Performance bonds: how to avoid guarantees
This is a nasty topic. Not because surety bonds are inherently bad, but because it is a subject of great distress to contractors and their insurance/bond agents. For example:
Why is the bail bond company taking money from me when I can see Am I in a weak cash position? I need it to successfully carry out the new project.
You don’t pay me interest on the money? Why not?
When the job is half done, won’t you release part of the warranty?
Will you not release the guarantee upon acceptance/completion of the contract?
Will you not release the warranty until the end of the warranty period?
Etc. Much of aggravating phone calls and emails.
With all this aggravation ahead, why do some surety companies require collateral? The reason is to protect yourself in the event of a bail bond claim.
When a contract warranty loss occurs, the claims department expects to have two dependent resources for financial recovery:
The unpaid balance of the contract goes to the bond as they complete the work
The guarantor sues the applicant/company and their owners to recover the loss
Collateral requirements arise when the security wants to have certainty. If a problem develops, they don’t want to find that the client has no money left, or filed for bankruptcy… or left the country. If they’re going to write the bond, they want a guaranteed way to financial recovery.
Keeping in mind that warranty is a high price to pay for a bond, let’s look at an alternative approach that helps the warranty, but doesn’t take much of a bite out of the contractor!
“Retention” is money that the project owner retains (retains) to ensure the final completion of the project and the payment of related invoices. If the retention is 10%, the contractor receives 90% of the funds owed to him as the work progresses. In the end, the contract owner/obligee will still have 10% to keep the contractor interested in achieving full and satisfactory completion. In this way, the withheld money protects both the obligee Y collateral – making a bail bond claim less likely.
The “Final Payment Release Bond Consent” is a voluntary procedure that obligated persons may use as a courtesy to the bond. The last part of the contract funds can be useful leverage for the contractor to move in for final contract adjustments. There may be cracks in the building, broken glass, faulty lights, paint mistakes, little things that the obligee cares about but the contractor may be annoyed to fix. The Collateral Consent is another way for the surety company to avoid a claim. “Please fix this problem or we won’t agree to release your final payment.”
How can these two useful tools be incorporated to ensure that they help collateral and therefore replace the need for collateral?
The answer is to add a condition to the bond (required compliance required by the obligor) indicating that there can be no release or reduction of the withholding or final payment without the prior written consent of the surety. Now the surety company is guaranteed to have a financial resource available and the amount is known in advance, as is the guarantee. But the contractor didn’t have to empty the company’s bank account to do it: Win win!
What happens if the terms of the contract do not provide for a retention procedure? one can be aggregate for contract modification. If Funds Control (an escrow agent) is used to handle contract disbursements, a hold procedure can be added to the funds control agreement.
Consider this alternative procedure if your bonus underwriter needs help getting more creative with their underwriting solution.
Speaking of funds control, keep an eye out for our article next week “Compliance Bonds: How to Avoid Funds Control.”