Sometimes contractors cannot qualify for the bonds they need. Or maybe the bond cost, or underwriting terms are unacceptable. What are some of the alternative methods project owners can employ to assure the completion of their projects and the correct handling of money?
Standby Letter of Credit – This instrument is issued by a commercial bank and is available for draft by the project owner. Typically these are very difficult for a contractor to obtain, especially for 100% of a large contract amount.
Drawbacks: There is no pre-qualification of the contractor’s ability to perform the work. In the event of default, the project owner must manage the process of assessing the contract status and acquiring a completion contractor. This method does not prevent liens against the project or provide the process to resolve them. (Lien: Suppliers and subcontractors can place a lien against the title of the property to secure their claim that they are owed money by the contractor.)
References – The project owner can contact previous clients of the contractor who had similar projects. This may give some assurance regarding the ability to perform the work.
Drawbacks: It provides no safety net for completion in the event of default, or for failure to pay bills and the resulting liens – the latter being exposures covered by a Payment Bond.
Tripartite Agreement or Funds Control – All the project funds are handled by the project administrator who acts as the paymaster, paying everyone including the contractor. The purpose is to assure the money stays in the project and that all the bills are properly paid.
Drawbacks: This addresses a large part of the Payment Bond exposure but does not prevent all liens (*why not?) The Performance exposure is also left uncovered.
Joint Checks – Obligee writes individual checks each month in the name of the contractor plus each sub or supplier. This is intended to address the payment exposure by assuring the money actually reaches such payees and thus prevent liens.
Drawbacks: This procedure does not necessarily prevent all liens, nor does it facilitate resolving them if they do occur. There is no protection for the Performance Bond exposures.
Retainage – When each monthly invoice is generated by the contractor, the project owner deducts (retains) a percentage of the payment and holds those funds until 100% satisfactory completion of the project. This is intended to keep the contractor motivated.
Drawbacks: It will not prevent or resolve a default, and does not prevent liens.
Sub Guard – Subcontract Default Insurance obtained by general contractors in lieu of a Subcontract P&P Bond – covers failure to perform.
Drawbacks: Does not cover the Payment Bond exposures. There is no pre-qualification the subcontractor’s expertise or financial condition. The default insurance does not arrange for the completion of the failed subcontract, it only reimburses the costs.
Lien Releases – They are executed by subs and suppliers to confirm they received the last payment owed them. Requiring these monthly from the contractor is a step toward assuring such payments were made.
Drawbacks: It does not prevent all liens (* why not?) This procedure also does nothing in regard to the Performance obligation.
So what we have here is a box of band aides. ALL these procedures are less effective than a P&P bond. None of them address both the Performance and Payment exposures. They all fail to pre-qualify the contractors the way a surety does. This is the first service the surety provides and it is one that sureties are uniquely qualified to perform.
The second important deficiency is that in the event of default, none of them facilitate the efficient completion of the project. Performance Bond claims can result in the surety taking all the steps needed to complete the project. This is a great benefit for the project owner.
Now you know the real truth: There is no good alternative to a P&P bond! That’s why they are routinely required by statute on public work. They are the most efficient means of obtaining a qualified contractor. They assure the work will be performed in accordance with all aspects of the written contract, and they protect the owner from liens or the need to “pay twice” to resolve unpaid subs and suppliers.
Public owners are usually required to bond their projects and private owners are wise to do so.
* Funds Control and Lien Releases do not prevent liens from claimants who were project payees known only to the contractor.
A special note from the author: Steve Golia
I am an Independent Broker and Surety Bond Specialist. If you wish to co-broker bond business, together we will deliver the best in bonding expertise for your clients. I have a broad range of markets available and often can solve problems even when others have failed.
Call me now (856-304-7348) or email: Steven.Golia@gmail.com