Expert Commentary

All Guarantees Are Not Created Equal

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.


July 2001

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 already discussed:

  1. They are in the business full time to underwrite and issue bonds.
  2. They have the skills and resources to prequalify contractors and evaluate the projects to be bonded.
  3. 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.
  4. They have the resources in-house or through outside adjusters and attorneys to properly handle a claim situation.
  5. They frequently will provide their contractor with financial and management assistance to avoid a claim or default situation.
  6. 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.
  7. Once authorized, the bonds cannot be withdrawn or canceled. The owner and subcontractors can therefore have confidence that the guarantee is irrevocable.
  8. 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. Expert Commentary articles and other IRMI Online content do 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.

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