Surety Bonds for Construction Contracts

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Surety Bonds

for Construction Contracts

JEFFREY S. RUSSELL

The University of Wisconsin—Madison

American Society of Civil Engineers 1801 Alexander Bell Drive Reston, Virginia 20191-4400

ASCE PRESS

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Abstract: This book aims to demystify the complex field of suretyship for construction contracts by describing and analyzing each element of the surety bonding process in basic terms for contractors, owners, design professionals, construction accountants and attorneys, and other construction industry personnel. It is the only comprehensive book on surety bonding as it relates to construction contracts written from the perspective of contractors, sureties, and owners. The book outlines the basic players in the surety relationship, what each can expect at every stage of the bonding process, how to properly structure key documents, and what a contractor should look for in a surety and an independent surety agent. In addition to exploring the numerous facets of the bonding relationship, the book moves through many of the subtitles of this complex endeavor, including the surety's role in prequalifying contractors and why an owner might consider requiring, or even waiving, surety bonds. To help elucidate the interworkings of suretyship, numerous examples and extended case studies drawn from the experience of professionals working in the industry, as well as sample bond forms and surety documents, have been included. Finally, this work covers such issues as international guaranty, reinsurance, surety and Design/Build, and trends emerging in the surety market.

Library of Congress Cataloging-in-Publication Data Russell, Jeffrey S.

Surety bonds for construction contracts / Jeffrey S. Russell, p. cm.

Includes bibliographical references and index.

ISBN 0-7844-0426-7

1. Insurance, Surety and fidelity—United States. 2. Contractors—Bonding—United States.

I. Title.

KF1228.R87 1999

346.73 '08684-dc21 99-049594

Any statements expressed in these materials are those of the individual authors and do not necessarily represent the views of ASCE, which takes no responsibility for any statement made herein. No reference made in this publication to any specific method, product, process or service constitutes or implies an endorsement, recommendation, or warranty thereof by ASCE. The materials are for general information only and do not represent a standard of ASCE, nor are they intended as a reference in purchase specifications, contracts, regulations, statutes, or any other legal document. ASCE makes no representation or warranty of any kind, whether express or implied, concerning the accuracy,

completeness, suitability, or utility of any information, apparatus, product, or process discussed in this publication, and assumes no liability therefore. This information should not be used without first securing competent advice with respect to its suitability for any general or specific application.

Anyone utilizing this information assumes all liability arising from such use, including but not limited to infringement of any patent or patents.

Photocopies. Authorization to photocopy material for internal or personal use under circumstances not falling within the fair use provisions of the Copyright Act is granted by ASCE to libraries and other users registered with the Copyright Clearance Center (CCC) Transactional Reporting Service, provided that the base fee of $8.00 per chapter plus $.50 per page is paid directly to CCC, 222 Rosewood Drive, Danvers, MA 01923. The identification for ASCE Books is 0-7844-0426-7/00/

$8.00 + $.50 per page. Requests for special permission or bulk copying should be addressed to Permissions & Copyright Dept, ASCE.

Library of Congress Catalog Card No: 99-049594 ISBN 0-7844-0426-7

Manufactured in the United States of America.

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Chapter 13: Overview of Underwriting Process 55 Chapter 14: Sequence of Events: A Contractor's Perspective 57 Chapter 15: Surety Underwriting Criteria 63 Character 63 Capacity 64 Continuity 68 Chapter 16: Capital and Financial Review 73 Financial Data Considerations 73 Financial Analysis 79 Chapter 17: Bond Cost 97 Contract Price 97 Contract Type 98 Stipulated Contract Length 99 Example Premium Computations 101 State Insurance Departments 102 Bond Payment Terms for Contractors 102 Payment and Performance Bond Cost 103 Maintenance Bond Cost 103 Chapter 18: Underwriting Case Study 107 The Underwriting Process: Action Reviews PCC 108 Conclusions and Decisions 120 Lessons 122

PART V SURETY BOND CLAIMS

Chapter 19: Considerations in Handling Surety Bond Claims 125 Surety's Rights, Remedies, and Defenses 125 Five Steps of Surety Participation in Contractor Default 127 Special Concerns and Effects of Bankruptcy Upon Surety 159 Chapter 20: Contract Surety: Effective Claim Management 163 Maintenance Bond Claims 164 Claim Case Study: The Defaulting of PCC 165 Claim Case Study: The Defaulting of Zimbrick International 178

PART VI PRACTICAL CONSIDERATIONS REGARDING THE SURETY INDUSTRY

Chapter 21: Alternatives to Surety Bonding 185 Waiver of Bonds 185 Individual Sureties 186 Self-Surety 187 Cash Equivalent 188 Letters of Credit 188

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Chapter 22: International Guaranty 193 Surety Bonds and Letters of Credit in an International Context 195 Chapter 23: Aggregate Industry Performance 199 Reasons Postulated for Loss Experience 214 Chapter 24: Sources of Information Pertaining to Sureties 219 Chapter 25: Surety and Design/Build: The Future 223 History 224 A More Thorough Underwriting 225 Contractor's Liability Insurance 227 Chapter 26: Special Surety Concerns and Industry Trends 229 Warranties and Maintenance Bonds 229 Competition Among Sureties and Contractors 230 Private Market 232 Hazardous Waste and Superfund Legislation 233 Small- to Medium-Sized and Disadvantaged Firms 234 Miller Act 238 Transfer of Ownership 239 Chapter 27: Summary 241 Glossary 243 Appendices 247

Appendix I. Sample General Indemnification Agreement:

Old Republic Surety 249 Appendix II. Sample Bid Bond Form: AIA Document A310 255 Appendix III. Sample Performance Bond Form: AI A Document A312 259 Appendix IV. Sample Payment Bond Form: AIA Document A312 265 Appendix V. Sample Maintenance Bond Form: Fidelity and Deposit

Company of Mary land 271 Appendix VI. Specimen Clauses for Bid, Performance, and Payment

Bonds 275 Appendix VII. Sample Contractor Questionnaire Used by Surety:

National Association of Bond Producers 279 Appendix VIII. Sample Report of Independent Certified Public

Accountants and Financial Statements Audit of Example

Contractor, Inc. 287 Appendix IX. Sample Dun & Bradstreet Reports 305 Appendix X. Sample Robert Morris Associates Reports 313 Appendix XI. Listing of Surety Association of America Contract

Types 317 Appendix XII. Underwriting Case Study Documents: Prometheus

Construction Company, Inc 323 Appendix XIII. Effective Claim Management: Clem Winter, C. Winter

Enterprises, Inc 363 Appendix XIV. Common Disputes Arising From Surety Contract

Bonds 381 Appendix XV. Sources of Information About Suretyship 385

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References 389 Index 397 About the Author 401

VI

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Now faith is being sure of what we hope for and certain of what we do not see.

Hebrews 11:1

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Surety Bonds for Construction Contracts

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ACKNOWLEDGMENTS

I want to express my gratitude to the University of Wisconsin-Madison College of Engineering, Department of Civil and Environmental Engineering for the freedom and flexibility to pursue my research interests. It is in great part due to the academic and administrative support I have received at this institution that the following work was written.

The material presented is based, in-part, on research funded by the National Science Foundation (NSF) and on papers published in various American Society of Civil Engineers (ASCE) journals. I greatly appreciate the opportunity and support from both NSF and ASCE.

Many thanks go to Mr. Brewer Stouffer, who played a critical role in pulling all of the material together and editing the manuscript. Without his continued persistence and dedication, this endeavor could not have been accomplished. I am also deeply grateful to Mr. Dennis Wine, an industry professional who provided extremely thorough and insightful critique of the project. I also acknowledge Mrs. Susan Brunsell, who provided continuous help and technical support.

A special acknowledgment goes to Mr. Clem Winter for providing invaluable information and assistance on Chapter 7: Reinsurance and Co-surety and throughout Part 5. Surety Bond Claims. Mr. Winter has hands-on surety claims experience and knowledge through almost 40 years spent in the field and offices of a primary surety and a major surety reinsurer. He now serves as a surety claims consultant and expert witness on surety claims cases and is President of C. Winter Enterprises, Inc. and Surety Financial Services, LLC of Wichita, Kansas. In addition to providing information, Mr. Winter put the author in touch with numerous industry experts who provided further critique and insight in the complex surety relationship.

My thanks goes out to these and many others too numerous to mention for their help and commitment in making the completion of this project possible. To my family, especially, who invested their time and energy and encouraged me to pursue my dreams—my father, Mr. Ronald F. Russell; my mother, Mrs. Georgia A. Holmes; my uncle, James C. Russell; and my wife, Vicki, and our children, Nicole, Jacob, Matthew, and Rachel—I thank you deeply for the unconditional love and support you continue to show.

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PREFACE

This book aims to demystify the complex field of suretyship for construction contracts by describing and analyzing each element of the surety bonding process in basic terms for contractors, owners, design professionals, and other construction industry personnel. While seemingly a straightforward task, the realities of today's complex construction and surety industries make it difficult to linearly describe what surety bonds are and how they work. In addition, since the readership will bring with them varying levels of understanding about suretyship and construction processes, it is necessary to provide adequate background information for many levels of understanding. Therefore, in addition to a comprehensive glossary, great pains have been taken to structure the book for maximum breadth.

As a way to begin understanding the surety relationship, think of an unassembled six-piece puzzle. To construct the larger puzzle from the smaller units, the pieces must be connected together. In a similar fashion, understanding contract surety requires a working knowledge of the components of suretyship.

Figure P-l helps demonstrate this comparison.

Let each puzzle piece represent one of the six sections of the book. To arrive at a working understanding of how surety is used in today's construction industry, which is to fit the pieces together, the reader must not only be aware of the elements of the surety relationship, he or she must also grasp how the different people and parts work together throughout the bonding process. To understand the whole it is necessary to understand each piece, and to understand each piece it is simultaneously necessary to comprehend the whole. If any piece is missing, one's understanding will be more than incomplete; it may be incorrect.

To ultimately describe how suretyship works in today's half-a-trillion dollar construction industry, which is to say to build a working puzzle, an understanding of what suretyship is, how surety bonds are.used, who is involved in issuing them, and what they typically guaranty is crucial. Accordingly, the first three sections of the book explore suretyship as a concept, the specific types of surety bonds available for construction contracts, and the basic tenants of the surety relationship including who is involved, in what capacity, and how the various parties interact. How a contractor can go about securing bonding and why the private owner should consider surety bonding to guarantee projects is discussed as well. Therefore, Parts 1 through 3 outline the nature of the surety relationship, providing the background necessary to grasp how suretyship works.

Upon this base of understanding, the author's next task is to outline the significant considerations in the surety underwriting decision process, which comprises Part 4. As Figure P-2 demonstrates, a surety company is subdivided into two main branches: underwriters and claim personnel. The former decides which contractors to write bonds for, while the latter resolves any problems that may arise from a bonded contractor's failure to complete a bonded contract for any reason. These roles are discussed further in Part 2 and in increasing depth in Parts 4 and 5.

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Figure P-l Constructing the Surety Puzzle

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Figure P-2 The Surety Division: Separate but Equal

Fundamentally, evaluation by the underwriter on the basis of the following four major factors sustains the underwriting process of the contractor: character, capacity, capital, and continuity. Surety companies expend a large amount of their evaluation effort analyzing a contractor's financial condition, which is to say its available capital. However, the remaining factors are extremely important, and the contractor that fails to meet any of the expected standards may find it impossible to obtain surety bonds. In addition, communication with insurance agents, banks, attorneys, and the surety, as well as among members of the contracting firm itself, is important and will therefore be discussed in Part 4 as well.

This book provides an extensive description of the financial analysis underwriters perform, including several example analyses of contractor data.

Such information should help contractors understand what financial information the underwriters will need and help them prepare it, while also providing owners with some insight as to how they might benefit from this financial analysis. In addition, the author intends to describe how an underwriter's needs and interests are consistent with those of the project owner from evaluation process undertaken during the underwriting process to the resolution of any complications that may arise on a project. Such understanding is critical in reducing the possibility of contractor failure, a goal that everyone in the construction industry, including owners, sureties, and contractors themselves, strives to achieve.

Through gaining a solid understanding of the surety underwriting process, including what the surety requires, prime contractors and subcontractors can substantially reduce the frustration they might otherwise experience in trying to obtain bonds; concurrently, contractors can also improve their chances for

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establishing a successful bonding relationship. Some contractors believe surety bonding has become easier to obtain during the 1990s. To the extent that sureties have become more aggressive in their marketing as competition has heightened and relaxed in their underwriting requirements, this observation is "on target."

However, even though the current prosperous climate has allowed many contractors on the cusp to find a surety willing to underwrite its ventures, with an ever-increasing emphasis on capital, many undercapitalized contractors have found and will continue to find it difficult to locate a surety willing to underwrite bonds.

Individual states have legislated special allowances and conditions to aid contractors who cannot obtain bonds. In New York for example, the Commissioner can require a 20% retainage in lieu of the performance bond.

Obtaining surety bonds is complicated and consumes contractors' time and resources. However, one benefit of going through the process is that a strong bond rating is an important tool from a marketing standpoint when competing against other companies for projects. As in all commercial endeavors, a healthy credit rating is important. For contractors that may have experienced difficulties acquiring bonding and for contractors unfamiliar or new to surety bonding, in addition to discussing alternatives to surety products, this book may serve as a guide to help evolve toward a bondable enterprise.

To facilitate understanding between "surety companies" and the independent "agents" or "brokers" whom contractors retain to place their surety bonds, this book will henceforth refer to surety companies as "sureties" and

"underwriters," and the agents or brokers as "independent surety agents" or

"producers." This book will describe the regulation of underwriters and producers, and will also discuss factors that influence bond premiums. In addition, the reader will find some of the advisory rate tables that The Surety Association of America (SAA) promulgates, with sample premium computations, average agent commissions, and average costs for financial preparations by Certified Public Accountants (CPAs).

To understand how a surety arrives at the decision to underwrite a contractor, it is necessary to grasp how the entire industry operates. Throughout this book, and especially in the final section, the scope will widen to look at how industry-wide concerns can affect the local owner and contractor. Understanding the general economic climate of the surety industry is especially important, as it is a good general indicator of surety underwriters' attitudes. If business is good, they will be more willing to underwrite a potentially qualified contractor, while if business is bad, the surety will only underwrite those contractors that it is practically certain will not fail.

Sureties suffered significant and unexpected annual losses on their contract bond business from 1984 to 1987. This poor result was at least to some extent brought about by a lack of underwriting discipline in the prior few years.

Some underwriters believed that if the contractor was large enough, there was little chance of failure. This attitude seemed quite logical as over a long span of years very few of the largest contractors had failed. Accordingly, even if a large contractor wanted a work program that seemed excessive, the surety would tend to be supportive for fear that the contractor would go to its competition if the surety refused.

When a very large, overextended contractor fails, it can generate large losses for the surety. Between 1984 and 1987, several large contractors failed.

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To a considerable extent, their losses were a major cause of poor surety industry results during those years. It is important to recognize that not all of the surety companies suffered losses during these years. Those few sureties that maintained their underwriting discipline went through this period virtually unscathed. Even those sureties that suffered substantial losses usually only had one or two poor years out of four. Nonetheless, the significant losses forced many surety companies to adopt more stringent underwriting criteria and caused others to discontinue writing bonds altogether. Hence, in the late 1980s and early 1990s, some contractors, particularly those that were financially, managerially, or technically weak, found themselves forced to take only unbonded work or discontinue operations altogether.

However, in recent years the surety industry has been profitable.

Contractors and producers report that it is now much easier for a contractor to get a bond than it was even in the early 1990s. Since 1988, this string of profitable years has created a strong desire among the sureties to expand, or at least maintain, their market share in view of perceived potential profit. Since sureties compete for business on the basis of the service they offer, the prices they charge, and the underwriting criteria they apply, to attract or retain business, the surety might indicate a willingness to support a larger work program or offer a lower premium rate to the contractor. As a result of this desire by the sureties to maintain or increase their market share, many contractors that were once having difficulty obtaining bonds have found a surety willing to handle their account.

However, even in the best of times there will always be contractors lacking some important quality or asset that will be declined bonding. Accordingly, this book discusses possible alternatives to surety bonding, including how to acquire a waiver of bonds, individual sureties, letters of credit, and certified checks or cash.

The end of the 20th century and the beginning of the 21st century may yield different industry results. The surety industry tends to be cyclical, with this current period of growth and profitability going on 11 years. There was a slight loss in 1996, but profits were solid in 1997. The current profitable climate has attracted many new companies, and when sureties are aggressively seeking to write more bonds in a competitive environment, there is a tendency for some companies to loosen underwriting standards. As competition increases, underwriting inexperience can become significant as many personnel lack the discipline or experience to focus their analysis to render sound underwriting decisions. Heightened competition coupled with underqualified personnel may result in some contractors being guaranteed surety bonds who are actually not fully qualified to perform the work associated with a project. This could result in contractor bankruptcy and could force less-successful surety companies out of the market. Recently, many industry experts have pointed to first signs of this occurring.

Given the nature of the construction industry and surety underwriting, experience is essential for long-term success. In the current climate with a dearth of experience, once in a while a surety bond may be issued to a contractor who proves to be unqualified to perform the contract. Consequently, some owners may choose to use other contractor evaluation methods such as owner-contractor prequalification, even if they are requiring surety bonds. This method of evaluation is one of the author's areas of expertise and the subject of another book by him entitled Constructor Prequalification: Choosing the Best Constructor and Avoiding Constructor Failure (Russell 1996).

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Many construction project owners, especially those in the private sector, will depend on their own contractor evaluations and not require surety bonds.

However, if they make a mistake in judging the contractor, they will incur the financial consequences of the contractor failure. When the surety makes a mistake in judgment, regardless of the reason, the construction project owner and those who furnish their labor, materials, or services at least have the potential of recovering some or all of their loss from the surety.

In the event that the contractor fails to perform the contract and is defaulted by the project owner, a surety bond claim usually results. A surety bond claim occurs when the project owner or a payment bond claimant invokes his or her rights in accordance with the terms and conditions set forth in the payment bond, in an attempt to avoid or recoup financial losses through payments from or through performance by the surety. Contractor "default" or "failure" implies that the contractor is unable to fulfill one or more of its contractual obligations. A contractor's default may be caused by a variety of underlying problems such as inefficient job site administration, subcontractor failure, unexpected material shortages, labor disputes, price increases, scheduling conflicts, bad weather, personnel changes, or the insufficient availability of cash to pay laborers, subcontractors, and material suppliers.

In Part 5, this book will discuss considerations in handling surety bond claims and will also outline the steps a surety company may take when contractor default occurs. In the order that a surety would execute them, these steps are: 1) investigation, 2) evaluation, 3) decision-making, 4) implementation, and 5) monitoring. Examples of actual surety bond claims and an extended hypothetical account based on interviews with surety claim personnel and investigations of case law are given as a supplement to the procedural information. In addition, an outline of the actions taken to discharge a claim written by a claim manager with over 30 years of surety and reinsurance experience is found in Appendix XIII.

In the last section of the book, Part 6, practical applications regarding surety bonding, including the U.S. Government Small Business Administration Surety Bond Guarantee Program, special concerns currently confronting the surety industry, the aggregate performance of the surety industry, sources of information that one can access to check the authenticity of a surety bond, typical disputes arising from surety contract bonds, and obligee considerations regarding surety bonds are all addressed in depth. Finally, the author describes and projects surety industry trends, including developments brought about by the increasing use of Design/Build delivery and maintenance bonds.

With an understanding of how the surety industry is structured, how individual sureties make underwriting and claim decisions, and how individual bonds function, contractors, owners, design and construction professionals will benefit. All will make better informed decisions about whether to enter the world of bonding to begin with, and thereafter, how best to negotiate that terrain.

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Surety Bonds for Construction Contracts

Surety Bonds

for Construction Contracts

JEFFREY S. RUSSELL

ASCE PRESS

CONTENTS

PREFACE