Understanding Surety Due Diligence in Construction
Most construction contractors are familiar with the requirements concerning surety bonds. However, there are some steps that contractors can take to increase the number of bonds that they can carry and the ease with which they are obtained.
All contractors should have a basic understanding of how surety companies determine risk and make the decision to bond. Contrary to some opinion, a surety bond is not an insurance policy. Rather, it is a guarantee that governs the performance of the contract as stated in the bond. Unlike surety companies, insurance companies take a risk that you will not file a claim. They collect your premium payments while essentially betting against you. They may weigh certain factors before providing coverage, like health issues if you are seeking life insurance. However, surety companies engage in a much more intense due diligence analysis before they decide to bond. This is primarily because there is generally more risk associated with a bond than insurance.
Joint and Several Liability Risks
In the bonding world, the contractor, often referred to as the principa, is required to fulfill the terms and conditions contained in the bond, often referred to as the "obligation." If the contractor fails to perform or complete the "obligation" pursuant to the bond, both the contractor, and the surety can be liable on the bond.
Typically, the principal and the surety share joint and several liability meaning that either the principal, the surety or both may be sued on the bond and that either of them can be responsible for any damages. This is an important point to understand because joint and several liability factors into a surety's decision to bond the contractor and the determination as to the limit of the bond.
Surety Due Diligence
Sureties, or bonding companies, look at a number of factors when determining whether to bond a construction company and to decide what amounts to cover. Awareness of these factors can help contractors structure their business in ways that will make it easier to obtain bonds.
Limit Liability and Claims
As mentioned above, joint and several liability is always a concern for surety companies. Therefore, the amount of litigation a contractor may have can impact a bonding company's decision. If the company has a history of being sued, this can be a red flag.
In addition to litigation, surety companies look at the number of claims filed under previously obtained bonds. If there is a significant history of claims, the company may decide to pass on bonding the contractor. Limiting negligence, liability, and claims can have a positive impact on the company's ability to be bonded.
Profitability and Working Capital
Another factor that sureties focus on is the profitability of the contractor. It is important to note the difference between sales and profitability. Surety companies look at net worth and working capital in addition to other financial documents to determine the profitability of a company. They are less interested in sales without profit and financial stability.
Bonding companies who regularly work in the construction industry understand that a contractor may have a bad year or two. However, consistent decreases in profitability will have an adverse impact on the company's ability to obtain bonds.
Having strong working capital is one way to ensure that the contractor will be bonded. Surety companies look for assets such as cash, inventory, and receivables. Bonding companies would rather see the availability of working capital rather than equipment or other fixed assets, which could be sold off if the company became financially burdened.
Be Prepared for the Pre-Qualification Process
Construction companies need to understand that most if not all bonding companies undertake pre-qualifications screening procedures before issuing a bond. Having the information required by the bonding company on hand will make the process much easier.
Contractors will need to provide all relevant financial documents including current tax returns and financial statements prepared by a qualified accountant. Some companies may require a letter from the contractor's bank with a history of the company's balances and credit lines. Sureties may also require information concerning the corporate structure of the business, information about principles, employees and policies, and procedures. Finally, they will require information concerning the particular contract or job that the contractor is seeking to be bonded for.
Being bonded on projects is par for the course in the construction industry. Having an understanding of the way surety companies review and screen construction companies and taking action to put their company in a favorable position can have a positive impact on the contractor's ability to obtain a bond.