Tight Credit Puts Surety Bonds On The Spot

In a good economy, claims against performance and payment bonds can be minimized as bonded contractors, who must personally indemnify the surety company, risk using funds from one project to fund one having cash-flow difficulties.

However, what happens when fewer or, in some cases, no projects are being let by private developers or governmental agencies? Where is the cash flow going to come from to support projects where the contractor needs the cash? What happens if there is no new cash flow?

The answer is that there will be a rise in defaults by contractors on existing contracts.

It is no secret that the construction industry is feeling the strains of the tight credit market. With today's tight credit market, there is virtually no cash flow to the construction industry. With lenders on the sidelines refusing to lend, private developers are shelving or delaying plans to build condominiums and commercial rental buildings, and governmental agencies are canceling already planned projects.

Contractors who rely on the cash flow from profitable projects to support unprofitable ones will not have that constant stream of revenue to rely upon. That leaves contractors with two choices: To put up equity to financially support unprofitable contracts, or to default on contracts.

Since very few contractors will put up equity in a down construction market, the result may be a sharp rise in claims.

While we can expect contractor defaults to result in claims against performance bonds, you can be assured that the claims against payment bonds will come in first as the contractor puts off payment to subcontractors to pay any cost required to keep the current projects on schedule.

By keeping existing contracts on schedule, the contractor can avoid not only direct damages for its failure to complete but costly liquidated damages as well. (See related text box for definition.)

In the case of general contractors, they usually have many projects under contract at any given time. The general contractors hope to earn a profit on each of those projects. However, there are times when a general contractor suffers a negative cash flow from a project and must choose to either use its own funds to cover the negative cash flow, use funds from other ongoing projects, or abandon a project.

This negative cash flow can come as a result of a loss on a completed project, an ongoing project which is behind schedule, or an ongoing project for which the general contractor underbid the cost of the work.

Moreover, many performance and payment bonds are written for public improvement projects. Those governmental owners are notorious for slow payments even for approved work, and many times do not approve and pay for change order work for over a year causing the contractor to finance portions of the work.

If the general contractor decides to infuse capital into a money-losing contract, then the chance of a claim arising against a performance or payment bond is significantly reduced. However, when the general contractor decides to use funds from one project to cover costs on another, or simply abandon a project, claims against payment bonds will start to mount.

At first, when a general contractor starts using funds from one project to cover the costs of another, a contractor may be able to "catch up" with its current financial obligations since there are usually more profitable contracts ongoing than unprofitable ones.

However, in a tight credit market like the one today, when there is a severe lack of new projects to generate positive cash flow, there is a high probability that the contractor will end up without enough cash to pay all costs on a much greater scale than found in a typical credit market.

At that point, the general contractor will not be able to pay its subcontractors on those projects from which the contractor took the money to pay the costs of the previous contracts. Once that contractor fails to pay subcontractors, the subcontractors, faced with limitations on timeframes for claim notices set forth in state statutes or in the bonds themselves, will begin to send out notices of claim and commence actions against the bonds to preserve their rights.

Another type of claim that surety companies must also be careful of are those brought by union fringe benefit funds for nonpayment by contractors and their subcontractors for fringe benefits due for labor provided to the project.

Pursuant to collective bargaining agreements between employer-contractors and employer-subcontractors and the various union locals in any given geographic vicinity, for each hour worked by a worker, not only does the contractor or subcontractor have to pay the wages directly to the worker, but it also has to remit the corresponding hourly fringe benefit to the union fringe benefit funds for each hour worked.

When there is a lack of cash flow due to the lack of new projects, contractors and subcontractors tend to pay union fringe benefits last or do not pay them at all and simply go out of business. Pursuant to case law in many jurisdictions, the union fringe benefit funds have a claim against the payment bond for fringe benefits.

The fringe benefit funds can make claims for fringe benefits due from the principal on the bond (i.e., the contractor) or the subcontractor performing for the contractor. In those instances, the surety is often faced with a contractor or subcontractor who has closed up shop and disappeared, leaving the surety with no witnesses or documents to defend against fringe benefit claims.

Making matters worse for the surety, in the case of a subcontractor, the surety may be held liable for the fringe benefits (and wages too) despite the fact that the general contractor paid the subcontractor all amounts due under the subcontract.

In addition to the claims by subcontractors that will arise when the general contractor does not have the cash flow to pay its debts from previous projects due to the lack of new work, owners will be faced with the abandonment of contracts by general contractors. Without the cash from the next project to pay the subcontractors on other ongoing projects, the subcontractors will stop performing their work which will cause the general contractor to breach its contract with the owner.

The general contractor will leave the owner either with an incomplete project and claims by subcontractors despite the fact that the owner has paid the general contractor the funds which should have been paid over to the subcontractors, or finish the project late and be liable for liquidated or other consequential damages.

This will bring a rise in claims against performance bonds, the amounts of which generally can be greater than the payment bond claims combined depending on the value of the contract.

In sum, surety companies should be prepared for a significant rise in claims and must be extra careful in this economy to make sure that each person or company performing work at the project is getting paid. While that's easier said than done, sureties must take extra precautions in policing payments to minimize claims.