Month: February 2014

Secrets of Bonding #43: Subcontractors and Subcontracts

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“If you are a bonding company, why won’t you bond subcontractors?”

It might seem odd, but some Sureties do not embrace the opportunity to serve subcontractors.  So what’s differentfish about subcontractors and subcontracts?  Why do some sureties red line this entire segment of the market?

The Food Chain

One complaint underwriters may have about subcontractors is that they are farther down the food chain than General Contractors. GCs have a “prime” contract, meaning they work directly for the project owner, and are the first recipient of monetary payments.  The subcontractors are subsequently paid by the GC.  Subs may face delays and sometimes even harassment at the hands of GCs. Remember, subcontracts are all private contracts not regulated by governmental rules even if the prime contract is public. Put simply, subs have a harder time collecting their money.

Other Issues for Subs and Their Sureties

  • GCs do not normally disclose bid results (2nd & 3rd  bidder’s figures).  This makes it difficult to evaluate contract price adequacy – a disadvantage for both the sub and surety.
  • Unregulated procurement procedures and contract administration – GCs may be aggressive in their procurement methods, pressuring subs for price concessions: “Knock their heads together.” Such practices make the subcontracts less profitable and therefore more risky for the sub and surety.  Subs can also be victimized with verbal awards and unwritten change orders.
  • Contract documents (including bond forms) may be non-standard, drafted by GCs specifically to give strong advantages over subs and sureties.  In some cases the normal Performance bond is transformed into a forfeiture type financial obligation.
  • Flow-down or pass-through clauses in subcontracts force subs to assume obligations rightfully belonging to the GC. An example would be wording that makes the sub responsible for the liquidated damage amount on the prime contract if they are found to have caused a delay on the subcontract.
  • “Pay when paid” language can result in delayed payment to the sub.  “Pay if paid” can result in the sub never being paid.
  • Unbonded public work is rare, but in such cases there is no Payment Bond at the GC level to protect the sub, and liens (filed against the project for failure to receive payment) may be prohibited.
  • Indemnification: Broad form indemnity clauses in the contract can make the sub financially responsible even if they are not at fault.
  • Delay damages: Subs may be barred from seeking financial recovery.
  • Lien waivers: When read literally, these documents may operate to waive and release claims for which the subcontractor has not yet been paid. (Learn about Conditional and Unconditional Lien Waivers: Click!)
  • Termination for Convenience: This contract clause can enable the GC to terminate the contract and leave the sub with a series of unreimbursed expenses and lost profits.
  • Some trades perform their work late in the project, meaning the bond is carried for a lengthy period with no progress on the contract.
  • Certain trades can operate with minimal capitalization, so the field may be populated with lightly financed companies. Such competitors can drive down contract prices making it harder to bond their work.
  • Financial reporting may be less sophisticated than for GCs (CPA financial statements vs. bookkeeper or QuickBooks).
  • Due to their size and circumstances, subs may lack bank support, such as a working capital line.

Conclusion

Subcontractors literally perform the majority of all construction work.  They are the backbone of the construction industry and cannot be ignored by sureties.

When it comes to bonding, subcontractors need to demonstrate that they are well-managed companies that reflect the same attributes as a successful GC.

Secrets #5 and #15 contain important guidance to help agents get subcontractors approved.

Start by choosing a surety that is actively seeking to support subcontractor accounts without requiring collateral.

Steve Golia
First Indemnity of America Insurance Company
2740 Rt. 10 West, Suite 205
Morris Plains, NJ 07950
Office: 973-541-3417

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Secrets of Bonding #42: My Bond Amount Can Beat Your Contract Amount

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Q. What is the normal relationship between the contract and bond amounts?

A. Performance and Payment Bonds are normally issued for 100% of the initial contract amount.

Q. What do you call a bond that’s for less than the full contract amount?

A. Underwriters call these “percentage bonds,” such as a 50% Performance and Payment bond. Some obligees stipulate these in order to make the bond cheaper (doesn’t work), to help the contractor preserve their bond capacity (doesn’t), or to make the bond easier to obtain (nope). What it does do is deprive the obligee of part of the protection they are buying.

Q. What happens with the original 100% bond amount if there is a subsequent amendment increasing the contract price?

A. The bond is often required to automatically follow an increase in the contract amount, without “notice to or consent of” the surety.

Q. Is there a limit to how much the bond can be automatically increased?

A. A limitation may be stipulated in the bond to protect the surety from huge unanticipated increases, such as no more than a 10% increase without the written agreement of the surety.

Q. What is the basis of the calculation for the bond cost?

A. The cost of the bond is normally based on the amount of the contract being guaranteed, not the bond.  If the bond is for 75% of the contract amount, the bond cost would be unchanged. Why does this make sense?

  1. The surety’s decision making process is still based on the entire scope of the contract including all technical aspects and the difficulty of performance. The underwriting expenses are unchanged.
  2. Which 75% of the contract does the bond cover? It covers the entire contract, but subject to a lesser maximum bond penalty. You could say it covers the bad 75% where the claim lies.  Full penalty bond losses are extremely rare, so the reduction to 75% has little benefit for the surety.

Q. What is the cost difference for Performance only, no Payment bond?

A. Since the underwriting is unchanged, there is no cost reduction.

The Maximum Rule:

Does your brain hurt yet?  It will after this.

The purpose of the Maximum Rule is to limit how much is charged (the maximum) for a “percentage” bond.  Suppose you have a 10% P&P bond on a $1 million contract with a straight rate of $25 / thousand.  Based on the contract amount, the bond fee would be $25,000.  Will the obligee pay $25,000 for a $100,000 bond?  Even though the bond will cover the entire $1 million of work, it’s a hard sell.  This is where the Maximum Rule comes in.

The price calculation under the Maximum rule is different.  Here is a typical example:

If the rate used in the Maximum Rule is $50 / thousand for the aggregate of the Performance ($100,000) plus Payment bond ($100,000) amounts, it will equal $50 x 200 or $10,000.  So in this example the maximum applicable charge would be $10,000 for the $100,000 bond, in recognition of the greatly reduced bond penalty.

With the Maximum Rule, you charge the normal price or use the Max Rule price – whichever is less.  As the percentage of the bond amount increases, the advantage of using the Maximum Rule disappears.  In this example the tipping point is 25%.  The Performance and Payment bond amount must be less than 25% of the contract amount for the Max Rule to result in a reduced charge.

Conclusion

Here’s the good news.  The vast majority of contracts stipulate a P&P bond equal to 100% of the contract amount; this is the typical statutory requirement on public work.  The same routine is normally followed on private contracts as well because it is the best way to protect the obligee’s interests.

Call us with you next Contract, Site or Subdivision Bond.

FIA Surety / First Indemnity of America Insurance Company
2740 Rt. 10 West, Suite 205
Morris Plains, NJ 07950
Office: 973-541-3417

An “A Rated” Carrier

Visit our Free CE school.

Secrets of Bonding #41: Escaping the Stigma of Bankruptcy

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BKs come in a couple of flavors – all nasty tasting for surety underwriters.

Chapter 7: This is a liquidation bankruptcy, which means that a trustee sells off all non-exempt assets held by the debtor so that the debts can be repaid to the fullest extent possible. Businesses generally try to avoid Chapter 7 because it is impossible to conduct business operations.

Chapter 11: Business operations continue during this process.  Chapter 11, the most complex bankruptcy filing, is the one that most troubled businesses file. The debtor continues to function, maintains ownership of all assets, and tries to work out a reorganization plan to pay off creditors.

Chapter 12 is exclusively for farm operators.

Chapter 13 is like Chapter 11 but is for individuals instead of businesses.

It would be an understatement to say it is harder to qualify for surety bonds if you have a BK in your past.

Bonding companies typically use a structured method of decision making where each underwriter works within a framework.  The details are described in a Letter of Underwriting Authority which may say things like “All clients must have been in business at least three years” (*why?) or “Do not approve bonds for environmental remediation work.”

A common restriction would be: “Do not bond companies that have previously declared bankruptcy.”

Such rules are handed down by senior management of the surety company and their reinsurers. They just want the field underwriters to avoid such applicants – end of story!

Why is the BK a significant black mark? Why does this one checkbox effectively end the underwriting process with many sureties? We can only guess it is because surety underwriting uses credit analysis as a key element. So the ultimate bad credit event, a BK, is an automatic deal killer with those markets.

Escape the BK

When a construction company comes out of Chapter 11, what is the next step if surety support is desired?  Over the years, we have seen many cases where the owners decided to form a new company.  It’s a fresh start. But is this the best step?

Every bonding questionnaire asks about prior BKs, not only for the company involved, but also the individual people.  For example, ours says:

 “Has the company, any affiliate or subsidiary, or any owners / spouse or companies in which they have had an ownership interest or managerial role ever experienced a bankruptcy?”

That’s pretty broad. Note that forming a new company doesn’t change a bad “Yes” to a good “NO.”  Can it help at all with bonding?  Actually it may do more harm than good.

As we have discussed, the prior BK is likely to be revealed through the questionnaire and also the credit reports. And what the applicant company loses is the history, which is very important to bond underwriters.  The ability to say we have been in business for years and completed a long list of projects carries tremendous weight in the underwriting process. To a large extent, you throw all that away when you start a new firm.

* Remember the underwriting restriction above? Most sureties are reluctant to bond companies until they have a few successful years under their belt – so being new is always a disadvantage.

Conclusion

So how does a company escape the stigma of a BK?  The answer is you don’t.  The BK becomes a part of the company and personal credit history that may not be avoided or erased.

However, there may be a solution with the surety.  The contractor and agent need to select a surety with the flexibility and expertise to evaluate the details surrounding the BK.  The underwriters must be open-minded and willing to identify the strengths of the applicant, despite the BK.  Key points to develop:

  • Responsibility for the factors causing the BK
  • Final disposition of the BK debt
  • Continuity of ownership and key management
  • Current financial strength and trends
  • Current banking and other credit relationships

The reality is that most “prior BK” companies are not bad applicants for bonds. But agents need a surety with the ability to appreciate the value of these clients and support them without requiring collateral.

Call us with you next Contract, Site or Subdivision Bond.

FIA Surety / First Indemnity of America Insurance Company
2740 Rt. 10 West, Suite 205
Morris Plains, NJ 07950
Office: 973-541-3417

An “A Rated” Carrier

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Secrets of Bonding #40: Native American Tribes

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Note: This article concerns legal issues that face contractors, their bond agents and sureties. The author is not an attorney and is not offering legal advice. Our sole purpose is to provide information regarding the underwriting and production of surety bonds.  For legal advice, well you know who to call…

When a Performance Bond is needed on a Native American Tribal contract, two questions invariably come up:

  1. Does the obligee have Sovereign Immunity?
  2. In the event of litigation, is the legal venue a tribal court or the U.S. legal system?

These questions are enough to scare off many sureties, regardless of the quality of the applicant or expected ease of construction. Why is this and how can contractors and their agent’s successfully handle such projects?

Sovereign Immunity

In the U.S., tribes have always been treated as separate nations, each entitled to all the rights and powers exercised by any foreign nation. There are 566 federally recognized American Indian tribes, Alaska Native tribes and villages.

Tribes are distinct, independent political communities, with their own natural rights in matters of local self‐government. They have the power to make their own laws in internal matters and to enforce that law in their own courts.

The law of tribal sovereignty includes these well-settled tenets: 1) tribes have virtually unlimited authority over internal tribal affairs; 2) they are subject to the absolute power Congress has over them; 3) are immune from state law; 4) cannot be sued unless they have specifically waived their immunity; and 5) sovereign immunity only extends to individuals when tribal officials act within the scope of their official capacities.

56 Alaska Native tribes and villages are recognized in federal Indian law.  The Native villages retain the fundamental attributes of sovereignty. Both Alaskan tribes and American Indian tribes have long been recognized as possessing the common‐law immunity from suit traditionally enjoyed by sovereign powers.

The Implications

For contractors and their sureties, sovereign immunity means the tribe cannot be sued in a U.S. court if there is a contract dispute.  This could be a huge disadvantage for prime or sub-contractors and their sureties. Imagine not being able to sue when owed money.  What recourse is available for unpaid subs and suppliers if there is no payment bond?

Conversely, in the event of a bond claim, the surety and contractor may have to defend their case in a tribal court.  Are they prepared for this venue?  Contractors and construction company owners are indemnitors to the surety, meaning they are financially responsible for bond claims and related costs.  Unlike insurance, when a bond claim occurs, it is still the contractor’s problem, so this is an issue for the surety and the contractor.

The Cure

We cannot speak for all sureties, but here is the approach that has worked for us over the course of many years and numerous tribal contracts.

A “Waiver of Sovereign Immunity” must be executed by the obligee.  The point of it is twofold: Now the obligee can be sued if appropriate. Secondly, it moves litigation and claims away from the tribal court and into the U.S. legal system where the process may be more predictable.

There is no formula that the waiver must follow. The waiver clause itself, to be effective, only has to be “explicit” and “unequivocal.” The clause could be as simple as “[Tribal Obligee] hereby waives its sovereign immunity from suit in any court.”

It is up to the legal department of the surety to determine the wording they feel is appropriate.

In some cases, it may be unclear if Sovereign Immunity applies.

When in doubt, require a waiver!

A second method is to modify the construction contract.  The section that talks about claims and dispute resolution will indicate such matters will be heard in the local U.S. court, and adjudicated under U.S. law.

Tribal leaders will not be surprised when the surety and contractor request such changes.  Sovereign immunity is a shield they guard closely and strive to protect.  In some cases, tribes have waived bonds or cancelled contracts rather than give a waiver.  It is an issue that must be addressed in a straightforward manner if Performance and Payment Bonds are desired on tribal contracts.

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!  Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

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Secrets of Bonding #39: Design/Build vs. Design/Bid/Build

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Underwriters are watchful for “Design/Build” contracts.  If you feel like D/B projects are becoming more common, you’re correct!  The concept emerged in the 1980s and was formally codified by the federal government in 1996 after two years of collaboration with the private sector. The Clinger-Cohen Act established a two-step procurement process for such work.

Some sureties balk at the additional risk their clients assume on these projects. Put simply, the contractor becomes responsible for both design and construction.  In the event of a performance problem, this really cuts down on the finger pointing!

Bear in mind, it is the contractor (not the designer) who obtains the surety bond.  On “contractor-led” D/B projects, the contractor hires a licensed and insured architect to perform the design work. Another option is to form a joint venture between the architect and contractor.  In either case, a certain tension exists between these “partners” who have slightly different agendas, and this has implications for the surety – the guarantor of the project.

There is no denying we face unique risks on D/B contracts.  Let’s review them.

  • The designer must agree that their design (and subsequent revisions) will conform to the project budget “as bid.”  Without this, the contractor could be forced to absorb the cost of design changes.  Unprofitable contracts are more likely to go into default.
  • Similarly, designers must agree to conform to the project schedule. They cannot make changes that require construction timelines unsupported by the contract. Such changes could force the contractor to choose between significant unreimbursed expenses or failure to complete on time.
  • The design work must also conform to the project owner’s specifications at all times.

Design/Build contracts require some extra care, but can be bonded successfully.  Underwriters need to have the proper procedures and expertise to make these evaluations.

The alternative: Design/Bid/Build

You may encounter contracts specifically called Design/Bid/Build. So is this another new thing we have to learn?!

No, actually D/B/B this is the traditional construction method where the project owner hires and directs the architect. It is nothing new but may be named as such to identify the project as not Design/Build.

We may not have known it by name, but we have been helping contractors bond Design/Bid/Build projects for years!

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!  Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

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Secrets of Bonding #38: Capacity – How to Preserve It

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For contractors, Bonding Capacity is a good as gold.  It enables the company to pursue new projects with the confidence that their surety will back the contracts when the need arises.  This is the source of increased revenues and greater profits!

How is available bonding capacity calculated? First a bonding line is determined, consisting of an Aggregate (total) amount and a Single per job limit.  The Aggregate is then decreased by different factors that consume the line. What can be done to minimize this effect so bonds remain available for the client? Let’s look at how the numbers are developed and how they can be appropriately managed.

Bonded and unbonded work is included in the analysis.  (*Why is Unbonded work included?)  Here’s the math:

Aggregate Capacity amount  Minus:

  1. Undecided bids (full contract amount)
  2. Low but unawarded bids (full contract amount)
  3. Projects that are awarded, signed or started (full contract amount)
  4. Remaining Costs to Complete on open contracts

Equals the Available Bonding Capacity.

So how can agents help their contractors preserve this vital asset?

1.  Prompt reporting of bid results – When bid bonds are issued, the entire estimated contract amount is deducted from available capacity, not the bid bond amount.  The capacity is not restored until the “not low” results reach the underwriter.

2.  Updated Work In Process (WIP) schedule:

  • Surety underwriters and accountants determine a contractor’s “current work load” based on the costs they must incur (such as labor and materials) to complete their open contracts.  When there are no remaining costs to incur on a project, by definition, it is considered completed.  The WIP schedule shows revised Costs Incurred to Date and Estimated Costs to Complete. Both increased costs incurred and decreased future costs improve available capacity.  Future costs may be reduced by progress on the contracts and also by greater labor efficiency, material cost savings, improved scheduling and other factors.
  • A reduction in the contract amount (by amendment) has the same effect because it reduces unincurred costs. Report such amendments immediately.

3.  Prompt reporting of completed or terminated work, including unbonded projects, removes them from the work load and therefore increases availability.

Note: Factors that can reduce available capacity include unincurred contract costs that increase for any reason and the addition of new unbonded projects.

*The aggregate capacity amount is based on all the contractor’s professional and financial capabilities. If unbonded projects are acquired, they consume resources (supervisory staff, equipment, etc.) and therefore must be recognized within the use of the bond line.

Available Bonding Capacity is a moving target subject to frequent revision.  To maximize availability, send us the right info and keep it current.

First Indemnity of America Insurance Company
2740 Rt. 10 West, Suite 205
Morris Plains, NJ 07950
Office: 973-541-3417

An “A Rated” Carrier

 

Secrets of Bonding #37: Counting Counts!

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One for you, one for me.

Two for you; one, two for me.

Three for you; one, two, three for me!

What fun, unless you are a surety underwriter and you’re incorrectly evaluating a financial picture.

When we review a new applicant for bonding, a range of factors are considered and the financial aspect is always one of them.  Sureties want to be confident that the company is stable and will be able to perform the bonded contract.  This includes the financial capability to finance the start of the work and deal with any issues that arise.  Such problems, if left unresolved, are the things bond claims are made of.

Who is the typical applicant for performance bonds?  Most often it is a privately owned company.  The focus of the financial evaluation is the fiscal year-end (FYE) of the company, which frequently is December 31st.

A range of elements are reviewed to determine the health of the company and its ability to survive the issues that often arise on construction projects.  One element is Cash.  Always the first (most liquid) asset listed on the Balance Sheet, you’ve heard the expressions: Cash is king, Cold hard cash, A cash cow!  A strong cash position is universally recognized as a sign of health.

As part of the primary financial evaluation, underwriters calculate the company’s FYE cash position.  Secondarily, the finances and cash position of the company owners will be reviewed.  These parties are indemnitors to the surety even though they are not direct bond applicants (bond “Principals”).  In the event of loss, the surety is entitled to look to these parties for salvage and subrogation (financial recovery) – so the financial strength they add to the picture is relevant.

Trick Question: If financial statements show that the company has $100,000 cash at the 12/31 FYE and the owners personally have $100,000 on 1/31, do you have $200,000 for underwriting purposes?

Answer: You do unless that’s the same $100,000 that you’re counting twice.

Company owners may loan money to the firm and later pay it back. Money gets moved around, sometimes quickly.  There should be corresponding debt entries on the financials.  But if people “forget” to show them, readers can be tricked into counting the same asset twice.  How can underwriters prevent being fooled into double counting dollars?

The solution is to always require concurrent financial statement dates.  We will always request personal financial statements as of the fiscal year-end date of the company. Personal year-ends are automatically 12/31.  But if the company has chosen a different date, that will be the personal FS date we want.

It is also typical, when reviewing unaudited (unverified by an independent third party) financial reports, to ask for proof of the cash assets – such as bank or brokerage statements.

So there you have it.  When bond underwriters count the cash, they prevent counting the same dollars twice by requiring business and personal financials as of the same date, because Counting Counts!

Call us with you next Contract, Site or Subdivision Bond.

FIA Surety / First Indemnity of America Insurance Company
2740 Rt. 10 West, Suite 205
Morris Plains, NJ 07950
Office: 973-541-3417

An “A Rated” Carrier

Visit our Free CE school.

Secrets of Bonding #36: When Gross Profits are Gross!

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Gross Profit, Net Profit, “I can’t remember which is which.”

Here’s an easy way to remember: Gross profit is the larger number.  A Gross of something is a big amount: Picture 144 baby chicks hopping around…  In this case, Gross means “big” not “bad.”

Net profit is the smaller number. Think of when you pour something through a net or  sieve: Less comes out.

OK, so Gross Profit is found by subtracting Direct Costs from Revenues (or Sales).  These numbers always appear on a company financial statement (FS) in the “Profit & Loss” or “Statement of Income” section, near the top.

For a masonry contractor, examples of Direct Costs are bricks, mortar and the labor to install them.  Some Indirect Costs would be rent, phone expenses and office salaries.

You may have seen a Work In Process schedule which shows the financial status of open contracts. That is literally the same as the Gross Profit analysis but is specific for  each project. (Keep this in mind when you read the cool bonding tip at the end.)

Now in order to be successful, companies need to produce a Gross Profit sufficient to cover all their indirect expenses and then yield a Net Profit (which always appears at the bottom of the page.)

As surety agents, we often see companies that are suffering from lack of work. Their projects are profitable, but they don’t have enough of them.  They show a Gross Profit but cannot cover their Indirect Costs and therefore produce a Net Loss (they lose money for the year.) Maybe if they had laid off non-essential staff, closed an office or reduced other expenses, the Net Loss could have been avoided. The point here is that the contracts were performed successfully, but other expenses were not adequately managed and a Net Loss occurred.

The inspiration for this article was a FS we received that showed a negative Gross Profit. Pretty unusual.  So what did it mean?

In this case the company lost a significant amount of money on one contract.  The loss was so great that it exceeded all the gross profits earned on other projects resulting in a negative Gross Profit (a loss). Next comes the Indirect Expenses which resulted in a significant Net Loss.

When a negative Gross Profit is produced, it is almost impossible for a company to have a profitable year.  In that case, the Gross Profit is Gross – meaning bad!

Here’s an example of what you’d see on the Statement of Income:

Statement of Income

Income

          Current Earnings – $1,000,000

          Current Costs – $1,250,000

          Gross Profit (Loss) – ($250,000)

Indirect Costs

          General & Administrative Expenses – $75,000

Net Loss – ($325,000)

Cool Bonding Tip: The Gross Profit section of the P&L describes the accumulated results of past projects, similar to the WIP schedule which shows today’s projects individually, during their performance.

By comparing the expected GP % of incomplete jobs on the WIP schedule to last years P&L, you can predict if the new projects are likely to result in a NET profit for the upcoming year-end financial statement (assuming other factors, such as expenses and total revenues, are similar to the prior year.)

Business owners facing such circumstances should consider immediately cutting indirect expenses in a proportionate amount  so a fiscal year-end net profit is more likely.

Call us with you next Contract, Site or Subdivision Bond.

FIA Surety / First Indemnity of America Insurance Company
2740 Rt. 10 West, Suite 205
Morris Plains, NJ 07950
Office: 973-541-3417

An “A Rated” Carrier

Visit our Free CE school.

Secrets of Bonding #35: Good Loans / Bad Loans

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When it comes to Performance & Payment Bonds, there are two kinds of Stockholder Loans – and they can have a big effect on the underwriting.

The first step is to figure out if such loans are in the picture.  Where do you look?  You find these loans on the company financial statement: the Balance Sheet.

The Balance Sheet consists of Assets and Liabilities.  Money owed to the company is an Asset. A loan receivable would be an example.  If a stockholder borrows money from the company, the loan is an Asset on the company Balance Sheet and a Liability on the stockholder’s personal financial statement.  It is a Stockholder Loan Receivable. Assets are good to have – so is this?

Nope, it’s the “Bad Loan.”

Liabilities: Some examples are Accounts Payable, Bank Debt, and Accrued Taxes. If Liabilities are a burden, can a Stockholder Loan Payable be the “Good Loan”?

Yes it is!  Sounds crazy?  Let’s find out why.

Surety underwriters evaluate the financial strength of the company. When we review the assets we consider their strength and reliability.

  1. If a stockholder borrows money from the company, it has been “removed” in a sense – which hurts the bonding.
  2. In addition, we assume that in a worst case scenario, the stockholder will chose to not pay the loan back.  Be realistic: If they thought the company was headed for bankruptcy, would they throw more money down the hole?  Underwriters think that in such cases the loan will not be paid back and for these two reasons the Stockholder Loan Receivable (Asset) it is the Bad Loan.  When underwriters disallow the asset, they deduct an equivalent amount from Net Worth so the Balance Sheet balances.

The Stockholder Loan Payable is the Good Loan.  Can you guess why?  It’s a Liability. Are some liabilities actually good?

The liability side of the Balance Sheet has two main sections, Liabilities and Stockholders Equity aka Net Worth (NW).  Net Worth represents the portion of the assets owned by the stockholders as opposed to outside creditors, such as the bank.  Stockholders Equity is all money owned by the stockholders and owed by the company. (The company itself doesn’t own anything!)  Underwriters like NW because it is debt owed to the stockholders who are also indemnitors to the Surety.

The key to making the Stockholder Loan Payable most beneficial is to Subordinate the loan to the surety, which may enable it to be considered Stockholder’s Equity rather than debt.  The Subordination moves it from the liability section (bad) to the Stockholders Equity section (good).  When a Stockholders Loan Payable is Subordinated and considered Equity, it’s the really Good Loan!

Caution: Not all sureties have the flexibility to recognize this subordination procedure – so you’ll just have to ask.  We’re proud to say that we do.

So there you have it.  To summarize: Stockholders should not borrow from the company.  These loans are disallowed by underwriters and hurt the bonding capacity.  Clients who have such loans on their books should pay them down as quickly as possible.

Money they loan to the company (Stockholder Loan Payable, a liability) is helpful; it shows they supported the company when funds were needed.  However, for the debt to be considered Equity, it must be Subordinated – which locks it in the company for the long term.  Review Secret #20 “Subordination Agreements” or ask us for a copy.  A Subordinated Stockholder Loan Payable can be the Good Loan.

Good Loans / Bad Loans: Now you know!

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it! Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

Don’t want to miss our next exciting article?  Click the “Follow” link in the upper right corner.

 

Secrets of Bonding #34: Been There, Done That

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Prior Experience

“Prior Experience” There may be nothing more important when it comes to Bid and Performance Bonds. Let’s talk about why this is the case and how to develop this critical element of a bonding application.

In a real sense, the evaluation of a contractor’s prior experience is at the heart of surety underwriting.  Remember, surety bonds are not insurance, and sureties do not expect to have claims or losses.  A surety intends to provide bonds for proven applicants.

“In the last two years we built three projects of similar size and nature – all profitably completed and to the customer’s satisfaction.”

Surety questionnaires always ask about the large prior jobs so they can be compared to the upcoming bond opportunities.  However, there is more to the process than just comparing the contract amounts.

Size, Nature, Location

Surety underwriters compare the new project size to the largest similar contract previously completed. Conventional wisdom is to not increase more than 100% over prior experience.

The prior job must be a single contract, not a series of assignments for the same owner and … must actually be completed to count. The difficulty of the work must match.  Even if the dollar value was the same, underwriters would not bond a five story building if all the prior experience was on one story structures.

Location can help or hurt.  A job located “in our back yard” offers a special advantage regarding ease of supervision and performance.

On the other hand, there can be unique challenges when contractors roam beyond their normal turf.  Labor unions are different as is weather, ground conditions, labor productivity rates and other factors. Supervision of the work can be more difficult. Logistics for material delivery may be harder.  You also have to ask yourself, on competitively bid work, how can our contractor perform the work more efficiently (cheaper) than the companies located there?

All these factors enter into determining if prior experience qualifies the contractor for the new project.

Helpful Hints

Here are some ideas that may help when contractors are “stretching” for larger projects.

  1. Best Foot Forward – Don’t skimp on the details when describing prior completed jobs.  If the contract had addendums and the amount increased, the final contract amount is used for reference purposes. Include technical details such as major aspects of the work and any special accomplishments (completed ahead of schedule, received an award or other recognition.) Satisfied customers should be solicited for “good guy letters” upon completion.  Such letters can be forwarded to the surety with the application.
  2. Inflation – A large job completed years ago would be worth more in today’s dollars. This analysis can be particularly helpful on larger projects.
  3. Prior experience of individuals – Key people may have strategic experience from their prior employment. Be sure to describe their actual responsibility.
  4. Directly Related Experience – The contractor may have worked for this owner or architect before. They may have performed the “exact same job” but in a lower dollar amount.
  5. Special Skills or Equipment – Staff members may have special training that uniquely qualifies them for the large project.  The company could have behemoth or high-tech equipment that will facilitate the new contract.
  6. Ease of Performance – Is the contract actually a series of assignments to be performed sequentially – no one of which is beyond the contractor’s capabilities?
  7. Buddy up – A mentor, Joint Venture partner, or even a subcontractor can provide additional expertise for the new project.
  8. Analyze the Costs – Higher costs do not automatically mean greater difficulty.  The labor portion of a contract is viewed as a greater risk than materials or equipment. An hour of labor can be performed inefficiently or incorrectly but a brick is a brick. When new projects include expensive materials, it can increase the contract price even though the difficulty may be no greater than prior projects.

Summary

The point is that the underwriting has to make sense.  The management staff of the construction company knows their limitations better than anyone, and they have already decided the new project is a good opportunity with a reasonable risk. When presenting the file, you must explain why this is the case.

Call us with you next Contract, Site or Subdivision Bond.

FIA Surety / First Indemnity of America Insurance Company
2740 Rt. 10 West, Suite 205
Morris Plains, NJ 07950
Office: 973-541-3417

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