will guide the contractor through the bonding process, help establish and foster a business relationship with a surety company, and assist in managing the contractor s surety capacity. After meeting with the contractor and gaining an understanding of the firm s business and needs, the producer tailors the contractor s submission for the specific requirements of the surety company. The producer then submits the account to a surety company best matched to the contractor s profile and needs. The producer is an essential link between the contractor and the surety company and will therefore maintain communication with both. Value of a surety insurance agent Acts as a consultant in the selection process of other team members (e.g. banker, lawyer accountant); Helps to establish and maintain your Surety Support; Helps the contractor with business planning, especially discussions on risk management; Helps the contractor grow his or her surety program; Helps the contractor to present the information as positive as possible to the underwriter. Surety company underwriter Once the surety bond producer collects all the necessary information, he or she submits it to a surety company underwriter. The underwriter takes an in-depth look at the contract s entire business operations and must be satisfied that the contractor is capable of completing the project. A surety underwriter s primary goal is to prevent default. They make decisions on surety capacity (experience, working capital and cash flow). Prequalification process Each surety company has its own underwriting standards and requirements, but there are shared fundamentals common to the underwriting of most surety companies. Before a surety underwrites a bond, the contractor typically undergoes a careful, rigorous, and thorough process, often referred to as prequalification. The prequalification process takes time as the producer collects information, answers questions the surety underwriter may have, and assists in verifying information. 4

The surety must be satisfied that a contractor has the ability to meet current and future obligations, has a good reputation, has experience meeting the requirements of the projects to be undertaken, and has (or can readily obtain) the equipment necessary to perform the work. The surety also looks for contractors who run a well-managed, profitable enterprise, keep promises, deal fairly, and perform obligations in a timely manner. Prequalification checklist Here is what a contractor may need to provide: An organization chart of key employees and their responsibilities; Detailed resumes of key employees; Business and personal financial statements; Work in progress schedule as well as a history of the largest completed jobs; Evidence of a bank line of credit to augment working capital and to handle temporary cash flow deficits or stains; Marketing material; Letters of recommendations or references from subcontractors, owners, architects, and engineers on completed projects; A business plan outlining the type and size of work sought, prospects for such work, the geographic area in which the company operates, and growth and profit objectives. Continuity and contingency plan outlining how the business will continue in the event of the owner s death of disablement. Prequalification criteria The 3 C Capacity: Can the contractor perform the obligations of the contract? Does the contractor have the necessary structure, people and equipment? Capital: Does the contractor have the financial strength to fulfill the terms of the contract? Character: Historically, how has the contractor performed? What is the contractor s reputation? How are problems handled? Capacity: Ability to perform Can the contractor perform this type of work; Analysis of past projects size, profitability; Current workload cost to complete; The use of Construction Bonds in the US February 2016 5

Does the contractor have enough work crews; Does the contractor have the necessary equipment? Capital: Financial strength In depth, detailed evaluation of the contractor s financials strength: o Business financial statement as of fiscal year end and current interim on the % of completion basis; o Personal financial statements; o Bank line of credit; o Alternative solutions to lack of financial strength. Character: References and reputation Of the construction firm: o Business relations with Primes, subcontractors and vendors Previous owners, architects, engineers Banks o Credit reports Business Dunn & Bradstreet Personal credit reports of owners Financial statements Depending on how long the contractor has been in business, the surety will request fiscal year-end statements for at least the past three years and may require a financial statement audited by a certified public accountant (CPA). Quality of financial statements Financial statements are only as good as the accountant preparing them. That is why it is important to select a CPA who is knowledgeable of construction accounting and the American Institute of Certified Public Accountants Audit Guide for Constructions Contractors. 6

Sureties prefer, and at certain levels require, audited fiscal year-end statements, but there are occasions when a surety may accept a review or compilation statement. Audit The highest level of service performed by a CPA. An audit verifies relevant items, such as the balance sheet, with internal and external investigations of their accuracy. The objective is to obtain reasonable assurance financials that are accurate according to GAAP. An audit can take 1 or 2 months and costs between 10.000 and 20.000 USD. It is usually required for companies with revenue above 10 million USD. Review A middle level of service performed by a CPA. A review statement, which does not require the outside verification present in an audit, consists principally of a thorough review of the contractor s financial records and the application of certain analytical procedures to the financial data. The fee for a review is around 5.000 USD, and is usually required for companies with a revenue under 10 million USD. Compilation The CPA takes information from the management of the company and compiles it into a report. A compilation, however, provides little or no assurance of the credibility of the figures presented and would typically be accepted only for interim statements. The cost is generally a few thousand USD. Maintaining the surety relationship Start with smaller projects and grow the business. To maintain and increase surety capacity, it is important for a contractor to develop and maintain an ongoing relationship with the underwriter and producer. Developing a relationship requires commitment, trust, and above all communication. Maintaining the relationship through open communication and timely reporting on the company s financial condition and job status builds trust with the surety. Maturing into a growing partnership requires teamwork and an organized effort among the contractor, the surety underwriter, and the surety bond producer. There may be difficult times, and the surety may not always be willing to extend the surety capacity the contractor would like, but maintaining a relationship with the surety company builds trust and increases the surety s commitment to the contractor over time. The use of Construction Bonds in the US February 2016 7

Conclusion Even after all the information is provided to the surety there is no guarantee it will result in approval. The bond will be approved only if the surety is confident the contractor is qualified to perform the contract and work program successfully and has the financial capacity to withstand the numerous risks involved in the construction business. The decision to seek surety bonds should be based on long-term considerations. For Belgian companies which are recently established in the US or which do not have any presence in the US, it may be a challenge to get a surety bond. You can contact the brokers listed below to see what is possible. Surety producers The following brokers have experience with assisting foreign companies to get a performance bond: Steve Swartz, President South Coast Surety, Insurance Services Inc. 1100 Via Callejon, Suite A San Clemente, CA 92673 Website: www.southcoastsurety.com Tel: +1 (949) 361-1692 E-mail: steves@southcoastsurety.com Cynthia Baldonado, Contract and Commercial Bond Producer Viking, Bond Service Inc. 22601 N. 19 th Avenue, Suite 210 Phoenix, AZ 85027 Website: www.performancesuretybonds.com Tel: +1 (623) 933-9334 E-mail: cynthiab@vbsbond.com 8

Bank guarantee: Standby letter of credit 2 This is an alternative to the surety bond issued by an insurance company. A Standby Letter of Credit or Guarantee is a written undertaking given by the bank to the person with whom you are doing business (beneficiary) to pay a specified amount of money in the event that you or a third party do not meet specific financial or performance obligations. Difference between a Standby letter of credit and a Commercial letter of credit A standby letter of credit is similar to a commercial letter of credit used for import/export transactions in that a bank substitutes its credit worthiness for that of its customer. The commercial letter of credit facilitates trade through the use of documents evidencing performance and drafts. The standby letter of credit, however, often represents an obligation of the issuing bank to the beneficiary to 1) repay money borrowed by or advanced to or for the account party, or 2) make payment on account of any indebtedness undertaken by the account party, or 3) make payment on account of any claimed default by the account party in the performance of an obligation. Note that in each of these cases, payment is effected against the beneficiary's claim that default has occurred. In no case does the issuing bank agree to guarantee the completion of any project or contract, nor is it bound to make determination of fact(s) regarding the underlying transaction. The bank's liability is financial only. What are they used for? Bid bond Contracting parties involved in sizeable projects frequently request contractors bidding on the project to post a bond or standby letter of credit for a percentage of the contract amount. These are used for the bidding process only, and assure the contracting party that the contractor they selected will honor the original bid. Advance payment bond When the contractor, who has been awarded the project, begins work, an advance payment may be required for materials, startup costs, or general working capital. The contracting party generally requires a bond or standby letter of credit to ensure that the advance payment will be used for the project. In the event of contract default, the payment can be recovered from the bank, which issued 2 Bank of the West, www.bankofthewest.com The use of Construction Bonds in the US February 2016 9

the standby credit. These standby letters of credit can be issued to progressively decrease in amount through the life of the credit. Performance bond Throughout the life of the project, the contracting party is interested in ensuring that the project will be completed in accordance with its terms and conditions. A standby credit may be required to provide financial reimbursement in the event of default by the contractor. These are generally designed to decrease in amount over the life of the project. The language in the standby Bank customers, as applicants for a standby letter of credit, are encouraged to ask the beneficiary for the language they want in the standby. Most beneficiaries, who regularly accept standbys, will provide the applicant with an example of their format. Before the standby is issued, the customer, bank, beneficiary, and confirming bank, if any, should all agree on the language to be included. This prevents delays and saves amendment expense. When/how is payment made? To be paid, the beneficiary must comply with the standby's terms and conditions and submit the required documents. When paying, the bank is interested only in the conforming documents required by the letter of credit. In no instance would a bank investigate the accuracy or correctness of any statement made by the beneficiary. Also, the bank is not interested in the underlying transaction's terms and conditions. Standby L/C procedures Basics of Standby Letters of Credit Banks in the United States historically have not been allowed to issue guarantees. U.S. banks and foreign banks operating in the U.S. issue standby letters of credit, which act as a substitute in part for a guarantee. The drawing under the standby letter of credit is triggered by the beneficiary s statement of nonperformance of the underlying transaction. 10

Under letters of credit, banks only deal with documents. Banks do not research the truth of the non-performance (i.e. unpaid invoices, late delivery of product, etc.) nor do they make determinations of fact. The trigger language in the standby is the critical element of the standby letter of credit, and it is basically a statement by the beneficiary that non-performance has occurred. Most beneficiaries, who regularly accept standbys, have their own preferred text for the standby letter of credit. The applicant and the beneficiary of the letter of credit should give Global Trade Services sample language for the L/C as it relates to the underlying transaction, keeping in mind that the detailed specifics in any underlying contract should not be repeated in the letter of credit. Drafting the L/C There are at minimum three parties who must agree on the text of the letter of credit: the applicant, the beneficiary, and the bank. Once the bank receives sample language, the bank will draft the L/C using your basic language to conform to the rules of letters of credit, the UCP 600 or ISP 98, and their own internal requirements. Since the text is custom drafted for each standby letter of credit, sufficient time must be allowed: to draft the text, obtain your consent, the approval of the beneficiary, and make any agreed changes. The time frame must also take into account your internal approvals as well as the bank s credit approval process. The final steps, which also take time, are the preparation of the actual L/C by Global Trade Services; careful proof reading of the text, and the sending out of the L/C by courier to the beneficiary or by authenticated SWIFT to the beneficiary s advising bank. We recommend that at least ten business days be allowed for the entire standby letter of credit process, from drafting to receipt by the beneficiary of the issued L/C. Credit approval The issuance of a standby letter of credit requires specific credit approval for this type of transaction, especially with regard to the length of time (validity) the standby L/C will be outstanding. Many standby letters of credit involve a validity in excess of a year, which exceeds the maturity of the annual line of credit. This may be solved by an automatic extension clause, which gives the bank the option of extending or not extending the standby L/C. Fees Compensation for the credit risk is set by your bank and is reflected in the per annum percentage issuance fee paid at the time of issuance. Check your bank for the minimum fee and processing charge, as well as other out-of-pocket expenses. Depending on the complexity of the standby and the The use of Construction Bonds in the US February 2016 11

language supplied by you, there may be special handling/consultation fees assessed for the drafting of the standby letter of credit. Banks to work with For Belgian companies, it takes time to build a relationship with a local bank. The following banks in the US have special links with Belgium and provide special services to Belgian companies: Julien Christiaens, AVP Business Development Officer Benelux, Central & Northern Europe Bank of the West International Clientele Department - RBG 180 Montgomery Street 9th floor San Francisco, CA 94104 Website: www.bankofthewest.com Tel: +1 (415) 399-8237 E-mail: julien.christiaens@bankofthewest.com Bank of the West is owned by BNPParibasFortis Bill Cavanaugh, Trade Finance KBC Bank NV, New York Branch 1177 Avenue of the Americas, 8th Floor New York, NY 10036 Website: www.kbc.com Tel: +1 (212) 541-0761 E-mail: william.cavanaugh@kbc.be 12