All Guarantees Are Not Created Equal
July 2001
In construction, the obvious alternative to
the owner/lender assuming the performance risk is to secure some form of guarantee.
This article examines some of the alternatives and highlights differences between
them.
by Rolf A. Neuschaefer
Robert E. Harris Insurance Agency, Inc.
In my last article "To Risk or Not To Risk," we explored the pros and cons of an owner and/or lender assuming the performance
risks associated with a construction project. Many owners/lenders, by choice
or by default, elect to self-insure the performance risk because they believe
that their prequalification process will narrow the list to only "qualified"
contractors and that 100 percent performance is thereby assured.
It is hoped that the article raised awareness of the many difficulties in
undertaking an effective prequalification process and that satisfactory performance
is far from assured. The obvious alternative to the owner/lender assuming the
performance risk is to secure some form of guarantee. This article will examine
some of the alternatives and highlight reasons why all guarantees are not created
equal.
Indemnification
Some owners/lenders believe that the construction contract itself contains
adequate indemnification/guarantee language whereby the contractor agrees to
indemnify and hold the owner harmless from and against virtually anything. Obviously,
such indemnification is only as good as the financial resources backing it.
If the contractor fails to perform, you can pretty well assume that the contractual
guarantees will be of little value. This alternative is tantamount to being
self-insured.
Cash Collateral
Another option may be to request that the contractor deposit full or partial
cash (including cash, savings accounts, certificates of deposit, or certified
checks) collateral. This option is not practical because most contractors would
not be able to post a sufficient cash guarantee without jeopardizing their own
financial viability. Also, such collateral would require that proper assignment
forms and receipts be executed, which creates additional administrative burdens
both when taking and returning this form of collateral.
If a cash security deposit was pledged, the owner would have to make some
inquiry as to the source and ownership of the cash. The owner would then also
assume the fiduciary responsibility for safekeeping of the cash collateral.
In the event of a bankruptcy filing, the owner faces the possibility that the
collateral was not "established" or "cured," and fell within the 90-day Preference
Period. Any collateral not held for at least 90 days would become available
to all creditors, leaving the owner without the guarantee they expected.
Letter of Credit
A form of guarantee that has gained some acceptance is the posting of a "standby
letter of credit" or Irrevocable Letter of Credit (ILOC) from an acceptable
financial institution. The ILOC has the advantage that it is not subject to
the preference claim in a bankruptcy filing. The ILOC is a contractual agreement
between the bank and the party to whom the letter is issued.
The ILOC holder merely has to present a properly completed draft to draw
down on the ILOC in the event of a claim/loss situation. An owner would also
draw down on the ILOC if the issuer were to notify the holder that they intended
not to renew the ILOC prior to when the owner would be willing to release the
guarantee.
Owner Control. Notwithstanding some advantages
of the ILOC over other cash forms of collateral, it still presents the same
inherent problems for the contractor and the owner. For the contractor, the
biggest drawback is that the owner has the control to draw down on the ILOC,
which then will trigger the bank to immediately fund a loan for the amount drawn
down or liquidate the security that was given to the bank when the ILOC was
procured. This scenario could be very expensive for the contractor and create
financial turmoil.
Claim Burden. While cash or the ILOC gives
the owner seemingly ready access to the guarantee, it also places the owner
in the position of adjusting/handling the claim/loss. Given the likelihood that
the owner and contractor and/or the contractor and subcontractor will be embroiled
in one or more disputes, it potentially places the owner in a difficult situation
if they draw down on the collateral and ultimately the underlying dispute is
settled in the contactor's favor. The owner also has the burden of deciding
when to return the cash or ILOC, which may place the owner at odds with the
contractor.
To illustrate the claim settlement dilemma, assume that a subcontractor files
a claim with the owner alleging it had not been paid for work performed. If
the owner was persuaded by the demand, it could immediately draw down on the
cash or ILOC. This could prejudice or damage the contractor who may have a legitimate
dispute with the subcontractor. The owner has an exposure as well if it ignored
the contractor's request not to pay the subcontractor and if it is ultimately
determined that the subcontractor was not entitled to payment.
Fund Control Agreement
Some owners/lenders mistakenly believe that a Fund Control Agreement is an
alternative guarantee form. Fund control merely employs an independent third
party to disburse the construction funds to the various trade contractors and
suppliers on a given project. By marshalling the contract funds and disbursing
them pursuant to approved payment requests, it mitigates the possibility of
a payment bond type claim. It does not, however, guarantee that the project
will be built per plans, on time, within budget, and that all bills will be
paid. The fee for this type service is similar to the premium for a surety bond
but without any of the benefits that a surety guarantee bond provides.
Bonding
In my opinion, the alternative that offers the most benefits and fewest drawbacks
for both the contractor and the owner/lender are performance and payment surety
bonds issued by a licensed corporate surety, which most often is a subsidiary
or affiliate of an insurance company. I strongly suggest avoiding personal suretyship,
as this may not be a reliable financial source in the event of a loss and one
that would not be in a position to properly handle a claim situation. Most governmental
entities will not accept personal sureties for these very reasons.
Advantages. Corporate surety bonds underwritten
by recognized and licensed bonding companies working through professional surety
bond agents offer the following advantages/benefits over the guarantee options
discussed earlier:
- They are in the business full time to underwrite and issue bonds.
- They have the skills and resources to prequalify contractors and evaluate
the projects to be bonded.
- They are in a fiduciary position and have to deal fairly with the interests
of both their contractor client (the principal) and the owner (the obligee).
They are regulated by state insurance laws.
- They have the resources in-house or through outside adjusters and attorneys
to properly handle a claim situation.
- They frequently will provide their contractor with financial and management
assistance to avoid a claim or default situation.
- They are an effective buffer between an owner, who might be too quick
to draw down on a cash or ILOC guarantee, and a contractor who may have
legitimate contractual issues with an owner, a sub-contractor, vendor or
other service provider.
- Once authorized, the bonds cannot be withdrawn or canceled. The owner
and subcontractors can therefore have confidence that the guarantee is irrevocable.
- The owner/lender does not have to make a determination when it is safe
to return the cash or ILOC guarantee. The benefits of the bond continue
even after the project is completed or accepted.
Cost Comparison
Let's examine the dollar cost of a surety performance and payment bond. In
today's competitive surety market, a good general building contractor would
probably enjoy a graduated term premium rate of $9.00 or less per thousand.
A $5 million performance and payment surety guarantee, for example, would cost
$35,750 or an average rate of $7.15 per thousand, which equates to .0715 percent
of the total project value.
For comparison purposes, the fee for an ILOC will generally range between
1 percent and 2 percent on an annual basis. The fee could be less than 1 percent
if funds equal to the ILOC are on deposit with the bank.
For that premium the owner receives two bonds: a 100 percent performance
bond and a 100 percent labor and material payment bond. (Note:
most cash or ILOC guarantees are equal only to the contract price, and this
amount would have to cover both the performance and the payment risks.)
The owner is guaranteed that the project will be completed, all project bills
will be paid, and any claim issues can be referred to the surety for handling.
Most importantly, the owner benefits from the surety's prequalification process
and ongoing monitoring of the contractor.
Given the financial assurance that a bond provides, the prequalification
services implicit in the issuance of the guarantee, the freedom from being burdened
with handling potential claims, the premium for the guarantee may actually be
viewed as a bargain. There are Fortune 500 companies with active building programs
in the millions of dollars who, as a matter of corporate policy, bond virtually
all of their construction work. Yet, there are many private owners who may build
only one project or build infrequently who believe they have the skills to prequalify
contractors and who are willing to assume the many risks inherent in a building
project.
Requiring Bonds
An owner/lender on private work can mitigate the performance risks in any
building project by imposing bond requirements on all but routine work or work
above a specified dollar value. For example, all bidders must furnish a 5 percent
or 10 percent bid security (e.g., cash, certified check, or preferably a surety
bid bond) and the contractor to whom the job is to be awarded must furnish separate
100 percent performance, payment, and 1-year maintenance bonds (the latter bond
covers defective workmanship and materials, and is normally issued only on specific
request).
The bid bond is usually issued without separate charge and there is no additional
premium for the payment on the 1-year maintenance bond when issued together
with the performance bond. (If an owner requests bid and final bonds and then,
after taking bids, waives the final bonds, the surety is allowed to make a premium
charge for the bid bond based on its value—5 percent of a $5 million bid or
$250,000—since the owner had the benefit of the surety's prequalification process.
The rationale is similar to a bank charging a fee for a standby credit facility
regardless of whether the client draws/borrows on the credit line.)
Also, the premium for the performance bond is based on the value of the contract
and not the penal amount of the bond. The cost of a 100 percent, a 50 percent,
or a 25 percent bond is all the same. Therefore, an owner/lender should never
request anything less than 100 percent performance and 100 percent payment bonds.
Conclusion
It is hoped that this article provided insight into different guarantee forms
and highlighted the pros and cons of each. In my next article I will review
Subcontractor Default Insurance, which is a fairly new product in the marketplace.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author’s employer or IRMI. This article does not purport
to provide legal, accounting, or other professional advice or opinion. If such advice
is needed, consult with your attorney, accountant, or other qualified adviser.