The article appeared in the November 3, 2017 issue of Construction Executive’s Risk Management e-newsletter.
For many contractors — whether they perform on construction projects for private companies or local, state or federal agencies — bonding lines can be their lifeblood. A contractor’s ability to develop and maintain a strong relationship with a surety may be critical to whether the contractor will grow and develop or wither and expire. It’s important for contractors to have a clear understanding of exactly how a surety evaluates a construction firm for surety credit, what information the underwriters need and how to communicate both positive and negative company and job information. Having this level of understanding will help mitigate a construction firm’s risk for compromising the relationship with a surety firm and ultimately, impact operations.
While there are many ways to ensure project completion (such as subcontractor default insurance [“subguard”]), traditional surety bonds are still the most prevalent. The most common surety bond is a performance bond, which guarantees the performance of the general contractor and related subcontractors to the completion of a construction project. The bond amount is generally equal to the cost of the project and remains in place until the project is complete.
The other two bonds, which generally go hand in hand with a performance bond used in the construction industry, are the bid bond and payment bond. The bid bond is issued at the time of the initial bid and ensures that the bid has been submitted in good faith. The contractor will execute the contract and provide the required performance and payment bond. The payment bond ensures that the contractor will pay subcontractors and job-related costs, such as laborers and material suppliers, on time and in full.
Surety bonding lines are established between the contractor and surety firm, very similar to the establishment of a banking line of credit. While a construction firm’s banking line of credit is very important and is underwritten with financial scrutiny, a company’s bonding line can be even more important and have a more intense underwriting process. This is because a credit analyst with a surety firm is extremely well versed in all nuances of a construction firm and is skilled at dissecting financial data at the job cost level as well as the global operating level of a contractor.
Surety firms will evaluate many variables prior to determining bonding capacity and establishing bonding lines at the project level and company level, including but not limited to:
- Financial health and liquidity
- Bank lines of credit terms and conditions
- Prior job performance experience and references
- Prior job gross profit fade experience
- Prior job revenue, cost and profit control
- Claims and change order history
- Level of perceived open- and integrity-driven communication
Surety companies should not be viewed in an adversarial way due to the importance of the relationship and financial risks that they bear in the construction marketplace. When a surety firm turns a contractor down for a particular job there is usually a good reason. Generally, a financially sound, successful construction firm should be able to obtain bonds on a somewhat routine basis if the firm is focused on key operational areas:
- Project selection — Successful contractors are highly selective about the projects they take on, focusing on work that is within their core capabilities and makes both financial and operational sense.
- Project management and oversight — Successful contractors are focused on assigning experienced project teams to high-risk jobs.
- Project change order resolution controls — Successful contractors are very good at controlling, negotiating and collecting project change orders.
- Corporate overhead cost control — Successful contractors regularly monitor operating costs to ensure the company does not overspend in its day-to-day operations.
- Financial checks and balances — Successful contractors ensure sound, thoughtful financial decisions are made on a frequent basis.
The key to a successful bonding relationship is open, active and honest communication. As construction firms start to plan for the 2017 year-end, it is imperative that the surety firm be kept up to date on a variety of matters, including:
- Projected 2017 financial results
- Changes to banking relationships
- Status of significant under-billings and potential construction claims
- Status of significant construction litigation
- Estimate of cash flow requirements for 2017 tax liabilities
- Backlog update and job fade issues
At a minimum, this communication should occur on an interim basis and then once more when the CPA firm completes the final, year-end financial report. It is absolutely critical for the contractor to establish open lines of communication with the surety. This is not only important when things are going well, but perhaps even more important when major job issues occur, when litigation is on the horizon and when financial issues are mounting. Surety firms do not like “bad” surprises such as job fade issues, litigation, changes in bank financing, key personnel changes and other negative company operating factors. They are looking to see how contractors handle the impact of a bad project as this may determine whether the business will maintain its bonding relationship or not. While it may be tempting to try and hide this information from the surety firm, waiting too long to address bad news is a mistake.
There are three very important concepts in cultivating and maintaining a positive relationship with a surety:
- Timely, open communication with the company’s CPA, bonding agent and surety firm on a periodic basis
- Transparent communication with the surety firm on positive and negative operational issues as well as opportunities on up-coming job opportunities hitting the market place
- Responsiveness to questions posed by the surety on a specific job matter so issues can be addressed and hopefully, resolved quickly
Managing and enhancing a surety relationship is no different than managing any other business relationship. A construction firm must completely understand that a surety firm has a real interest in the operations and success of the construction firm’s operations and is financially exposed during the life of the job. While strong performance has a way of curing most issues, open, continuous communication with the surety firm should not be overlooked. Viewing the surety firm as a business partner rather than an adversary can be the difference between a successful construction firm and an unsuccessful one.