The Increasing Prevalence of Surety Bonds in Private Construction Projects

Well, considering it’s a cornerstone of our business, we’ve been at the forefront of surety bonds for the construction industry for 20+ years, only our solution is electronic which is about the most efficient and failsafe methodology for delivery. So yes, its critical for attorneys in construction practice dealing with private projects to become expert in all things surety bonds. And because they are so immersed in ensuring the accuracy and safety of the transaction, knowing that a solution like electronic bonds exists is essential to their education.

FROM THE LEGAL INTELLIGENCER / BY JOSHUA LORENZ

For construction attorneys, it’s now critical to understand the ins and outs of surety bonds and how they’re used in the context of private projects.

During uncertain times, people look for a security blanket of added protection when embarking on new projects, and surety bonds are one way to provide that. For decades now, surety bonds—typically three-party agreements between the surety, contractor/subcontractor and project owner—have been required for most public construction projects. Recently, and largely stemming from uncertainties caused by COVID-19, ongoing supply chain woes, and material shortages and inflation, many more owners and investors have begun requiring bonds for private construction projects, too.

For construction attorneys, it’s now critical to understand the ins and outs of surety bonds and how they’re used in the context of private projects.

Why Use Surety Bonds

There are several reasons why private owners may prefer, or even require, the use of surety bonds, which generally are noted as a project requirement in the RFP, but also can come up during various stages of contract negotiation.

Private contractors often work on several projects simultaneously, and with the current labor and supply-chain constraints there may be delays at any given time. These delays can domino into higher material costs, postponed project deadlines and possible contract breaches.

In private projects, bonding protects the owner from contractor default on the terms of their contract, and guarantees the contractor is protected against possible disruptions, unfinished projects, failure to meet contract specifications and unpaid debts. In this way, bonds offer extra assurances to the owner, and can also help contractors stand apart from their competitors, provided they’re able to win project bids and satisfy the criteria that’s required of them.

Types of Surety Bonds

The two primary types of surety bonds utilized in construction are payment bonds and performance bonds, though they can serve a slightly different purpose for private projects than their federal and state counterparts.

With the help of payment bonds, project owners can mitigate their exposure to financial risk and ensure that everyone, including bidders, contractors, subcontractors, suppliers and construction workers, is paid for the full scope of work they complete. Performance bonds, on the other hand, are put in place to ensure that the bonded scope of work gets completed in accordance with the specific terms laid out in the project contract.

Performance bonds are much less common in private construction projects due to the added cost and because owners, generally speaking, don’t contract with those whom they don’t trust to get the job done. Private owners who have worked with certain contractors before or are aware of their reputation may not need a performance bond to fall back on. If a relationship or solid reputation has already been established, there may be very little performance risk to worry about at the outset.

Challenges With Surety Bonds

Similar to insurance policies, bonds certainly can provide a substantial amount of security for private owners and contractors. That said, there are always obstacles to consider when pursuing a bond with a surety company.

Cost is the main drawback of proceeding with a bonded project. Bonds most often are equal to the contract value, and bond premiums are generally 1-3% of the bonded amount. During significant inflation, people may not be able to take on as many jobs depending on costs associated with their bonding capacity and requirements for a project. If a project costs 20% more to perform, that likewise will consume more of a contractor’s overall bonding capacity. The bottom line is any time you’re requiring bonding on a project, that’s more money out the door from a cost perspective.

The bond claim approval process also presents challenges for parties to navigate. Surety companies don’t just hand out money haphazardly—there are thorough investigative processes that are used to determine whether a bond claim is legitimate. Though sureties can seek reimbursement from the responsible party for any paid claims under the bond, they are initially responsible and cannot always collect.

After a claim is made and submitted to the surety company, the surety will then evaluate the principal party who is obligated to the bond, the claimant, the circumstances underlying the claim, and any defenses that the bonded party may have. This investigative process takes time as payment of a claim is far from automatic.

Additionally, not having sufficient bonding capacity may limit a contractor’s or subcontractor’s ability to work on a given project. Similarly, owners requiring a project to be bonded may limit the pool of potential bidders, thus potentially increasing the cost of the work. Bonding capacity is set by the surety based largely upon previous business and financial operations. Bonding capacity is also partially determined by a party’s track record and the success they’ve had on prior contracts, as well as the volume of work they’re committed to performing.

It’s important to remind clients that every surety company is different. Depending on the methods employed by the underwriter, the level of risk associated with the scope of work and the surety’s determination about a party’s qualifications, some parties might not be able to get bonds approved, or may only be approved at a higher rate.

The Attorney’s Role

Overall, as surety bonds become more commonplace in private projects, construction law attorneys have a responsibility to help clients navigate the benefits, drawbacks and uncertainties associated with bonded projects. Advising clients to ask the right questions from the start and consult with other participants on the project about whether the project should be bonded and what the terms of their contract and bond(s) require will set them up for a more successful project outcome and, ultimately, more fruitful and trustworthy working relationships.