STAFF REPORT June 22, 2005 To: From: Subject: Administration Committee Deputy City Manager and Chief Financial Officer Auditor General Procurement Processes Review - Bid Bonds/Performance Bonds Purpose: This report establishes a corporate policy to outline Bid Bond and Performance Bond requirements. Financial Implications and Impact Statement: There are no direct financial implications of this policy. It should be noted that this policy will clarify the usage of bid and performance bonds. Recommendations: It is recommended that: (1) Appendix A of this document, Use of Surety Bonds on the City of Toronto Procurement Contracts become the corporate procurement policy regarding Surety Bonds and that the policy be implemented as soon as logistically possible by Purchasing & Materials Management Division; and (2) the appropriate City Officials be directed to give effect to the foregoing. Background: City Council at its meeting of April 14, 15, and 16, 2003 adopted without amendment Audit Committee report No.1 Procurement Process Review City of Toronto which included in Appendix A Recommendation 35: The Chief Financial Officer and Treasurer, in consultation with the City Solicitor develop:
- 2 - (i) (ii) a corporate policy that outlines when Bid Bonds and Performance Bonds are required and the type of security that is acceptable; and a process to determine the dollar value of the security requested, taking into account the nature of goods or services to be provided, the magnitude of the contract and risks involved, to ensure that the interests of the City are adequately protected. Comments: Surety bonds are agreements by one party, the surety, to answer to a third person, called the obligee, for the debt or default of another party, called the principal. The surety guarantees a certain type of conduct on the part of the principal, and if the principal fails to behave in the manner guaranteed, the surety will be responsible to the obligee. Bid bonds guarantee that a bidder seeking to provide goods or services to the City will honour its bid price or forfeit its deposit. Performance Bonds are used to ensure that a contractor delivers goods or services as required under the contract and completes the job in a timely manner. The Performance Bond protects the City against potential financial loss in the event of nonperformance on the part of a contractor. The Auditor General has discovered a lack of clarity around the type of security that is acceptable for bids and that there are no corporate standards or guidelines with respect to when Bid Bonds and/or Performance Bonds are required and at what dollar value. Appendix A, Use of Surety Bonds on the City of Toronto Procurement Contracts attempts to harmonize practices within programs, and minimize exposures for the City to unnecessary risks in the event a contractor withdraws their bid after bid opening or does not meet the deliverables and other terms and conditions specified in the contract. Appendix A, Use of Surety Bonds on the City of Toronto Procurement Contracts clarifies what type of security is acceptable and establishes a corporate standard. Appendix B accompanies the policy with guidelines when Surety bonds are required and at what value. The Use of Surety Bonds on the City of Toronto Procurement Contracts were developed by a surety bonding working group struck to address the Auditor General s concerns and consists of representatives from Insurance and Risk Management, Legal, the Surety Association of Canada and Purchasing & Materials Management Division, in consultation with programs. It is recommended that Appendix A - the Use of Surety Bonds on the City of Toronto Procurement Contracts, be adopted as the corporate procurement policy on surety bonds.
- 3 - Conclusions: Appendix A, the Use of Surety Bonds on the City of Toronto Procurement Contracts clarifies the type of security that is acceptable for bids and establishes a corporate guideline with respect to when Bid Bonds and/or Performance Bonds are required and what dollar value is needed. The recommended Guideline addresses the concerns raised by the Auditor General s Procurement Process Review. Contact: Jeff Madeley, Manager, Insurance & Risk Management, Corporate Finance Tel: 416-392-6301; Fax: 416-397-4555; Email: jmadeley@toronto.ca Len Brittain, Director, Corporate Finance Tel: 416-392-5380; Fax: 416-397-4555; Email: lbrittai@toronto.ca Joseph P. Pennachetti Deputy City Manager and Chief Financial Officer Attachment: Appendix A Use of Surety Bonds on the City of Toronto Procurement Contracts Appendix B Guidelines for the Use of Surety Bonds on the City of Toronto Procurement Contracts (P:\2005\Fin\Cf\Ad05018Cf) - et
- 4 - Appendix A Use of Surety Bonds On the City of Toronto Procurement Contracts Purpose To establish a corporate policy governing the use of Surety Bonds within City of Toronto procurement contracts. Policy Surety bonds are endorsed by the City of Toronto as a suitable form of security for the performance of contracts. The policy provides: general guidance on when and how surety bonds should be incorporated into contract requirements standard bond forms that are endorsed by Insurance and Risk Management (IRM) and Legal a process of consultation or escalation through which a program or committee can obtain specific input and recommendations from IRM about the use of surety bonds in a specific contract. Criteria Categories of Bondable Contracts: For the purpose of this Guideline procurement contracts are arranged into three broad categories as follows: (a) (b) (c) Goods and Services Professional Services Construction Services Recommended Bond Amounts: Surety bonds are obtained to assure performance of a contract. The City requires surety bonds generally on contracts greater than $250,000 (see table below) or on contracts with risk factors that would require bonding below $250,000. Typically, the face amount (or penalty or bond amount ) of a bond is a factor of the value of the underlying contract. It is conventional that bonds are issued with a face amount of either 50% or 100% of the contract value as outlined in the table below. The City of Toronto Standard should reflect 50-100% of the contract value (which may consist of a 50% performance and 50 % labour and material payment bond).
- 5 - Note that there is no reference in the bond itself to the percentage relationship between the contract value and the bond amount. So, a 50% performance bond does not pay only 50% of a claim by the City. The bond will pay 100% of the claim up to the bond amount. The following bond types and amounts are recommended by category (subject to the Escalation process set out below). Category Bond Type Bond Amounts Bond Form A: Goods & Services Performance Bond 100% of contract value may be required where applicable based upon risk factors (i.e. an essential service) City Standard or CCDC* B: Professional Services C: Construction Services Performance Bond Agreement to Bond Bid Bond 100% of contract value may be required where applicable based upon risk factors (i.e. an essential service) N/A undertaking to provide performance/ payment bonds 10% of the bid price with consideration for contract size City Standard or CCDC City Standard or CCDC City Standard or CCDC Performance Bond 50% of contract value City Standard or CCDC Payment Bond 50% of contract value City Standard or CCDC (Labour & Materials) *CCDC Canadian Construction Documents Committee Risk Factors: Factors for Escalation: The surety industry pre-qualifies bidders based partly on the scope of contractual risk to be undertaken by the bidder. The City should anticipate that there may be some reduction in the number of potential bidders and/or an increase in the cost to a bidder to obtain a surety bond when one or more of the following factors are present in a contract. The program responsible should escalate and involve IRM in the process as early as possible, since it may be necessary for IRM to consult with the Surety industry in advance of a tender close to verify availability. The following are some of the factors to consider which may result in escalation: Contract duration more than 36 months; Contract warranty longer than 24 months; Design of a process (e.g. water or sewage treatment processes); Guarantee of the effectiveness or performance of a process or contract element;
- 6 - Liquidated Damages related to process design or efficacy and performance guarantee; Non-standard bond forms (the use of forms which are not City of Toronto standard forms); Requirement for bonds as part of a Request for Proposals (RFP s), or similar pre-tender prequalification process in which the RFP bonds guarantee delivery of further bonds for the performance of an uncertain future contract; Estimated or budgeted contract value significantly higher than what a program would consider a normal tender, or that the City would expect the construction market to perceive as being significantly higher than a normal contract value for that program. Escalation: If a program responsible for a procurement contract identifies any factor listed above, or whenever a program believes it prudent to seek the input and/or recommendations of IRM on a specific contract, the following escalation process should be followed: Notify IRM as far in advance of the tender closing date as possible, and provide information about the contract and the specific concern; IRM will if necessary contact the Surety Association of Canada to confirm the feasibility of any unorthodox or unique bonding requirement set out in City procurement documents. Standard Bond Forms: Types of Bonds: (a) Bid Bonds Provide financial protection to the Obligee (City of Toronto) in the event that the Principal fails or refuses to enter into a formal contract after its bid has been accepted in accordance with the bid document. A bid bond is a guarantee that if a bidder s tender or proposal is accepted, the bidder will enter into the contract within the time specified. If the bidder fails this obligation, the bid bond will provide a sum of money up to the face amount of the bond to bridge the difference between the amount of the original bid and the amount for which the City legally contracts with another party to do the work or supply the goods or services under the tender or RFP. This can also be identified, as an agreement to bond giving assurances that the specified appropriate bonds will be provided. A bid bond also provides assurance that the bidder is bondable by the surety (bonding company) and that the bidder will provide the City with the specified security which is usually a performance bond. A bid bond is not required unless risk factors associated with the tender require the imposition of the bid bond. It is inappropriate to require a bid bond if a performance bond relating to the contract will not be sought. Alternatives are a letter of credit or certified cheque.
- 7 - The acceptance of a certified cheque or a letter of credit is an acceptable alternative to a bid bond if a performance bond from a surety (bonding company) is not required on the contract. (b) Performance Bonds Provides an owner (Obligee, which is the City of Toronto) with protection ensuring completion of the contract in the event of default of the Principal (Contractor). A performance bond, subject to its limits, provides that the contractor will complete the contract in accordance with the plans and specifications, on time and at the agreed price. Where a maintenance clause is included in the contract, a performance bond automatically covers the maintenance clause. A performance bond is appropriate where installation, custom work or modification is included in the contract. Performance bonds are required with contracts for a value above $250,000 for the following types of purchases in addition to any projects which may be deemed essential to protect the interest of the City: e.g., equipment specifically manufactured; services; construction contracts; and specialized installations including supply of equipment. On occasion Goods and Services as well as Professional Services may require the use of a performance bond, which should be determined by the appropriate program at the time of tender. The acceptance of a certified cheque or a letter of credit may be an acceptable alternative to a performance bond as determined by the program in contact with the winning contractor. Performance bonds must be for between 50-100% of the contract amount except for construction contracts where the performance bond may be for 50% of the contract amount provided there is also a labour and materials payment bond for 50% of the contract amount. (c) Labour and Material Payment Bonds Ensure that the Principal s (contractor s) outstanding payables for labour and material, supplied under the bonded contract, are paid as described in the bond, thereby reducing the likelihood of liens against the City and schedule delays. Procedures Administrative Guidelines for Handling Surety Bond Claims: Claims Process: When a demand is made by the City under a bond the Surety will investigate the circumstances surrounding the demand. An investigation will be launched by the surety to determine if a contractor is actually in default, if the contractor has complied with the contract and what is the status of the work.
- 8 - If the contractor is found to be in default the surety will determine requirements for completing the project with several options available under a bond. Once a solution is determined the project is completed with the goal of minimal disruption. Claims Options: Options available include: Arrange for completion of the project by using a new contractor chosen by the surety. Agree to the terms of completion by the City and the surety funds costs in excess of the contract balance (if applicable) Negotiation of an amicable settlement for the completion of the project between the existing contractor and the City. Contact Jeff Madeley, Manager, Insurance & Risk Management 416-392-6301 Erick Gawlik, Senior Risk Management Analyst, Insurance and Risk Management 416-392-0850
- 9 - Appendix B Guidelines for the Use of Surety Bonds On the City of Toronto Procurement Contracts Reference Guide to the Use of Surety Bonds: Definitions: Bond Amount the maximum amount for which the Surety will be liable under the bond Principal the contractor or subcontractor whose performance is guaranteed by the Surety and who has entered into a written construction contract with the Obligee (City of Toronto). Obligee the owner or contractor (City of Toronto) who hold the bond and who has entered into a written construction contract with the Principal (Contractor). Surety the surety company that prequalifies the Principal, and issues and (with the Principal) executes the bond. Contract the written agreement between the Principal (Contractor) and the Obligee (City of Toronto). Surety Bonds vs Insurance - Surety bonds are often confused with insurance polices. Despite similarities, surety bonds involve three parties, while insurance are two party agreements whereby one party (the Insurer) agrees to indemnify another (the Insured) for a defined loss or set of losses. Surety bonds, are effectively credit instruments, and are underwritten much like a banker assesses a loan application. In this case, no losses are anticipated and if the underwriter believes a contractor may not be able to perform his or her contractual obligations, no bond will be issued. Premiums for bonds do not pay for losses; rather, they are a service fee for extending the required credit. The Surety also has the right to recover any losses from its Principal should it be forced to pay out under a bond. Principals seeking surety bonds are invariably required to sign an indemnity agreement under which they specifically agree to those terms. It should be noted that the surety bond will only comply with the contract obligations imposed by the City in the signed contract.
- 10 - Surety Bonds vs Letters of Credit - A Letter of Credit offers an owner the promise of cash on demand. They are first demand instruments under which the issue (usually a bank) must pay cash to the holder immediately upon a demand. There is no need to prove that the contractor is in default although a document to that effect is usually required. It should also be noted that the contractor might take legal action against the City in the event that the terms of the contract were not breached. A Letter of Credit or other liquid security allows the owner (City of Toronto) to fully control the default rectification process and eliminated the need to deal with the bonding company. A Letter of Credit can have a negative impact on a contractor s cash reserves and borrowing power. In some cases a Letter of Credit can restrict access to cash that may be required to address a problem on a job. Performance bonds can be in force for 2 years following Substantial Performance or Full Completion of work. Contractors posting cash or LOC may request security returned or reduced following completion but before the warranty period expires. Unlike Letters of Credit, Surety Bonds are not liquid security and will not provide cash on demand but provide a guarantee of performance on default which may result in the bonding company arranging for completion of a project that is in default. It should be noted that Letters of Credit do not provide prequalification. Although Letters of Credit or certified cheques may be alternatives to performance bonds, these alternatives leave the City to resolve performance issues on a contract without the benefit of a surety to take responsibility for completion of the project and no protection that the contract will be completed at the awarded price. Licensed Surety Companies: Contracts should specify that Bonds (when required) must be executed by a surety or insurance company duly registered and licensed under the Insurance Act, R.S.O. to conduct the business of suretyship and/or guarantee insurance and/or surety insurance by the Financial Services Commission of Ontario. Arrangements regarding the fees charged by sureties to contractor clients are the subject of private agreements between a surety and its client and can vary widely. The City should be aware, however, that typically the fees charged to contractors for bonds are calculated on the total contract value, and not on the bond amount inclusive of GST. At completion of a contract, sureties may assess the net value of any approved changes during the contract and assess an additional fee to reflect the higher contract value. The City should anticipate that contractors may either include such additional fees with their change order requests, or may ask for a further reimbursement at the conclusion of the contract. A similar fee may arise if work is extended beyond the original terms. Staff should be diligent in reviewing any such changes before payment.
- 11 - It should also be noted that such additional fee is charged to the contractor based on the increased risk to the contractor s organization represented by the increased contract value. The increased fee does not mean an increase in the bond amount. The bond amount will remain constant. Construction Industry Capacity: In the Construction Services category, in setting the percentage/value of the bonds, the City should be aware and take into consideration the capacity of the local or targeted construction bidding market when tendering a contract. For contracts having a total value, scope or type of work that is or would likely be perceived by the construction community to be a significant departure (usually an increase in value or specialty/complexity) from a normal tender by a program, the City should anticipate a more limited demand (i.e. number of bidders and bid price competition) than would be anticipated for a normal tender. Consultation with the Surety Industry: Surety Association of Canada The Surety Association of Canada (SAC) is a representative association of licensed surety underwriters across Canada. While not all licensed surety companies are members, SAC membership currently represents the vast majority of the total market for surety bonds in Canada. These guidelines where developed with input from the Surety Association of Canada. Surety Forum It is recommended that the City of Toronto convene an annual Surety Forum involving representatives of the Surety Association of Canada and of the following programs and stakeholders within the City of Toronto administration: Insurance and Risk Management (project lead)/ Corporate Finance Legal Services Purchasing and Material Management Division Participating Programs The purpose of these annual Surety Forums is to: Encourage good and ongoing communication between the City of Toronto and the membership of the Surety Association of Canada; Encourage a formal dialogue on issues of common interest or concern; and Review and obtain from the SAC recommendations for any amendments or revisions to these guidelines.