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Selecting the Right Performance Risk Security for Your Project: Does One Size Fit All?

By Ian Frank
Frantz Ward LLP

Imagine you are responsible to develop a comprehensive risk management program for an upcoming construction project estimated to cost $500 million. What are the options available to you, and where do you start? Or presume you have an opportunity to submit a proposal to serve as the construction manager for the project, and the owner is considering not using traditional bonding. What alternative forms of security do you explore or suggest? As a major trade contractor being asked to submit a bid on the job, is it viable or worth the risk if bonds are not in place? These are the questions that increasingly are facing construction industry participants in the current market.

Performance risks do not discriminate. The impact of defaults is shared by everyone. These risks include safety or environmental issues, schedule delays, defective work, payment defaults, design errors, scope disputes, and financial insolvency. Some of these risks may be insured. Still many others are not covered by traditional insurance policies, yet still plague projects and cause significant legal disputes. These risks require additional performance security.

BACKGROUND
Surety bonds are by far the most frequently used form of security against performance defaults. Whether a bid, performance, payment or warranty bond, they serve as a guarantee by the surety that its principal will fulfill certain defined contractual obligations to the obligee. The surety “stands in the shoes” of its principal when there is a default and is equally responsible, up to the penal sum of the bond. But a bond is a credit-risk product, not an insurance policy.

Subcontractor Default Insurance (SDI), however, is an insurance policy and provides another means of securing against defaults. SDI provides coverage to a single insured, typically the prime contractor or construction manager, for economic losses resulting from subcontractor defaults. SDI policies are written by multiple carriers, but are not for every contractor or project. It is targeted toward contractors with a high volume of subcontracted work annually, typically in the range of $75 million. Though published data regarding recent trends or the percentage of projects or contractors that use SDI is scarce, anecdotal information suggests that many large contractors, construction managers and design-build firms are using SDI as a replacement or supplement for bonds.

Additional forms of security, such as letters of credit (LOC) or parent/affiliate guarantees, provide another option, but historically have been used less frequently in the U.S. Most LOCs are irrevocable instruments issued by a bank or similar financial institution in a defined amount (usually about 10-25 percent of the contract amount), and are immediately payable upon demand of the holder, without any proof of default. Parent/affiliate guarantees are simply written agreements that act much like a bond in that they serve as a financial backstop for any contractor defaults by a related entity that hopefully has a healthy balance sheet.

COSTS
While you will not pay anything to get a guarantee from an affiliate, there can be significant known, and some hidden, costs for the other forms of security. Bond premiums vary depending upon underwriting criteria, the size of the bond and other factors, but can range from .5 percent to 2 percent of the contract price. The premium for SDI is often less than their bond counterparts, but it comes with a significant deductible (possibly $500,000 to $1 million), as well as co-pay requirements for claims that exceed the deductible. An LOC might only cost a contractor about 1 percent of the face amount on an annual basis, but the true costs come in the form of cash restrictions because it must be 100 percent cash secured. This often presents an insurmountable challenge to many contractors with demanding working capital needs.

QUALIFICATION PROCESS
The hallmark of bonding is the independent underwriting process conducted by the surety regarding the contractor’s character, capital and capacity. It is intended to serve as a pre-qualification of the principal’s financial and technical ability to complete the project. It is never a guarantee against default. Still, since bonds are issued with the expectation that no losses will occur, sureties are usually thorough when underwriting a risk. SDI also involves a qualification process that includes a review of financial information and past performance, but instead of being done confidentially by the surety, the information is laid out for the contractor to see. This can serve as a source of tension and anxiety at the beginning of the relationship. Bonded subcontractors do not need to qualify and are not covered by the SDI policy.

Neither an LOC, nor a parent guarantee, involves any qualification process, which can be a significant disadvantage. The absence of underwriting prevents any quality control, and makes these methods merely a “vessel” for recovery of damages. They do not provide a means of evaluating performance risk early in a project, something important to all participants, who would prefer to have contractors that have been vetted and are not likely to default.

SCOPE OF COVERAGE AND REMEDIES
Performance and payment bonds provide guarantees against a wide variety of performance risks. From the owner’s perspective, they ensure that the contractor will perform the work in accordance with the contract documents, in a timely manner. They also protect trade contractors against the risk of non-payment. Parent/affiliate guarantees can be written in a way to provide the same coverage as traditional bonding. SDI policies, on the other hand, permit the insured to recover a broad scope of damages for subcontractor defaults, but have a number of gaps in comparison to bonds.

SDI policy coverage usually extends to: (i) the cost of completing the work; (ii) the cost of correcting defective work; (iii) attorneys’ fees and other professional or consulting costs; (iv) liquidated damages; and (v) extended overhead, acceleration and other schedule-related costs. But SDI lacks any direct financial guarantee against the prime contractor’s insolvency or default, including their inability to absorb the significant self-insurance requirements associated with these policies. The most often cited criticism of SDI, however, is the absence of any payment protection to subs and suppliers that would exist with a payment bond. Though other remedies exist to minimize this risk, such as mechanic’s liens, project account claims, or joint check arrangements, those options are often not available or a meaningful form of security.

LOCs are not limited in scope as they are payable in full upon demand without proof of default or itemization of damages. But an LOC fails as an adequate form of security where there is a default with catastrophic financial consequences given that it is rarely for the full value of the contract.

CLAIM PROCESS AND RECOVERY
LOCs have no claim process, and therefore present the riskiest proposition for any contractor issuing them. Proof of default is not required, so it is “pay now and argue later.” Though not quite as simple as asserting a demand against an LOC, the claim process for an SDI policy is intended to be very prompt, often weeks or less than a few months. The contractor insured controls the process entirely, and is the only one that can make a claim. Also, unlike most bonds, subcontractors need not be terminated and thrown off the job as a condition of pursuing a policy claim. The tradeoff for this speed is certainty. SDI policies often contain a “clawback” provision that requires the contractor to return the proceeds where it is later determined that the sub did not default.

Bond claims allow a claimant to have finality with recovery, but often at the expense of speed. Strict compliance with the terms of the bond and governing laws is critical. The claimant receives an independent investigation of the claim by the surety, but that analysis takes time and comes with the reality that the surety likely has a well-established relationship with its principal. Most bond defaults involving disputed underlying performance issues result in litigation, with the surety tendering its defense to the principal. The prospect of deferring to the position of the defaulting contractor is even more pronounced when parent guarantees are involved. Parent guarantors are likely to side with their contractor affiliates and there is not even an expectation of an independent investigation.

CONCLUSION
While SDI, LOCs and parent guarantees are not likely to replace traditional bonding any time soon, each has its attributes and shortcomings. LOCs and parent guarantees may provide meaningful protection for contractors that are unable to secure or do not have access to traditional bonding (e.g., specialty equipment/material manufacturers), or have exhausted annual bond capacity. These options may also experience increased consideration due to the influence of international constructors in the U.S. construction market. Further, where viable payment remedies exist for trade contractors and the owner is confident in its construction manager’s ability to perform, SDI may be the answer. In the end, the decision regarding which method is the right fit depends on an individualized assessment of the key risks, players, delivery method, and other project-specific factors.

Ian Frank is a partner with ALFA International member firm Frantz Ward in Cleveland. Ian focuses his practice on construction and surety law, counseling and representing contractors, material and equipment manufacturers, design professionals and other stakeholders in managing and litigating complex commercial construction disputes.