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Contract Bonds are a set of bonds that guarantees the successful completion of a contract. In general, contract bonds are used to guarantee that the contractor will perform according to the specifications of the construction contract (performance bond) and that all material and labor providers will be paid (payment bond). If the contractor fails to perform according to contract, the surety company is responsible to the obligee for the successful completion of the contract or payment, up to the limit of the bond, which is usually for an amount equal to the cost of the construction project. The surety company then has recourse against the contractor for reimbursement.
Contract bonds are underwritten differently at every surety company, with each company placing a different emphasis on the type of contractor, scope of the contract. Level of financial presentation and risk level with which the surety would take on. For example, some sureties prefer to only bond general contractors, while other sureties will bond both the general contractor and any sub contractors. With scope of work, some sureties are known for providing generous single/aggregate bond programs for contractors who focus on environmental contracts, while some sureties will refuse to underwrite environmental contractors. Among the most important distinction between surety companies is with the level of financial presentation. In the "standard" surety market, most surety companies will only accept Certified Public Accountant (CPA) financial statements, with an emphasis on "audit" or "reviewed" statements. In the "non-standard" or "sub-standard" market, sureties still prefer CPA statements, but will consider underwriting the account in the absence of CPA those statements, usually by requiring some form of collateral.
What are some of the benefits of contract bonding?
- Professional references – The surety companies and bond producers knows accountants, bankers, and lawyers who understand the construction business.
- Corporate experience – Producers and surety company personnel can share their experience on issues facing a contractor.
- Funding verification – This service becomes very important if a contractor is involved in private construction. Many contractors have faced bankruptcy because they did not ask the source of funding on private projects. The surety will insist on knowing the source and adequacy of funds before it will commit to bonding a project.
- Contract reviews – Many sureties perform contract reviews to identify contract terms, general condition requirements, or anomalies in the specifications, or bond forms that may be onerous, unacceptable, or add undue risk to the project.
- Continuity plans – Sureties can assist the contractor with a continuity plan to protect the contractor’s family, estate, partners, creditors, employees, and assets.
- Increase in working capital - Some owners will accept cash/securities and other forms of liquid asset in lieu of a bond, but such option will greatly reduce a company's working capital.
How are contract bonds underwritten?
* Each surety company has their own guidelines and criteria for underwriting a contract bond. But in general, they will follow the 3 "C's" when determining whether a contractor qualifies for a contract bond. The 3 "C's" are as follow:
1) Character: applicant's standing and reputation are such to warrant the conclusion that they are of good character and worthy of trust.
2) Capacity: if the obligation entered into by the applicant requires particular skills or ability in its performance, the applicant should possess those necessary skills and ability
3) Capital: the applicant should be solvent and would be unlikely to commit dishonest act or perform inefficiently because of strained financial resources.
With some sureties, if the contractor is lacking in any of the above "C's" they might require collateral in the form of cash or letter of credit.
******** In submitting the initial request for bonding, the following information should be included to insure a quicker response.
1) Contractor's questionnaire: An application that provides a basic summary of the company, including information on the owners and key personnel of the company. Additional information includes history of projects completed, key suppliers, insurance providers, banking institutions, etc.
2) Business Financial Statements (Balance sheet, income statement, statement of cash flows and aging schedule for account receivables and account payables) are classified into 4 categories, in order of preference by the surety.
- Audited Statements: An audit verifies relevant items in the financial statement with internal and external investigations of their accuracy. The accountant certifies that the financial statement is presented in accordance with generally accepted accounting principles.
- Reviewed Statements: A review statement, which does not require the outside verification present in an audit, consists principally of a thorough review of the contractor’s financial records and the application of certain analytical procedures to the financial data. Although narrower in scope than a full audit, the review does provide some limited assurance about the financial statements. Surety companies will generally require reviewed statements for all contract bonds over $1 million in penal sum.
- Compilation Statements: A compilation statement provides little or no assurance of the credibility of the figures presented and would typically be accepted only for interim statements. Surety companies will generally require compilation statements for all single bond request above a penal sum of $250,000 and up to, but not above $1 million in penal sum.
- In-house Statements: An in-house statement is internally prepares and very little weight or credibility at attached to the information on the statements. Generally surety companies will accept these statements for bonds up to a penal sum of $250,000.
3) Personal financial statement for all owners (indemnitors) of the entity. Like the business financial statements, they can be audited, reviewed, compilation or in-house. Most sureties will accept in house statements as long as the key assets (cash, stocks, short term assets can be verified).
4) Resume of all key personnel: Provides a clear and concise history of the people who will be overseeing the business and contract. Let's the surety know that the key employees has the knowledge and experience to run the business and undertake that scope of work.
5) Copy of insurance certificates: As most contracts require certain insurance policies to be obtained by the contractor and/or be active during the completion of the contract. To avoid any potential performance bond claims, surety companies will ask for copies of all insurance certificates. Such insurance includes, general liability insurance, worker's compensation insurance, professional liability insurance, etc.
6) Bank reference letter and bank statements: In an effort to better gauge a contractor's access to short term funds and their working capital, sureties will look to current bank statements and bank lines of credit (BLOC) statements to verify that the contractor has sufficient funds to take on further contracts. It is recommended that the 3 most recent month's statement be submitted.
7) Work in progress (WIP) or work on hand schedule: Surety companies will want to verify that the contractor will be able to take on additional projects in addition to their current obligations. As a result surety companies will focus on the work in progress schedule to see what affects the additional contract will have. When filling out the WIP, it is important to make the distinction between projects that are bonded and projects that are un-bonded as some surety companies calculate a contractor's backlog with just bonded projects, while other sureties count the total of all contracts; bonded and unbonded.
8) Copies of all relevant licenses: In most states, a contractor's license is required to contract projects. In some instances, there are specialty licenses, such as those required for hazardous work and environmental contracts. Such licenses are requisites in contracts, so the surety will want to verify that all licenses are currently active as to avoid performance bond claims.
9) Documentation showing ownership structure. As part of the indemnification process, surety company will want to verify how the company is structured. If the entity is a corporation, provide a copy of the articles of incorporation. If entity is a LLC, provide a copy of the LLC agreement. If it is a partnership, provide a copy of the partnership agreement. If any owners of the entity owns a related entity, also submit the document showing the ownership of the related entity.
10) Copies of applicable trust: If any owners of the entity has any assets held in trust, the surety company will require that trust be indemnified, so a copy of any trust should be included in the initial submission.