Month: September 2014

Secrets of Bonding #73: Substitute Bid Bonds

Remember how much fun it was to have a substitute teacher? Well, this is a little less exciting…

In Secret #49 we talked about bidding with a check.  This is a related topic. Substitute bid bonds are an odd part of what we do as surety professionals.  Here’s how you may run into one.

It is common for project specifications to offer a number of methods to provide the bid security that accompanies a contractors project proposal.  The options may include a check made out to the obligee, or a bid bond.

A substitute bid bond may be issued after bid security has already been given with the contractor’s proposal.  This bid bond will replace, or be substituted for the existing security – thus the name.

This may arise when the contractor has no surety at the time of the bid.  They bid with a check.  Now, with a surety in place, their first request is “How about helping us get our cash back?  It’s tied up with that bid.”

What a great way to start off by helping the new client. However, sureties are not always in favor of issuing these, and some refuse to do so under any circumstances.  Why?!

1. Bid Spread: In this case, the contractor is the low bidder, but they are too low. (Read Secret #16 to learn about unacceptable bid spreads.) The contractor may be in line for the project, but the surety does not want to issue the performance bond (aka final bond).  If the bonding company provides the substitute bid bond, they become obligated to issue the final bond or face a bid bond claim (two bad options!) “Sorry, we are not able to provide a substitute bid bond for that project.”

The fallout is that the contractor may blame the surety when they lose their bid security for failing to deliver the final bond. They will also lose the expected income from the project – pretty ugly.

2. Final Bond Optional: The specs may indicate that a Performance & Payment bond is not mandatory. It is optional at the obligee’s discretion. This amounts to adverse selection against the surety.  If the obligee thinks the contractor looks capable: No bond.  If there is some doubt about their ability to perform or the adequacy of the price, better pass the risk over to the bonding company.

For this reason, substitute bid bonds may be declined if a final bond is not mandatory.  Remember, final bonds are where sureties make their money.  Bid bonds are usually free.  The contractor will not lose anything as a result of the refusal to issue the substitute and they are already eligible to win the contract.

3. Not Low Bidder: This is similar to Number 2. Here the contractor is second or third bidder. The common practice is for obligees to hold the bid security of the second and third bidders in case they need to give them the project (maybe the low bidder can’t get their final bond issued?) The bid checks could be held for months!

From the surety’s perspective there is no question about the adequacy of the second or third bidder’s number.  This may be a well-priced contract. The problem is that they are unlikely to issue a final bond.  (Projects are rarely awarded to the second or third bidders.) This has even less chance of making money for them than a normal bid bond request.

To the contractor, a substitute bid bond may seem like a great idea. For the surety, the only desirable situation is when their client is low bidder with an acceptable bid spread and a mandatory final bond. Absent that, don’t be surprised if the surety only wants to get involved after the contract award takes place and the final bond is needed.

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Secrets of Bonding #72: Surety Consents 1, 2, 3.

Sorry OCD, we are starting with Consent #3!

#3: Surety Consent to Release of Final Payment

This may be one of the final steps in the life of a bonded contract. The obligee (party protected by the bond) may give the surety the opportunity of providing a “consent to release final payment” before the last money is paid out.

 It is common for contractors to be paid on a monthly basis.  When it is time for the final payment, it may be the obligee’s last opportunity to influence the contractor to resolve deficiencies in the work product.  The contractor may be more likely to make corrections before the last money is paid out than after.  Un-resolved problems can eventually become bond claims.

 The bonding company should determine if the obligee is satisfied with the work (Status Inquiry form) before issuing the consent. In this manner, they may spur the contractor to action and  eliminate a potential bond claim.

 This procedure benefits the obligee in two ways:

  1. The surety will require responsiveness to the obligees reasonable performance demands before consenting to the payment
  2. It reduces the surety’s ability to refuse a future bond claim on the basis that funds were improperly released by the obligee

View sample: http://74.218.115.26/wp-content/uploads/2010/07/4D-AIA-CONSENT-OF-SURETY-FINAL-PAYMENT.pdf

 #2 Consent to Release / Reduce Retainage

This is similar to the Final Payment, but it can occur during the life of the contract.

The obligee may ask the surety for consent to release or reduce the retainage funds.  This money is a portion of each monthly payment (called a requisition) that is held back (retained) by the obligee.  For example, in a contract with a 10% retainage, the obligee will pay $9,000 on a monthly requisition for $10,000.  The retainage is accumulated in the hands of the obligee and used as motivation to assure acceptability of the work as the project concludes.

The retainage percentage may also be reduced during the contract.  There could be 10% retained during the first half of the project, then 0% for the balance.  This enables the obligee to gather some protective money in the early stages, while allowing the contractor to have better cash flow toward the end. View sample: http://www.state.nj.us/treasury/dpmc/Assets/Files/Contractor%20Award%20Doucuments/DPMC-20r(1),%20Consent%20of%20Surety%20to%20Reduction%20in%20Retainage.pdf

Now we come to #1.  Why did we cover these in reverse?

#1 Surety Consent to Issue Final Bond

This consent, which concerns the Final or Performance bond,  is commonly used on all public construction contracts in NJ, and may be used by obligees on private work anywhere (such as a GC soliciting for subcontractors).  View sample: http://www.njsbga.org/yelbook_sec_c-all.pdf

We saved this one for last, because without it, there is no contract!

Important points:

  1. If required in the bidding specifications, the contractors proposal could be rejected for failure to include a consent or if the document is defective.
  2. The surety may issue a “capped consent.” It includes a condition that voids the surety’s obligation above a stipulated amount: “…however, such contract/performance bond amount shall in no event exceed $___.” This language protects the surety from having to support a contract higher than the approved amount. If the contractor does bid above the approved figure, it is likely the bid will be rejected by the obligee based on such language. The contractor must be mindful of this limitation.
  3. Sureties do not automatically issue these consents. They must be specifically requested when ordering the bid bond.
  4. Bonding companies issue this form of consent reluctantly. It deprives them of the discretion to not issue the performance bond if the contractor’s condition has deteriorated, or if there is an unacceptable bid spread. (Read Secret #16: Bid Spreads)
  5. The consent does not require that the same surety be used for the bid and performance bonds. However, if the bid surety balks on the final bond, the contractor and obligee may remind them they are obligated to provide it.

Consents of Surety: They are one more intricate piece in the surety puzzle.

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Secrets of Bonding #71: The Best Way to Avoid Low Profits

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In this edition of Secrets we will continue a discussion that began in #70 which covered “Labor, Contracts, and Labor Contracts.”  Last time we concluded by describing a project with unusual characteristics:

Materials: 40%     Labor: 60%     Overhead/Profit: 0%

These percentages describe a job that is predicted to yeild no profit. Why would a contractor bid this way? Some possible reasons:

  • Maintain labor force – The project will enable them to keep their valuable / long term employees working
  • The revenues and cash flow will help with creditors
  • There are design deficiencies that will result in profitable addendums to the contract
  • Protect their relationship with a repeat customer (keep out competition)
  • With the job in hand, additional profits can be squeezed out of the subcontractors and vendors

While these strategies (or others) could make sense to the contractor, it is likely the bond underwriters will be reluctant to support the project.  Why?

Remember, if a default occurs, the surety may be required to step in and complete the project.  Their primary financial resource will be the remaining (not yet paid out) contract funds. If the project was estimated with a 0% profit, it would be easy for increased costs or inefficiencies to result in a losing job – which means the surety would be forced to add funds in order to reach completion of the project.

Contract estimates are just that: Estimates or Guestimates.  A job projected to produce a 10% profit may actually end up at 11% or 9% or Zero! Faced with this uncertainty, and the unavoidable responsibility to finish the work, a 0% profit projection may be too much risk for the surety.

The best way for contractors to avoid low profits is to not accept underpriced work.  Whatever benefits they might perceive, the risks are a huge burden. Construction work is a challenge under the best of circumstances.

Starting with the expectation that you are on the verge of a loss only adds to the exposure faced by contractors and their bonding companies.

 

The experts at Bonding Pros can help insurance agents and contractors when tough bonding situations arise. We have the markets and the know-how to succeed even when others have failed.

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Secrets of Bonding #70: Labor, Contracts, and Labor Contracts

On the subject of Bid and Performance / Payment Bonds, the process of obtaining one always includes a Bond Request Form.  This document is required by surety company decision makers (bond underwriters), who need to view a summary of the relevant details.

They also use this form to document the approval of the bond, and may make note of special conditions they are requiring, the bond rate and execution / shipping instructions.

The bond request form contains general info identifying the client and the beneficiary of the new bond (the obligee), plus specific details about the project.

For example, it will ask for the description and location of the work, the start and end date, and details about the performance. Subcontractors will be described. There will be a question about other projects the contractor is performing.  There will also be a question about labor on the project.

The labor question is usually part of a group like this:

Est. Materials:___%     Est. Labor___%     Est Overhead / Profit___%

(It’s worth noting that the sum of the three should equal 100%!)

The answer to the labor question has certain implications for the underwriter. There is no “normal” scenario, but let’s use this for illustration:

Materials: 30%     Labor: 60%     Overhead/Profit: 10%

If 30-60-10 is a response within the range of normal, how would you interpret this?

Materials: 90%     Labor: 0%     Overhead/Profit: 10%

This looks like a material supply contract.  The client has a product they are selling.  They have no “on-site labor.”  They are not assembling or incurring any labor costs at the project location.  When evaluating the relative degree of risk associated with bonding this contract, is there more or less risk than normal?

You may run into the opposite situation:

Materials: 0%     Labor: 90%     Overhead/Profit: 10%

This is a “labor contract.” Maybe a general contractor needs carpenters on a project so they give out a labor only subcontract. Would underwriters consider this factor a plus?

The answer is that labor is considered more unpredictable than materials.  You know the exact cost of materials, but how much for installation? There are variable factors that can influence the ultimate cost of project labor (human productivity, worker morale, quality of supervision, design deficiencies, weather, other contractors, etc.)

Conclusion:

A material “supply contract” is easier to bond than a labor and material contract or a labor contract.

 

What about this?

Materials: 40%     Labor: 60%     Overhead/Profit: 0%

Sounds like the subject of a future “Secret!”

Secrets of Bonding is brought to you by Bonding Pros

We solve bonding problems! For over 30 years we’ve been enabling contractors to get the bonds they need – even when others have failed.

We’re available to help you right now!  Brokers Welcomed.

Bonding Pros: 856-304-7348  www.BondingPros.com