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CEE_595_06_Surety_Bonds

CEE_595_06_Surety_Bonds - How Surety Bonds Work This...

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Unformatted text preview: How Surety Bonds Work This article is the second installment of an abridged version of Federal Publications’ February 1996 Construction Briefings entitled chty Bond Basics, copyright 1996 by Federal Publications, htcorporated, written by Messrs. Donohue and Thomas. A complimentary copy of the Construction Briefings may be obtained by contacting our firm. Subscriptions to Construction Briefings are available from Federal Publications, Incorporated, irao coth Sn'eet, N.W., Washington, D.C. aoo36. Construction contractors are interested in satisfying surety bond requirements on the projects for which they compete as inexpensively as possible. A surety’s primary objective is to identify contractors that have the ability, resources, and tenacity required to complete the construction projects they propose to build. Thus most of the process of obtaining surety bonds is devoted to information about the contractor’s business. A secondary but necessary element in the process is to identify individual indemnitors who have sufficient assets to hold the surety harmless from any claims filed against the bonds. Contractors’ Interests in Selecting a Surety Contractors have a choice in selecting surety companies. Different EllI'Efies may charge the contractor a different premium rate, resulting in savings for the contractor. In addition, one surety may be willing to issue bonds with a higher dollar limit than another, and this can result in additional work for which the contractor can compete and perform. The contractor also has an interest in finding out the financial strength and experience of the surety. If a problem develops during the project, one surety might more readily choose to work with the contractor toward resolution than would another surety, perhaps avoiding a .default. Contractors thus have an interest in inquiring into these issues before selecting a surety company. Where Bonds Are Available a contractor can usually apply for and obtain construction surety bonds at the insurance broker it uses for business-related insurance policies. The broker probably has already obtained the necessary financial information from the contractor for casualty insurance purposes. The broker may even be the primary point of contact between the surety and the contractor. Suretybond premiums usuallyarepricedas apercentageoftbepenalsmnofthe bonds issued. The premium percentage rate may vary among surety companies and among different contractors. The largest, most financially secure contractors in the United States would pay the lowest bond premium. A typical contractor may pay a bond premium between one percent and five percent oftbe penal sum. Surety’s Evaluation of the Contractor’s Business httpu'rwwwattnyccnvgciatflhnnl fit! 8f2fl03 How Surety Bonds Work Page 2 of 9 Each surety company has different criteria for deciding which contractors it will bond. However, all sureties evaluate the contractor and the contractor’s work to decide whether the surety will bond that contractor. Since the surety guarantees the contractor’s performance, the surety needs to decide whether the contractor hastheabiiityandresourcestoperfomAnyguarantorhasaninterestin guaranteeing only a dependable product or service, and sureties are no different. A surety’s means of evaluating a contractor to decide if it 1will issue bonds is the underwriting process. This process sometimes is described as evaluating the 4 C's-Character, Continuity, Capital, and Capacity. Character of the Business and Key Personnel A surety would like to guarantee the performance of those contractors that have shown that they are honorable, dependable businesses that can be counted on to perform. A surety is interested in how long the contractor has been in business and its reputation in the industry among owners, architectsfengineers, general contractors, subcontractors, and suppliers. With a new business, a surety may look to the experience and reputation of key management personnel. Also, a surely is interested in the rcputations of other key personnel. A surety will look at the contractor’s management structure and organization chart,theiengthoftimecurrentmanagementhasbeeninpiace,andthe experience and track record of the managers. The contractor’s experience in the construction industry is important, but the surely is also interested in the contractor’s management sldlis. Basically, a surety looks for the characteristics common to any well-run business: a management team experienced in the industry, with a proven track record of success; an adequate accounting system with appropriate financial controls and reporting capabilities; and a history of stable, profitable business. A surety would like to see a full-time CEfl who is experienced in the construction industry, with an adequate staff to perform the work. Finally, a surety probably would want to see that the contractor has identified its strengths, and sticks to the types of construction projects it does best. Continuity of the Business A surety is interested in continuity in the management of the contractor’s business. A surety prefers a written plan to continue the business upon the death or retirement of key contractor personnel. This includes a written plan of succession for management personnel, and buy—sell agreements for stock or other interests in the business. In general, a surety is interested in seeing a well- thought-out plan to continue performance of the work and the contimdty of the business should key conn-actor personnel leave the business. Capital in the Busian httpzfimavattnyeomigeiarflhtmi fiilfliflflfli How Surety Bonds Work Page 3 of 9 A surety is interested in the contractor’s net worth, amount of uncompleted work, cash flow, accounts receivable, and accounts receivable aging information. A surety also looks at the contractor's credit history, working relationships with subcontractors and suppliers, and bank account information. A surety is interested in evaluating all of a contractor’s capital assets as a way of learning the financial strength of the contractor. A surety also requires that individual indemnitors have sufficient assets to secure their promise to indemnify the suretyintheeventclaimsaremadeagainstthebond. Capacity of the Business A surety must decide how much work a contractor can perform. profitably in order to set a bonding limit for that conu'actor. Such an evaluation includes subjective judgments about which different sureties may reach different decisions. The capacities of the contractor’s available plant, equipment, and personnel are factors in reaching this decision. Considering these and other factors, a surety will set an upward dollar limit for a maidrnum individual project that it will bond, and an upward dollar limit for the total of all projects it will bond for that contractor. A surety's interest is to prevent the contractor from becoming over-extended by taking on more work than the contractor can handle. Evaluation of the Indemnitors’ Assets A surety will not issue bonds to a contractor unless the surety has decided that the contractor can perform the contract and complete the project. However, once this determination is made, a surely will then require security for its bonds. This security is usually an agreement by individuals, indemnitors, who agree to indemnify the surety. The surety will evaluate these individuals and their net worth to figure out their financial ability to stand for any loss that the contractor causes. Types ofAcceptable Assets Different sureties use different evaluations and have different opinions concerning the types and amounts of assets they find acceptable. Surefies prefer unencumbered tangible assets that quickly and easily may be liquidated into cash. The FAR part 28 listing of assets acceptable and unacceptable to the federal government is a fairly good guide for what commercial surety companies prefer as well. Like the federal government, surety companies prefer cash, certificates of deposit or other cash equivalents, irrevocable letters of credit from acceptable financial institutions, United States government securities, stocks and bonds actively traded on U3. National Securities Exchanges (New York Stock Exchange, American Stock Exchange, etc}, or real property owned in fee simple. Assets that a commercial sin-ety probably would find less desirable or unacceptable would be accounts receivable, foreign securities, a principal residence that likely would be wholly or partially exempt from attachment under a homestead exemption in most states, and life estates or future interests in real property. (laterally, http:iiwww.attay.comigciatt2.haul macaw How Surety Beads Work Page 4 of 9 commercial surety companies look less favorably on assets that are of speculative value, whose value may fluctuate markedly over flute, and which would be dfificult to attach and liquidate. Identification of Assets as Collateral Dnce the assets offered as collateral are found acceptable, then the principal, indemnitors, and the surety may identify them in writing. The assets may be identified in a receipt of collateral form, an affidavit, or other document. The idea is to identify the assets in sufficient detail so that they could be segregated and pursued by the surety if necessary to obtain the indemnification promised by the indemnity agreement, discussed below. Common Provisions in Indemnity Agreements The surety will not issue bonds unless it has received agreements from the principal and other indemnitors with sufficient assets, in the surety’s opinion, to secure the surety from any claims that may be made against the bonds. This is donebyanhtdenmityagrcementtobesignedbytbe principal andtheindividuals who will serve as indemnitors. The agreement is a contractual obligation that provides security for the surety. The indemnity agreement sets forth and expands upon the separate common law obligations between the principal and the surety. A separate indemnity agreement may be issued for each bond. However, more frequently, the parties enter into a general indemnity agreement covering any bonds that the surety may issue to that contractor. Typical provisions in such a general indemnity agreement are explained below. Indemnification of the Surety by the lndemrdtors The indemnitors (the contractor and individuals who have pledged their assets to support the bonds} agree that they will indemnify (completely reimburse} the surety for any liabilities, attorney’s fees, expenses, or damages the surety may incur as a result ofits issuance ofa bondto the principal. A suretythat pays the debts or obligations of its principal is entitled to indemnification by the principal even at common law. The written hidenmity agreement confirms the principal’s obligation and extends the obligation to all the indemnitors. Not surprisingly, a very broad form of indemnification typically is provided to cover all types of anticipated costs. Frequently, the indemnification provision will say that it includes all damages incurred by the surequ reliance upon representations by the principal or indemnitors concerning defenses available to thesuretyinanyclaimsmadeagainsttbebonds. Thus ifthesuretyassertsa defense based on representations by the indenmitors or the principals, and the defense ultimately is found to have been frivolous, the indemnitors would be required to reimburse the surety for any damages or sanctions sustained by the surety. httpihvwwattnycomfgciarahunl on SINGS How Surety Bonds Work I’age 5 of 9 Asuretyalsohastheconmmnlawrightagainstitsprincipaltorequirethe principal to pay any debt or liability before the surety is called upon to pay it. This is usually called the common law right of “exoneraflom” the surety is exonerated from liability by the principal’s payment of the debt. An indemnity agreement contains provisions in which the other indemnitors agree to give the surety the same right to require them to pay claims agaiitst the bonds as they are made. Thus typical provisions of an indemnity agreement give the surety the right to require the indemnitors to pay claims before the surety is re-quired to do so, and to completely reimburse the surety for claims paid by the surety. Indemnltors Agree to Deposit Collateral as Reserves When the surety is advised of a claim or possible claim, the surety may establish a “reserve”—which is an account or fund with a sum sufficient to pay the estimated extent of the possible claim. A typical provision in an indemnity agreement states that if the surety sets up such a reserve to cover potential liability, the principal and indemnitors agree to deposit with the surety an equal amount to serve as collateral. In addition, such provisions say that assets pledged by the principal and lndemnitors will be made available to the surety as collateral for such a reserve. Such provisions typically also say that the surety has the right to use such collateral to pay any and all liability it may have under its bonds. Surety’s Authority to Take Over the Work Another typical provision gives the surety the right, but not the obligation, to take over prosecution of the work usmg the principal’s plant and equipment, and to consent to changes in the contract or the work. These provisions also grant the surety the right to make loans or advances to the principal or others for purposes of completing the contract, and require the principal and indcmnitors to reimburse the surety for such loans. The effect of these provisions is to authorize the surety, by taking these measures, to use its own judgment to try to avoid a default and to minimize damages due to a default. Assignment of Contracts The principal and indemnitors may also assign to the surety all of their rights under the contracts for which the surety issues bonds. Such provisions specify that they include all subcontracts, the principal’s rights under all subcontractors’ surety bonds; all cont-actual rights to plant, equipment, tools and materials; all rights to receive proceeds from contracts; and all claims and causes of aetion that the principal or indemnitors may have concerning a project bonded by the surety. This provides the surety the opportunity to maintain the benefits of the principal’s subcontracts in the event the principal is defaulted. Indemnity Agreement May Be Filed as a Security Agreement The principals and indemnitors also agree that the indemnity agreement and httpzflwwwsttnycomfgciartlhtml sleeves How Surety Bonds 1Wort: Page 6 of 9 related receipt of collateral documents may be filed by the surety as a security agreement under the Uniform Conunercial Code (UCC) to provide notice of the surety’s security interest in the collateral pledged by the principal and indemnitors. The 1.115;, adopted with slight variations in all fifty states, provides a uniform system for filing notice in property records so that creditors and others may have notice of another creditor’s prior interests in these assets. The effect of this provision in an indemnity agreement is to allow the surety to protect its interests in the indemnitor’s assets and to establish a position superior to subsequent creditors. Contract Proceeds are Trust Funds for Bond Beneficiaries Another common provision in indemnity agreements says that the funds paid to the principal under bonded contrasts shall be held by the principal as trust funds for the benefit of the beneficiaries of the bonds issued by the surety. Thus payments by the owner to the prime contractor on a bonded contract would be held in trust for the benefit of subcontractors and suppliers, who are the beneficiaries of a payment bond. often indenmity agreements also provide that the surety may require the principal to establish a separate account for contract proceeds, designated as a trust fund, and that the surety must approve all withdrawals from such an account. This allows the surety to monitor payments on the project and to see that subcontractors and suppliers receive their payments. Surety’s Right to Settle Claims Against the Bond Another typical provision specifies that the surety has the sole and exclusive right to decide whether any clailns against the bond should be paid, settled, or defended. The principal and indentnitors agree that the surety’s decisions on such matters shall be final and binding on them. Surety’s Right to Examine Finanoial Records An indemrdty agreement usually contains provisions giving the surety the right to request financial information from the principal and indemnitors as it deems necessary. This provision will include the right to examine books, records, accounts, and other financial information as necessary. Further, such provisions often give the surety the right to request financial information from third parties, such as banks, credit reporting services, subcontractors, or suppliers. Other Typical Provisions A general indemnity agreement, which would cover any bonds issued by the surety, willprovide thatthesuretyretains the righttorefuseto issue anyhond at any time. Thus the surety has the right, but not the obligation, to issue additional bonds. flther terms provide that the indemnitors waive receipt of notices of the execution of bonds and waive minor informalities in the execution of bonds. httpfr‘uovwatbwcomfgeiartlhunl fill 8f2flfl3 How Surety Bonds Work Page “i of 9 lndemnitors also agree to accept service of process and to voluntarily join suits that may be brought against other indemnitors. Surety’s Role During Contract Performance Subject to certain legal exceptions, performance and payment bonds specify that the surety waives prior notice and the right to consent to changes in the work. In addition, mom contracts provide that changes may be made without notice to the surety. This does not mean that the surety does not have a role during contract performance before any claims are filed. Under some bond forms, the surety may be required to participate in meetings to resolve problems or disputes. In addition, the surety’s rights under indemnity agreements, reviewed above, govern this period. For example, if the indemnity agreement provides that progress payments are to be treated by the principal as trust funds for the subcontractors and suppliers, the surety has the right to require the principal to comply. Also, the surety has the right to obtain financial information from the principal, and may receive payment and progress information and construction information during performance. The surety also has the right to advance funds to prevent a default. Role of Principal and Surety When Claims are Filed Against the Bond Performance Bond Claims The obligee of a performance bond typically is the owner, but it may also he the general contractor or other superior contractor. As discussed above, the surety’s obligation under a performance bond is to see that the bonded contract is completed in case of a default by the principal. The surety may learn of a possible default beforehand, by receiving complaints directly from the obligee, the principal, or even third parties. The surety also may gain information beforehand by receiving information about payment disputes that concern the payment bond (discussed below). If the surety learns of a possible default before it happens, the surety usually requests information about the situation from its principal and others, such as the owner or other contractors working on the project. Each situation is different, and the surety’s options and actions differ in each case. Some performance bond forms require the owner to give a pre- default notice to the surety, and provide for a meeting of the owner, contractor, and surety to discuss completion of the contract. The surety usually has the right, but not the obligation, to advance funds to the principal or others. If such advances are made, the principal and other indemrdtors would be required to repay these advances to the surety. The surety also may notify the owner or general contractor that fu...
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