Filed Under:Risk, Loss Control

Protect Prime Contractors' Businesses with Subcontractor Bonds

The recession had a broad impact on contractors, but it seems to have hit subcontractors particularly hard. Generally, subcontractors are small businesses with modest balance sheets, and even minor business disruptions can cause defaults. Subcontractor performance and payment bonds (sub-bonds) are one of the best ways for prime contractors to guard against such defaults.

Unlike other products, sub-bonds offer a combination of payment and performance protection. Independent agents have an opportunity to educate their customers about the benefits of these financial tools.

Sub-bonds: qualified, motivated and solidly backed
Before issuing a sub-bond, a surety takes a variety of underwriting steps to gauge the subcontractor’s stability. Surety underwriters conduct detailed reviews of a subcontractor’s balance sheet, which gives them a view into the subcontractor’s financial strengths and weaknesses. Underwriters also explore the subcontractor’s technical abilities and managerial skills.

Sureties require indemnity against losses. An indemnity obligation is a powerful motivating force because it often involves the encumbrance of both business and personal assets. If a subcontractor’s proprietors know that they are professionally and personally bound to complete a project, they are much more likely to perform their contractual obligations. Other products may protect against subcontractor defaults, but they do not include indemnity elements that so strongly motivate performance.

Despite the indemnity obligations associated with sub-bonds, defaults can still occur. If a bonded subcontractor defaults, the surety will assume the subcontractor’s performance and payment obligations. Generally, sureties hold assets that must exceed the obligations of any given bonded obligation. This financial strength offers prime contractors peace of mind that they don’t receive from other financial tools.

Bond claims: educate, comply and communicate
A common complaint about surety bonds is that the claim process is too slow. This complaint often stems from a lack of familiarity with suretyship and the bond claim process. To help expedite claims, prime contractors must ensure that their personnel know and understand the terms and conditions of their subcontracts and the associated bond forms. Once familiar with the rules governing a sub-bond, there are several important issues to monitor to ensure compliance, including:

  • If a subcontract requires notice within a certain period, it is important for the prime contractor to make sure that the notice is timely.
  • If the subcontract calls for a cure period prior to a default declaration, the prime contractor must make sure that the cure period is granted.
  • In a claim situation, the surety is entitled to assert the defenses of its bond principal, and every instance of noncompliance by the prime contractor is a potential defense that the surety may assert. Strict compliance with the terms and conditions of the subcontract and bond form should address these issues.

Once the prime contractor has a claim, it is important to communicate with the surety. A short demand letter may amount to a bond claim, but such a letter lacks the information that the surety needs to conduct an investigation. If the prime contractor wants to move quickly, it must give the surety the information that it needs, including copies of the subcontract, relevant correspondence, change orders, requests for information and technical reports. Giving the surety the proper information will accelerate the claim.

After providing the surety with the information needed to substantiate its claim, the prime contractor should continue to communicate proactively with the surety.

Take control of the documents that govern the claim
To help expedite the claim process, prime contractors can craft subcontracts and bonds that make the claim process easier.

A tailored subcontract should allow the prime contractor to advance emergency or critical path work without impairing its right to seek recovery of the associated costs. Involving the surety in this process is important. The prime contractor should provide the surety with detailed descriptions of the work performed and document all costs and expenses incurred. The prime contractor also should secure the surety’s prior consent to perform the work and memorialize these agreements in writing. In conjunction with a well-crafted subcontract, taking these steps should reduce potential coverage arguments and expedite the claim process.

Manuscripted bond forms allow the prime contractor to move the project forward and provide greater coverage certainty. But the surety must agree to issue the form, so drafting a sub-bond requires care. Manuscripted forms should include at least these concepts:

  • The prime contractor’s performance must be a condition precedent to the surety’s obligations
  • Bond coverage must be conditioned on the prime contractor’s declaration of a subcontractor default and termination
  • The prime contractor must notify the surety
  • The bond’s penal sum must cap the surety’s obligation.

To help keep a project moving along, a manuscripted bond allows the prime contractor to exercise self-help without waiving the bond’s protections. Also, the bond may allow the surety to assist completion by financing the subcontractor during the surety’s investigation. Alternatively, the bond can allow the surety to assume performance during its investigation. The surety will incur costs exercising any of these options, and these costs must be credited toward the bond’s penal sum. With care and thoughtfulness, tailored forms will better serve the interests of all parties.

Some of the most successful independent agents are using sub-bonds as tools to demonstrate their expertise and value to clients, helping them protect their businesses from dangerous risks.

 

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