Month: April 2018

Secrets of Bonding #161: No More Performance Bonds!

This is the Bonding Company’s worst nightmare…

In this article we will cover the situations in which no Performance or Payment Bond is needed!  Some of the projects are big and federal, some are private, ALL are unbonded.  Here we go!

As a point of reference, you may expect that federal, state and municipal contracts demand a Performance and Payment (P&P) Bond equal to the contract amount.  Normally they do.  General Contractors working for a private owner, such as the construction of an office building or apartment project, may face the same requirement.  This can apply to subcontractors, too.

Federal Projects

This area includes all branches of the federal government. Examples: Army Corps of Engineers, General Services Administration, Dept. of Energy, etc. Their contracts are administered following the rules of the Federal Acquisition Regulations (FAR).

Suprisingly, the FAR says that no P&P bond is required on contracts under $150,000.

For contracts $150,000 and higher that require security, there are times when the bond requirement may be reduced below 100% or waived entirely.  These include:

  • Overseas Contracts
  • Emergency Acquisitions
  • Sole-Source Projects

If 100% security is mandatory, the FAR lists acceptable alternatives to a P&P bond:

  • US Government (investment) Bonds
  • Certified Check
  • Bank Draft
  • Money Order
  • Currency
  • Irrevocable Letter of Credit

Here’s another option: For contracts performed in a foreign country, the government can accept a bond from a non-T-Listed surety. (Circular 570) Crazy!

State and Municipal Contracts

The bonding requirements may vary by state, but generally their flavor is similar to federal.  They, too, may accept alternative forms of secutity such as an ILOC.

Private Contracts

Anything goes.  On private contracts, the owner has complete discretion to set the bonding requirements – including no bond needed.  Keep in mind, the cost of the bond is added to the contract, so the owner can save some money by not requiring a bond.  They may take other precautions to protect themselves.  Some examples:

  • Require a retainage. These are funds that are held back from the contractor and only released when the project is fully accepted (reduces the risk of Performance failure)
  • Lien releases may be required each month to prove suppliers and subcontractors are being paid appropriately (reduces the risk of Payment failure)
  • Funds Control / Tripartite Agreement – a paymaster is employed to handle the contract funds (Payment risk)
  • Joint checks are issued to the contractor and payees below them – to assure the funds reach the intended parties (Payment risk)
  • Physical site inspections to verify progress (Performance risk)

The Nightmare

In these articles we talk a lot about how contractors can obtain surety bonds and manage them.  But it is interesting to note: A construction company could go forever, performing state and federal projects – and NEVER get a bond.  It’s true!

If everyone did this, it would be the surety’s worst nightmare.  But in reality, there are financial advantages to using P&P bonds, so bonding usually is the first choice. 

Your first choice should be KIS Surety when fast, creative underwriting is needed on bonds up to $10,000,000.  We are the national contract bond underwriting department for Great Midwest Insurance Company, a corporate surety with an A-8 rating.  

We can help you solve your next contract surety need.  Call us now: 856-304-7348

(Don’t miss our next exciting article.  Click the “Follow” button at the top right.)

Secrets of Bonding #160: Deep in the Weeds with Set Aside Letters

In this article we will peel back the onion on Set Aside Letters (SAL) issued by banks in connection with construction loans.  What are they, when they are useful for bonding companies and when are they not?

Here is the essence of such documents:

“The agreement covering the project will provide that the funds in said impound account are … to be disbursed for payment of the (Name of Project) mentioned above and only after (Bank) has satisfied itself that the work paid for has actually been performed… In the event (Borrower) fails to complete the project described herein… all funds remaining in said impound account shall be immediately available to Surety to complete and pay the costs of said project, and in such event, (Borrower) waives any claim or interest in the remaining funds. Surety shall not in any way be obligated to repay said funds so used to (Bank).

This is an irrevocable commitment of funds which is not subject to recall or offset by (Bank).”

Pretty interesting!  This letter / agreement keeps the loan in play to fund the completion of the project  – even if the borrower (bank customer) fails / defaults.

When Are Set Aside Letters Used?

These documents are a common underwriting tool when a Site or Subdivision Bond is issued by a surety. If the bond applicant (who is also the developer and borrower) is relying on a construction loan to fund the bonded work, the SAL protects the surety by providing funds for the completion of the work in the event of a default.

What a great idea.  So why don’t we use these on everything?  Let’s look at another example.

Commercial Projects

The project owner hires a bonded contractor and a bank loan will fund the project.  The bank needs a guarantee that the asset / project (which backs the loan) will be built as intended.  A Performance and Payment Bond accomplishes this and assures there will be no Mechanics Liens against the property for unpaid bills.  These two aspects benefit the project owner and the lender.  Keep in mind, in a borrower default situation, the bank becomes the new owner of the property.

It is common for the bank to stipulate that a bonded contractor be used, and they may want to be a named beneficiary on the P&P bond – accomplished by issuing a Dual Obligee Rider.  In turn, should the underwriter require a SAL from the lender?

On Commercial projects, the normal practice is to NOT obtain a SAL from the lender.  Why not?  Why is this different?

Choose one:

a. The bank is a secured lender

b. The bank can subrogate against the borrower’s assets

c. The Dual Obligee Rider serves a purpose similar to the SAL

a. and b. are true, but the answer is c.

Welcome to the Weeds

We’re going in now. The Dual Obligee Rider adds the lender as a beneficiary with all the rights and obligations of the obligee named on the bond (the project owner).  And what are they?  Obviously they are entitled to make a performance claim and have the project delivered as indicated in the contract.

The named obligee also has obligations, one of the most primary is to PAY the builder. Important: The obligee is prohibited from making a performance claim if they have failed to pay the contractor.

Therefore, when the bank is included under a Dual Obligee Rider, they accept the benefits and obligations.  If the borrower defaults, the lender cannot make a bond claim unless they continue to pay the construction loan to the surety.  (Now the bank owns the project and the surety has become the contractor.)

Summary

Is this starting to make sense?  When a borrower defaults on a commercial project, a lender included by Dual Obligee Rider cannot make a claim unless they continue to pay the project funds to the surety.

Deeper Weeds

On Site and Subdivision there is a unique risk – the lender can take a free ride on the surety by having the bonding company pay out of pocket to complete the project.

Site and Sub-D bonds have the local municipality as obligee, not the bank.  The bank doesn’t want a Dual Obligee Rider because they automatically receive a financial benefit if the municipality makes a bond claim to demand completion of the project.  If the borrower has defaulted, the bank has the opportunity to withhold the balance of the loan (the borrower is gone), and watch the surety pay to complete a project they now own.  And they were not even the bond claimant…

This is the risk sureties avoid on Site and Subdivision Bonds by requiring the SAL that keeps the loan in play, even if the bond applicant / borrower has failed.

Admittedly, this is a pretty obscure subject, but also interesting to us “bond nerds.”  It never hurts to understand how things fit together.  These skills help us solve your complicated bond opportunities.  Take advantage of our expertise when the next one pops up.

KIS Surety is the national contract bond underwriting department for Great Midwest Insurance Company, a national, corporate surety with an A-8 rating.  We throw all this underwriting talent at your bond opportunities and support contracts up to $10,000,000.

If you have a contract surety case that needs a fast, creative response, call us: 856-304-7348

(Don’t miss our next exciting article.  Click the “Follow” button at the top right.)