How Sureties and Contractors Can Mitigate Performance DefaultsPosted by Dennis McDonnell
No one likes it when a job goes south. The owner loses money, subcontractors don’t get paid, and there can be costly litigation. In short, it’s in everyone’s best interest to prevent a performance default and get the job back on track.
From a surety company’s perspective, mitigating a potential default starts with the bonding process. A performance bond is designed to ensure that the contract will be performed fully, thus protecting the owner or general contractor from any additional financial exposure if there is a default.
During the underwriting process, the surety seeks to determine whether the principal (contractor) can fulfill its contractual obligations. This is when, if you’re a contractor, you may be asked to provide financial statements, tax returns, balance sheets, work-in-progress schedules, etc., as well as references and letters of recommendation.
Sureties also evaluate the risk of the contract, the contractor’s overall work portfolio, past performance, work history, operational efficiency, managerial skills, reputation and character. The surety must try to anticipate any potential problems on the job and how the contractor might resolve them.
For example, sureties may become concerned if a job is outside a contractor’s territory (such as in another state) or beyond the contractor’s normal scope of business. Lack of experience with local labor can be a concern, too. Whenever there is a red flag, the underwriter must assess if the contractor has the experience and capacity to complete the project and its contractual obligations.
In essence, the surety does everything it can to ensure that there will be a low risk of default. After all, if there is a default, it may be the surety’s responsibility to complete the contract.
Understanding how performance bonds work
Many contractors think of their bond as an insurance policy, as if a claim will be paid by the surety much like a homeowners or auto policy claim. This is not the case. Surety companies do not expect to incur a loss on a bond, and any losses are ultimately borne by the principal — that is, the contractor. Unlike insurance, which pays for a covered loss, the surety bond is designed to guarantee that the principal will complete its obligation to the obligee (the owner of the project). If the surety must step in and finish the job, the principal is still obligated to repay the surety for the loss.
It’s important for contractors to understand that the surety company does not represent them in the claim process. The surety is an independent party that must do its own investigation when a claim is filed. The best thing that a contractor can do is to be open and honest in their communication with the surety. Often when contractors are having difficulty with a project, they tend to stop communicating, which results in a one-sided argument. That’s probably the worst thing you can do.
Our advice is to be forthright and provide any documentation the surety asks for. Just talking through the process can help. If your problems are purely financial, and you simply don’t have the funds to complete the job, you should be truthful about that. Or if you’re having problems managing the project, it’s better to let the surety know up front. The surety may be able to help. Don’t stick your head in the sand.
Depending on the terms of the performance bond, the surety may be able to offer several remedies to the obligee. For example, it can:
- Take over the contract and hire a replacement contractor.
- Rebid the contract and tender the new contractor to the owner.
- Give the existing contractor technical or financial support.
- Pay the full amount of the bond to the obligee.
Hire a knowledgeable attorney
Contractors don’t always appreciate the complexity of a contract or their obligations to other parties, including the surety. They may also be bound by an indemnity agreement, which is a legal agreement outlining the rights provided the surety as well as a guarantee of repayment that often makes contractors personally responsible for the surety’s loss.
It’s important to have a knowledgeable construction attorney who is familiar with suretyship, and who can provide legal and business advice. Legal disputes do occur, and a good construction attorney can help you resolve them through negotiation or mediation to avoid an expensive lawsuit. Your attorney should also be able to assist you with permits and inspections, labor and employment law and construction law.
Most important, a good attorney can help you assess the risks that might arise from the terms and conditions of a contract. An attorney can explain your rights and obligations, negotiate on your behalf and guide you through any disputes that might arise.
Ultimately, mitigating defaults comes down to communicating with the project owner and surety, staying on top of the job and understanding your duty to perform. Defaulting on a project should be a last resort that you try very, very hard to avoid. Your surety can help you understand the ramifications of a default, but you have to take the first step. And that’s simply staying informed and keeping in touch with your surety.
As the Vice President of Claims, Dennis McDonnell is responsible for all aspects of Old Republic Surety Company’s Claims Department. Dennis previously held roles with increasing levels of responsibility from other surety companies prior to joining Old Republic Surety Company. Dennis graduated from UW Stevens Point with a Bachelor's degree in Accounting and Finance and he received his law degree from the University of Denver.