FEATURE STORY

FUNDAMENTALS OF

BONDING

By: Adam Baron

Let’s begin with describing the basic bond arrangement and the parties involved… Surety is a three party arrangement where one party (the contractor, referred to as the Principal) has a contractual obligation to a second party (the owner, referred to as the obligee); with a third party (the surety) being a guarantor of the first party, both jointly obligated to the owner/obligee.

Detailing and defining the three parties to a bond a bit further, there is:

the Contractor (referred to as the Principal). The Principal is to perform the work as contractually outlined in the underlying contract, plans, specifications and general conditions which all detail what the Principal is expected to do and within what time frame.

the Obligee: The obligee is the party for whom the contractor is performing the work. The obligee, usually the project owner, has little expected of them with respect to the bond obligations. They, of course, must adhere to the contract terms and (perhaps most importantly) pay the Principal (contractor) as contractually agreed. Otherwise, there is little required of the Obligee.

the Surety: The surety is the ‘backer’ of the contractor. They prequalify the contractor/principal in terms of experience, capability and financial capacity. If sufficient, the surety will agree to issue a bond for the specific contract. The bond issued guarantees certain obligations of the Principal. If all goes well, the surety will have little to do (and little communication with the owner/obligee). In due course they will be able to close their bond file (when appropriate) without much involvement. However, if the contractor/principal should fail to perform on the job, or fail to pay certain vendors, then the surety would become much more involved with the Obligee (and Contractor/Principal) in finding, and possibly funding, a remedy to the situation.

[Quick sidebar: The above (and next section below as well) is generally referring to a bonded Prime Contractor relationship scenario where the Prime is bonded to a project owner. However, in the past decade on Guam, we’ve seen a spike in large prime contractors requiring their subcontractors to bond to them (the prime, as obligee). While the Prime’s bond protects the government from the Prime possibly becoming unable to perform its obligations, the Prime is not, in turn, protected from subcontractor default. Thus, the Prime may want similar protection and may require certain subs to post subcontractor performance and payment bonds to the Prime’s benefit. In these situations, there is a slight variation to the above identity of the three parties. While the Surety remains as surety, the subcontractor in this case would be the Principal of a subcontractor bond, and the Prime Contractor – as beneficiary of the bond – would become the Obligee. I wanted to note the differences when the bonded contractor (Principal) is a subcontractor as opposed to the Prime. If you are reading this from the prospective of a bonded sub, you’ll want to note the subtle differences in identity of the three parties as you read further below… Now back to our regularly scheduled program…] There are basically three primary types of bonds pertaining to contract surety. These are: Bid bonds, Performance Bonds and Payment Bonds. Each is briefly described below:

Bid Bonds: Bid bonds are most frequently mandated on public/gov’t projects. If/when required, the bid bond will be provided to the owner (government) by the Prime Contractor as part of the contractor’s bid submission. The bid bond guarantees that the bid was placed in good faith and that the contractor, if awarded the contract, will enter in to the contract and provide the required Performance and/or Payment bonds. The bid bond is usually a set percentage of the total bid amount (usually 5% to 20% of the bid). In the event that the contractor fails to enter in to the contract or fails to provide the requirement Performance/Payment bonds, the owner has the right to claim to the surety for an amount up to the full penalty of the bid bond (ie. the full 5-20%). The amount of the claim depends on how much additional costs the owner incurs if the second-low contractor is to be selected in lieu of the low bidder.

Performance bonds: The performance bond protects the owner (Obligee) from financial loss due to the contractor’s failure to perform in accordance with the contract, plans and specifications. If, on a bonded project, a Principal fails to perform accordingly, the owner has recourse to file a claim with the surety. The surety must then investigate and, if appropriate, step in and remedy the situation. They can do so by: 1) facilitating a bailout plan with the original contractor-Principal (if agreeable to the owner), or 2) the surety can find an acceptable replacement contractor at the surety’s expense, or 3) the surety can negotiate a financial settlement with the Obligee/owner.

Payment bonds. The payment bond protects the Obligee (beneficiary) from certain unpaid suppliers, subcontractors or labors (and other possible claimants) having a direct working relationship with the

contractor-Principal (or, in some cases, under the prime contractor’s subs (ie. two layers down)). These are typically entities which have mechanic’s lien rights. In the event that the bonded contractor (or his subcontractor) is unable to pay uncontested amounts payable to certain subcontractors, suppliers or laborers (or other possible claimants), the surety would then step in and satisfy the uncontested job-specific payables of the contractor. It is interesting to note that Payment bond claims can occur even if the job site performance is proceeding satisfactorily.

One final item worth explaining is the Indemnity Agreement. The concept of the indemnity agreement is one of the defining differences between surety and insurance. The indemnity agreement is a critical element of a surety relationship and is one of the main aspects of surety that lend it to appear more like bank credit than an insurance policy. Resembling a bank’s loan agreement, the primary function of the indemnity agreement is to serve as the contractor’s agreement to reimburse the surety for all costs incurred by the surety in the event that the surety has to step in and complete the bonded contractor’s obligations. I hope you have found the above informative and invite you to further explore surety bonds by visiting the National Association of Surety Bond Producers learning resources web page at:

https://www.nasbp.org/guaranteed/resources/contractor

and/or the Surety Information Office website at www.sio.org. Both are very helpful and provide ample information regarding surety bonds.

Adam Baron Bond Manager Cassidy’s Associated Insurers, Inc. www.cassidysguam.com adamb@cassidysguam.com