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.
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:
- 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.