1. Understanding Contract Surety
Risk & Responsibility
Understanding
Contract
Surety
Engage the students by ascertaining their interest in construction. Ask whether they want to:
join a large GC firm;
start their own business; or
provide consulting to contractors, etc.
Whatever they become, it is important to understand the basic principles of contract surety bonds and how they are used in construction.
This presentation covers:
Contract surety bonds;
Who requires bonds;
Principles of contract surety;
Prequalification;
Contractor failure;
Claims role-play; and
Benefits of surety bonds.

2. Contract Surety Bonds Bid Bond Performance Bond Payment Bond
Bid bond - provides financial assurance that the contractor intends to enter into the contract at the price bid and will provide any other required bonds.

3. Contract Surety Bonds Bid Bond Performance Bond Payment Bond
Performance bond - protects owner from financial loss should the contractor fail to perform the work in accordance with the terms and conditions of the contract.

4. Contract Surety Bonds Bid Bond Performance Bond Payment Bond
Payment bond - guarantees that the contractor will pay certain subcontractors, laborers, and material suppliers associated with the project.
Be certain that class understands these types of bonds. Explain in non-technical terms.

5. Who Requires Bonds? Public Sector Federal Government
State & Local Governments
Discuss why bonds are required on public projects:
Job usually awarded to lowest responsible bidder.
Government typically cannot select contractor based solely on work history with government projects.
Law. Congress introduced the Heard Act in 1894 & Miller Act in 1935 to protect taxpayers in event of contractor failure.
“Little Miller Acts” Find out mandate for surety bonds in the school’s state, and provide the specifics to the students.
NASBP members & affiliates - go to the members only section of the NASBP Web site ( select “government relations” and then “Little Miller Acts.”
SFAA members - access legislative updates from the members only section of SFAA’s Web site (

6. Who Requires Bonds? Private Sector Private Owners Lending Institutions
General Contractors
Surety bonds are not mandated for private work, but may be required.
Private owners may specify contract surety bonds:
assure contractor is capable;
completion of contract if contractor defaults;
claims handling and funding if the contractor defaults; and
mitigate lien exposure (subcontractors and suppliers protected by payment bond).
Lending institutions:
protect their lending capital;
provide assurance of project completion; and
mitigate liens.
General contractors bond subcontractors so subcontractor will:
perform its work; and
pay its bills.
Students need to understand why contract surety bonds can be critical to their success by managing risk. Bonding capacity may be requirement of a job.

7. Principles Of Contract Surety
Principal
Obligee
Principles of contract surety:
Three party agreement - one party guarantees to another that a third will perform a contract. In other words, the surety company assures the project owner that the contractor can and will fulfill the contract documents.
Prequalification
contractor’s capability to perform the contract
Contract Completion
If the contractor defaults (provided the owner has met his or her obligations) the surety company may:
pay excess costs for a replacement contractor;
finance or assist the existing contractor; or
tender the bond penalty.
Payment to subs/suppliers (payment bond)
pay qualified subs and suppliers
mitigate lien exposure for private owner.
Differences between bonds and insurance:
A surety company will not issue a bond if contractor is not capable of completing the contract according to the contract documents.
Surety companies do NOT expect a loss. Prequalification is meant to prevent loss.
Both are regulated and licensed by state departments of insurance.
Surety

8. Prequalification Financial Strength Character Experience Equipment
Credit
History
The surety company’s prequalification process, also called underwriting, carefully analyses the contractor’s entire business operation, because the surety is backing the promise that the contractor will perform the contract. The surety determines the contractor’s ability to meet current and future contract and financial obligations.
The owner wants assurance that the contractor is capable of completing the project according to the contract.
Surety underwriter investigates contractor’s company to determine that it has ability to fulfill obligations as agreed.
(Refer students to Study Guide for more detail on prequalification)
Banking
Relationships

9. Capital Capacity Character
Prequalification
Capital
Capacity
Character
To investigate the contractor’s entire business operation, the surety underwriter looks at several factors in three general areas of the contractor’s business:
Capacity to Perform - underwriter determines if contractor has knowledge, experience, equipment, and planning to complete the project.
Financial Strength - underwriter analyzes
detailed financial statements of past 3-5 years;
contractor’s credit rating;
bank line of credit;
status of current jobs (bonded and non-bonded); and
ability to repay any payment the surety may make on his or her behalf.
Character - contractor’s experience and reputation in fulfilling its promises and obligations.
If contractor meets above criteria, the surety company will issue the contractor a bond.

10. Prequalification Capital Financial statements Working capital
Work-in-progress
Indemnity
Detailed Financial Statements - to determine the contractor’s current net worth, working capital, and past profitability. A review is typically made of the multi-year annual reports as well as the most recent interim reports.
Contract Schedules - to offer a detailed financial review of completed contracts as well as work in progress, both bonded and non-bonded
Accounting and Cost Control Information Records - to evaluate the contractor’s current financial status on all open and completed work (bonded and non-bonded)
Profitability Trends
Cash Flow Projections
Credit References - to determine the contractor’s relationship and history with creditors
Bank Line of Credit - review of working capital supplement including its terms and condition
Personal and Corporate Assets - review of the value of stock, cash-on-hand, net worth, and other financial resources or commitments of the company and /or individuals with ownership in the company. The surety company may require the contractor to sign an indemnity agreement stipulating what assets the surety can claim in the event of a loss.

11. Business plan- short & long term
Prequalification
Capital
Financial statements
Working capital
Work-in-progress
Indemnity
Capacity
Resumes
Contingency plan
Business plan- short & long term
Equipment
Track Record & History of the Company - review of major projects and programs completed by contractor in context of current proposal to verify whether the contractor has completed similar projects in the past without problems
Trade References - to discover the contractor’s reputation in business dealings with owners, subcontractors, and suppliers
Organizational Structure and Reporting - review the contractor’s approach to managing the projects it undertakes
Resumes of the Construction Company Owners & Key Personnel - to determine whether the contractor has knowledgeable and experienced people
Tools & Equipment - to verify that the contractor has (or can obtain) the necessary equipment to complete the project
Business Continuation Plans - to provide assurance that the contractor will be able to continue performance on all projects (both bonded and non-bonded) in the event of significant ownership or personnel changes
Analysis of Past, Current, and Future Projects in Progress - to verify that the contractor can perform the project to be bonded and all other work currently under way or planned (both bonded and non-bonded)

12. Business plan- short & long term
Prequalification
Capital
Financial statements
Working capital
Work-in-progress
Indemnity
Capacity
Resumes
Contingency plan
Business plan- short & long term
Equipment
Character
Reputation
Relationships
References
The surety may review references from owners, architects, subcontractors, suppliers, and others the contractor has worked with to get a sense of the contractor’s reputation for fair, businesslike dealings.

13. Contractor Failure
Although prequalification greatly reduces the likelihood of contractor default, many things can cause contractor failure.
According to Dun & Bradstreet Business Failure Record, an average of 10,000 contractors fail each year with liabilities of nearly $3 billion per year.
Even construction firms that have been in business for several years may fail.
Construction firms in business:
5 years or less - account for 37% of failures
6-10 years - account for 26% of failures
11+ years - account for 37% of failures
Comparison of the ENR top 400 contractors shows:
Of the top 50 contractors in 1990, 14 (28%) failed to even appear in the top 400 list in 2000.

14. Contractor Failure Failure Over Expansion Change in Scope of Work
Poor Accounting/
Financial Controls
Project
Management
Problems
Uncontrollable
Factors
Onerous
Contract Terms
Contractor failure may be brought on by any of these events or a combination thereof.
Rapid over expansion or unrealistic growth - stretches a contractor’s management and financial resources.
Changes in the line of work, scope of business, or territory - contractor is taking on new work - either in type, size, or location. Contractors must have enough quality personnel, adequate equipment, and knowledge to perform the work. Several factors come into play when taking on a new line of work or work in a new territory.
Lack of a comprehensive business plan - if there is a significant change in the ownership or direction of the company, it may not be adequately prepared for the future or strayed into activities outside its core competency.
Poor Accounting/Financial Controls
Accounting, business, and project management problems - Contractors cannot assess their job progress or liquid capital without adequately managing all aspects of the project along with proper accounting/financial records.
Estimating and job cost reporting problems - Contractor underestimates or fails accurately to report the cost of performing a contract.
Accounts/Receivables collection problems whether delayed or uncollectable, can lead to serious cash flow problems
Project Management Problems
Change in the contracting company’s ownership or key personnel - often causes changes in how the company operates. A company that was successful under one owner will not necessarily be as successful under a new owner.
Communication failures - whether internal, with the owner, or with the surety.
Uncontrollable factors such as inclement weather, natural disasters, and labor shortages often arise. If severe enough, they may lead to serious problems unless otherwise mitigated.
Onerous contract terms and conditions.
Subcontractor failure of major or critical subs can lead to delays and financial deterioration. Failure of a common major sub on multiple projects can lead to even greater problems.
Owner failure or an adversarial owner - creates problems for the contractor if not resolved.
Subcontractor
Failure
Owner
Failure

15. “Surety Involvement Saves Projects”
Case in Point
“Surety Involvement Saves Projects”
This brief case study shows how a surety’s involvement protected an owner from financial loss and brought four important projects to completion on time.

16. The Facts Old line family-owned contracting company
Company sold to 5 key employees
16 projects in progress
$20 million school with cost overruns & schedule delays
A family owned construction company had been in business for decades when the last surviving family member sold the company to five key employees. Six years later, as the company was in the midst of 16 ongoing projects (most bonded, but some not), one project ran into significant cost over-runs.
The project was a bonded $20 million school in the 14th month of a 20-month schedule. Work had slowed considerably in the last four months as the contractor rushed to complete four other projects. In addition, a major subcontractor had walked off the job, leaving $250,000 of re-work to be done. This was the beginning of a huge financial strain on the company and it started spreading to the contractor’s other projects.

17. The Problems
Default on 3 senior citizen homes & 1 low income community rehab center
Delays would hinder substantial HUD financing and tax credits
School officials, fearing the school would not open for the fall semester, were ready to declare the contractor in default. Unknown to school officials, the owner of three senior citizen homes and a low-income community rehabilitation center had just declared the contractor in default.
While they were hesitant to default the contractor, further delay meant that the projects could lose substantial HUD financing and tax credits. In addition, many people would not be able to occupy their new living quarters.

18. What Happened Contractor over-extended Re-work slowed schedule
Key subs not bonded
How did the construction company get into this mess?
The company had over-extended its current capabilities, stretching available labor and equipment too thin. It failed to bond key subcontractors on the school. When the HVAC contractor walked off the job, he left $250,000 of re-work to be completed by the contractor. In addition to the financial constraint, the re-work also slowed the schedule considerably.
Financial constraints and delays had spread to the senior housing and rehab projects. The construction company was unable to keep the projects on schedule and deal with the myriad of federal and state regulations.
The good news is that the contractor had so far managed to keep its remaining 11 projects on schedule, and expected a profit.

19. The Surety’s Solution
Hired a replacement contractor with experience on HUD projects
Assembled team to handle HUD, federal, & state requirements
Retained and paid subcontractors, laborers & suppliers
Financial help with schools
Once notified of the senior housing and rehab center default, the surety conducted an investigation. The contractor was forthcoming about the problems on those projects and the school.
After meeting with the owner of the senior housing and rehab projects, the surety hired a replacement contractor with an excellent track record on HUD projects to complete those projects. This enabled the contractor to refocus equipment and personnel on the other projects, especially the school.
A special team was assembled to handle all the complex federal and state documentation required to keep the housing and rehab jobs on track and in compliance with HUD regulations. The original subcontractors, laborers, and suppliers were retained to complete the work since they were familiar with the project and provided the most assurance of timely completion. The surety paid for work that had already been completed under the payment bond.
With the agreement of the contractor, the surety took quick action. It arranged a line of credit with the contractor’s bank. This financial support enabled the contractor to complete the school. The surety also found a new subcontractor to fix the HVAC problems.

20. The Outcome Paperwork not delayed Work completed on time
No loss of tax credits or financing
Occupied in time to satisfy HUD deadlines
The outcome of this case is a great example of a surety bond doing what it was supposed to do for the customer.
On the senior housing and rehab center projects, the necessary paperwork moved through channels without delays, the work was completed on time, and there was no loss of tax credits or special financing. But most importantly, residents were able to occupy the premises in time to satisfy agency deadlines.
The school opened on time. The construction company stayed in business. As part of the indemnity agreements, profits on the remaining jobs helped reimburse the surety for its losses.

21. The Outcome Surety protected school district
and taxpayers from $1,865,753 loss
Premium paid for bonds:
$129,290
The surety paid $1.86 million to complete the school. The school district paid only $129,290 for the surety bond. The cost to complete the senior citizen homes and rehab center were substantial, but costs were covered by the performance and payment bonds.

22. Benefits of Surety Bonds
Qualified bidders
Reduced risk of liens
Timely project completion
Defect protection
Owner
Benefits to the owner.
Pool of qualified bidders. The prequalification process assures capable and responsible contractors can bid on projects. This limits unrealistic bids from contractors who would not be capable of performing the contract.
Reduces the risk of liens and financial loss. When a payment bond is issued, it prevents certain subs and suppliers from filing liens on the project. Instead, the qualifying subcontractor or supplier files a claim with the surety company in the event of nonpayment from the general contractor. The performance bond protects the owner against unapproved cost overruns.
Increases the likelihood of timely project completion. Default is not in the best interest of the surety company, contractor, or owner. When an owner or contractor notifies the surety company of problems with the project, the surety may offer assistance to the contractor in order to prevent default.
Protects against defective materials and workmanship. This protects the owner and the contractor from bearing the cost associated with latent defects. 

23. Benefits of Surety Bonds
Contract reviews
Continuity plans
Expertise
Project qualification
Private construction
Lending institutions
Subcontractor protection
Technical, managerial, financial assistance
Contractor
Benefits to contractor
Increase the number of projects for which a contractor can qualify. Contractors must obtain a surety bond to bid on most public work projects.
Private owners may require surety bonds.
Financial lending institutions may require contractors to be bonded as a stipulation of a loan.
The ability for contractors to obtain surety bonds directly affects the work they can bid on.
Protects subcontractors from the general contractor’s failure or inability to pay. May encourage subcontractors and suppliers to submit more competitive prices for materials and labor if they know they are guaranteed payment.
The surety company may offer the contractor technical, managerial, or financial assistance if problems arise. This may help the project move to timely completion and significantly reduce the likelihood of default. 

24. Surety Information Office www.sio.org | sio@sio.org
For More Information
Surety Information Office |
SIO is a joint initiative of The National Association of Surety Bond Producers (NASBP) and Surety & Fidelity Association of America (SFAA).
For additional information on contract surety bonds in construction, contact the Surety Information Office.