FAQ Construction Bonds

A surety bond is a promise to be liable for the debt, default, or failure of another. A surety bond is a three-party contract by which one party (the surety) guarantees the performance of a second party (the principal) to a third party (the obligee). Surety bonds that are written for construction projects are called contract surety bonds. (Otherwise, they are called commercial surety bonds.)

The surety is a company licensed by a state department of insurance to provide surety bonds to third parties to guarantee the performance of a principal.

The principal is the person or entity (in construction, the contractor or subcontractor) on whose behalf the bond is given. It is the principal’s obligation that the surety guarantees.

The obligee is the individual or entity with whom the principal has a contract and to whom the bond is given. In construction this is the project owner or the prime contractor. If the owner is the bond obligee, then the prime contractor is the principal. If the prime contractor is the obligee, then the subcontractor is the principal.

Depending on the level of support desiered requierments will vary below are the common items need for programs with needs over 500K.  Past 3 fiscal year-end financial statements  Current interim financial statement and aging receivables and payables report  Copies of any bank loan agreements, including lines of credit and recent line of credit statement  A current personal financial statement  A current statement of work in progress  Resumés of owners/key employees  Letters of recommendation about the accomplishments of your company  A statement of qualifications for the company  Certificate(s) of insurance  A contractor’s questionnaire

A bid bond provides financial protection to the obligee (who can be the owner when the general contractor provides the bonds, or the general contractor when the subcontractor provides the bonds) if a bidder is awarded a contract but fails to sign the contract or fails to provide the required performance and payment bonds. The bid bond also helps to screen out unqualified bidders, as a surety will not issue a bid bond on behalf of a contractor that it believes cannot fulfill the contract obligation. Prequalification means that the surety has investigated the contractor and determined that the contractor has the ability to carry out the work under the construction contract. The surety’s specific obligation under the bid bond is set forth in the bond itself. The surety is usually obligated to pay the owner the cost of having to repeat the bid process if the awarded bidder is unable or unwilling to perform. The surety’s liability is generally limited to the face amount, or penal sum of the bond, which is in the range of 5 to 20 percent of the contract price.

The bid bond is both a percentage of contract security and evidence of prequalification for the ultimate contract value. Thus, consideration of the full contract amount on bid day is necessary at the same time the bid bond is being considered. If the contractor is deemed qualified to perform the contract, the bid bond is issued. If the contractor is deemed unqualified to perform the work, the bid bond will not be approved, notwithstanding that the bid bond is only a small percentage of the contract amount

A performance bond provides an obligee with a guarantee that, in the event of a contractor’s default, the surety can be called upon to complete or cause to be completed the contract in accordance with the plans and specifications. Bonds differ in terms of the types of options available to the surety, and to the obligee, in the event of a default. If the bonded contractor fails to perform its work in accordance with the plans and specifications, the owner, which has performed its contractual obligations, has a right of action against the surety to obtain completion of the contract and enforce the owner’s rights under the contract.

The cost of a bond is based on rates filed with the state insurance department. The cost of a bond can vary, from less than 0.5% to as much as 3%. For a small and emerging contractor with minimal experience, a contractor can expect the rate to be between 2-3%. There are always adjustments to the bond premiums based on the final contract price. If the price increases, there’s an increase in premium; and if the price decreases, the premium is reduced as well. A contractor should always include the cost of its bond in all proposals and in its change orders, no matter how small because bond premiums are typically reimbursed. Several small change orders over time can turn into a large increase in the contract, which will result in an increase in premium. A contractor wants to avoid the premium coming out of its profit. If a surety requires a U.S. Small Business Administration (SBA) guarantee or funds control/escrow as a condition of approval, the cost of the bond can increase up to an additional 1% of the total contract price. These fees are paid to the SBA and/ or escrow company and are in addition to the premium paid to the surety.

A payment bond ensures that certain subcontractors and suppliers will be paid for labor and materials incorporated into the project, if the bonded principal fails to pay for labor and materials supplied for the project. A laborer or supplier that has a right to make a claim against a payment bond is referred to as a “claimant.” Who is a proper claimant under a payment bond is typically restricted or limited by statute, the contract, or the bond. Most payment bonds require a claimant that does not have a contract with the principal to give the principal or surety, or both, written notice of its claim within a specific period of time after furnishing the labor or materials for which the claim is made. It is critically important to meet these deadlines, in the bond or any statutes governing the bond, or the claimant will lose its rights under the bond.

A warranty bond (sometimes called a maintenance bond) guarantees the owner that any work defects found in the original construction will be repaired during the warranty period. They are typically used when an owner wants a warranty period beyond one year. A warranty period can be extended for an annual fee, but sureties are reluctant to go beyond a few years. If the contractor is unable to resolve the warranty issue or is not in business during the specific warranty period, the warranty bond provides the owner with a remedy. The annual fee for a warranty bond is a fraction of the cost of a performance bond.

A general agreement of indemnity, or GIA, is a contract between a surety company and a contractor. The GIA is a powerful legal document that obligates the named indemnitors to protect the surety company from any loss or expense that the surety suffers as a result of having issued bonds on behalf of the bond principal. Therefore, under a GIA, if the contractor fails to fulfill its bonded obligation on a project, and the surety suffers any loss, the indemnitors are legally bound to indemnify, or pay back, the surety for its losses. The surety’s losses include what is paid to finish the project and the expenses associated with the surety’s diligence in investigating the claim itself. A fundamental concept of suretyship is that the surety will not sustain a loss. The surety expects to be indemnified (that is, paid back) and reimbursed for any payments or losses by the principal and indemnitors under the indemnity agreement so that the surety has no ultimate loss. Therefore, the GIA is almost always signed and delivered to the surety before the surety will issue any bonds on behalf of the principal. The GIA will apply to all bonds issued by the surety for the principal. A GIA is a standard document in the construction and surety industries, which provides a surety issuing bonds with many enforceable legal rights against the indemnitors that signed the GIA. Contractors should be aware, however, that there is no standard indemnity agreement and that the language of GIAs varies from surety to surety; and few sureties will negotiate the terms of their specific GIA. Before signing a GIA, a contractor should review and understand it to ensure there are no provisions in the GIA that are too risky to the business. Courts will readily enforce the unambiguous provisions in GIAs. Prudent contractors should consider seeking advice from knowledgeable legal counsel before signing a GIA.

Two methods of accounting for contractors are generally accepted under accounting guidelines: (1) the completed contract method; and (2) the percentage of completion method. The completed contract method is only allowable in circumstances not resulting in a significant variation from the percentage of completion method. Under the completed contract method, all costs and revenue recognition are deferred until the contract is completed. This method is recommended where estimates are unreliable; it is contradictory to what a surety professional would typically require. It likely only applies to home builders and to contractors with seasonal work, or for contracts started and completed within the same fiscal year. The percentage of completion method of accounting for contractors is preferred and is more likely to be demanded by surety professionals. Using this method presumes that a contractor has the ability to make reasonable cost and revenue estimates and that the owner is expected and able to satisfy obligations under the contract. There are different ways to determine percentage of completion. Generally, the cost-to-cost method is used. Estimation of revenues on a contract can be complex. Key items include the original contract price, contract options, change orders, claims and provisions for acceleration payments, and liquidated damages. All must be considered to arrive at an adjusted contract price. The percentage of completion, multiplied by the adjusted contract price, establishes the amount earned as of the financial statement date. While a more in-depth discussion around the appropriate treatment of these contract adjustments would be needed, surety professionals will watch for the clarity of the disclosure in the financial statements and analyze how reliable the contractor has been in the past.

A financial statement is the main source of information about a contractor’s financial position, its performance, and changes in its financial position. It is important because a contractor’s financial statements provide users with the information necessary to make economic decisions about the contractor. The financial statement is used by bankers, sureties, vendors, investors, and others to make assessments about the contractor’s future risks and potential and to establish benchmark trends and relationships. They provide the basis for obtaining credit, setting capacity limits, and identifying investment opportunities. Users rely on data within the financial statements and data that can be derived from them to make their judgments, among which are:  Working capital – current assets less current liabilities  Net worth – owners’ investment in the contractor  Debt to worth – measure of the contractor’s financial leverage  Activity ratios – measure of how the contractor uses its assets  Coverage ratios – measure of a contractor’s ability to meet its obligations  Contract/revenue backlog – amount and quality of the contractor’s uncompleted work Clear and concise footnote disclosures are key components to a quality financial statement, providing a road map for the user to properly interpret the information in the contractor’s financial statement.

CPAs offer three financial statement services based on the level of assurance that a contractor might require. A compilation, the lowest level of assurance, is when financial statements are compiled based on information provided by the contractor. Although a CPA looks over the statements, the CPA does not give any assurance to the validity of the original figures. While this information is generally sufficient for smaller, privately owned companies, it is likely not enough when third parties become involved. The next level up and the most commonly used is the review. During a review, the CPA will take a deeper look at the contractor’s financials to make sure that no material modifications need to be made. Once a review is complete, the CPA will conclude that he/she is not aware of any significant changes necessary to the financial statements. Because of this conclusion, and the required independence of the CPA during a review, many creditors and regulatory agencies require review-level assurance before working with a contractor. Many owners also find this level of assurance helpful if they do not manage day-to-day operations of their organization. An audit is the most comprehensive service, providing the highest level of assurance that a contractor’s financial statements accurately reflect its financial position. An audit takes the review one step further by not only looking at specific transactions, but also verifying them with sources outside the organization to assess accuracy. Not all contractors will need the extensive assurance of an audit, so it is always beneficial to confer with a CPA, and your surety bond producer, to determine the right level of financial statement preparation that will be needed.

Contractor prequalification, as performed by surety underwriters, involves a thorough and continuing process for reviewing and evaluating balance sheets, workin-progress schedules, and financial statements. Surety underwriters also evaluate factors such as the risk under the specific contract for which the contractor seeks a bond, the contractor’s entire work portfolio, past performance, experience, operational efficiency, managerial skills, business plan, and reputation for integrity. Obtaining bonds is more like obtaining bank credit than purchasing insurance. Different sureties will stress varying factors during the underwriting process, but almost all will consider the following factors: Financial capacity Net worth Cash flow Assets Credit score Work in progress Work history, including expertise and experience Banking relationship Nature of project to be bonded Character of the contractor