3 minute read
Managing Contractor Insolvency Risk
from CB Jan Feb_2023
by MediaEdge
BY ALEXANDER SPRAGGS
One of the greatest risks to construction projects is the insolvency of one of the parties involved. This risk is exacerbated when rising interest rates make borrowing more expensive while inflation makes construction more expensive.
The Bank of Canada’s objective of increasing downward pressure on inflating prices is acutely felt in the construction industry. Struggling contractors and subcontractors who see fewer and fewer projects down the road will bid lower in an aim to win a project and keep cash flowing. At the same time, owners facing lower sales revenue and limited borrowing power will put intense pressure on contractors to stay within budget. Projects with multiple struggling parties involved will be on a knife’s edge, and the insolvency of one trade can trigger the whole construction pyramid to come tumbling down in a wave of defaults.
One of the best ways to protect your business from insolvency risk, whether you are a developer, contractor, or trade, is to bond your project or seek out bonded projects.
How Bonds Work
Two types of bonds relevant to this risk are Performance Bonds and a Labour and Material (L&M) Bonds. There are three parties to these bonds, the obligee, the principal and the surety. If a prime contract is bonded, the owner is the obligee, the general contractor is the principal and the surety company is the surety. In the case of a bonded subcontract, the general contractor is the obligee and the subcontractor is the principal.
For a Performance Bond the surety ensures, for the benefit of the obligee, that the bonded contract will be performed, up to the penal value of the bond (typically half the value of the bonded contract). In the case of an L&M Bond, the surety ensures that all parties providing labour and materials to the principal on the project will be paid in full.
Beyond these fundamental protections against insolvency that bonds are intended to provide, there are several other aspects of bonding that help to mitigate the risk of insolvency.
Underwriting The Risk
The insolvency of a principal is the fundamental risk that a surety takes on. Accordingly, when a surety is asked by a contractor to bond a contract, they will underwrite that bond by analyzing the contractor, the contract and the contract price to ensure the risk of contractor default is low. Further, once a surety begins a relationship with a principal, they will often bond all that principal’s projects. Sureties will use their ongoing relationship with and knowledge of a contractor to constantly assess risk. A prudent bonding company will refuse to bond a project where they see that a contractor may have stretched themselves too thin or bid too low.
Further, bonding companies secure themselves against a principal’s risk of insolvency by requiring indemnities from the owners of that principal. This ensures that the people responsible for the business of a contractor have skin in the game.
Finally, bonding companies have significant expertise in the construction market. Where a principal begins to flag, sureties are able to use their experience in the industry to step in and either ensure that the principal finishes the contract or smooth the transition from the principal to a completion contractor.
Common Mistakes
Having bonds in place on a project is not the same as having insurance on a project. Sureties have certain rights which insurers do not.
One common mistake made by obligees when a principal starts showing signs of going sideways is to start working outside the express terms of a contract to help nudge a struggling contractor along to completion. Even something as innocuous as making an advance on a contract can prejudice a surety’s rights and potentially nullify a bond. It is critical when working on a bonded contract to work within the terms of the bonded contract and, when in doubt, confer with the surety when a principal is flagging.
Further, a bond’s terms must be strictly adhered to. There are critical provisions regarding notice and deadlines for making claims that may void a bond altogether if breached.
Knowing how to navigate a bonded contract, make claims against a bond, or communicate with a surety can make all the difference between getting paid or getting in line with all the other creditors. It can also make the difference between keeping a project on the rails and on budget, or watching it grind to an expensive halt. When in doubt, don’t hesitate to reach out to a legal professional with knowledge of the surety business to ensure you take full advantage of your rights on a bonded project.
Alexander Spraggs is an associate at Pihl Law in Kelowna, practicing primarily in the areas of construction law and commercial litigation. He has a particular interest in construction insurance coverage claims and bonding disputes and has represented sureties and bond holders in a variety of complex construction projects across British Columbia and Alberta.