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Secrets of Bonding #66: Timing, the Cart, the Horse

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Being in the right place, or the wrong place, can make all the difference. In the world of surety bonding, particularly contract bonds, timing plays an important role.

Here is a typical scenario.  It is a question of timing:

The client comes to us to get their bond account set up for the first time.  We send over the “laundry list” of documentation that is normally required.  It’s a bit daunting.  For companies that have never been bonded, they probably do not have all the info readily available.  They must gather documents, others must be filled out, they must be scanned and shipped. There are better ways to spend a Friday evening!

The cause of this activity is usually that the first bonded project has popped up.  We had a case like this recently where the project was being negotiated.  No bid bond was required. If the effort was successful, the contractor would need a bond.  If not, the bond monster goes back to sleep.

Our new client seemed unconcerned about the bond.  They didn’t want to take the time to develop their file unless they won the project.  Only then would they find out if it is easy, hard, or impossible to get the bond!

For this applicant, the project comes first – then the bond. Is this a smart approach?  Maybe not, because sometimes the first bond is a harder, slower process than expected!

Let’s look at some aspects that could cause unexpected delays (assume this is not for a small contract):

  1. Financial Information – The underwriters will request business financial statements, not just tax returns. Not all companies automatically prepare these. If the year-end date is not close, it can be very inconvenient to go back and reconstruct the financial picture.
  2. Accounting Methods – Companies that have been using Cash Method statements will find they need to re-issue the document using a different accounting method.  To accomplish this, the accountant will require an additional body of financial information, then they commence with their processing.
  3. CPA – Don’t have one? You will need to choose/engage a firm then allow time for their due diligence and procedures.
  4. Accounting Presentation – If a CPA Compilation has been the norm, it may be necessary to upgrade and re-issued as a Review. The CPA will need time to perform the additional services.
  5. Outside References – These are sent to creditors and vendors for handling, then you wait for their response.
  6. Historical Data – The project history of the company and its key people, including contract details, will be required. Prior financial data is needed. Three years of complete tax returns are often requested.
  7. Work In Process Schedules – Many contractors do not employ a sophisticated method of analysis. All sureties do! It may be necessary to upgrade the reporting with highly detailed individual project cost records and profit projections.
  8. Credit Reports – Erroneous or incomplete reports can have a devastating effect on the underwriting, and such problems are slow to correct. Adjustments to the credit report are only accomplished after a time consuming process with the rating bureau.

Issues like these can throw the timing off, and delay the bond issuance, but they are all correctable.

There may be other unexpected problems that cannot be easily fixed.  For example, unacceptable financial ratios.  The company could be solvent and profitable, but with poor ratios, some underwriters will say “Come back and see us next year.”  An unacceptable company or personal credit report can have the same effect.

Contractors often dread the bond underwriting process.  We’re not trying to foment anxiety by describing these pitfalls – actually just the opposite!  By allowing enough time, we often can help the client through them.

Summary: Get your bonding set up in advance. Then you have it when you need it with no last minute surprises or disappointments.

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 #62: ILOC: What is it? What isn’t it?

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Sample #1

IRREVOCABLE LETTER-OF-CREDIT
Wisconsin Department of Transportation
Motor Carrier Services – IRP Unit
P.O. Box 7955
Madison, WI 53707-7955

We hereby establish our irrevocable letter of credit in your favor for ACCOUNT NAME, in an amount not to exceed $00.00.
All checks written by ACCOUNT NAME payable to Registration Fee Trust, (Wisconsin Department of Transportation) for the remaining registration fees will be honored by BANK NAME up to the irrevocable credit limit.

If ACCOUNT NAME fails to make payments to the Wisconsin Department of Transportation when due, the BANK NAME will allow the Department of Transportation to draw on the Irrevocable Letter of Credit up to the credit limit, provided the BANK NAME receives written documentation from the Wisconsin Department of Transportation stating registration fees have not been paid when due.

This IRREVOCABLE LETTER OF CREDIT expires: _______, ______, ______

Sample #2

CITY OF FREDERICK
IRREVOCABLE LETTER OF CREDIT
Date of Issue: _____ Date of Expiry: _____ Issue Number: __________

Beneficiary:
The City of Frederick
c/o DPW Projects Division
Attention Linda Dutrow
111 Airport Drive East
Frederick, Maryland 21701

Gentlemen,
We hereby authorize you to draw on us for account of (name)____________ at (address) ______, up to an aggregate amount of $ _____ (_____) dollars and _ cents) US Dollars, available by your drafts at sight accompanied by a signed statement that the funds are being drawn and required for payment in accordance with an executed Public Works Agreement between the City of Frederick and the party named in this paragraph for (project description) _________________.

Drafts must be drawn and negotiated not later than ______ at our counters. Partial drawings are permitted.

Each draft must state that it is drawn under the Irrevocable Letter of Credit of (name of issuing bank) _____________ Number _____________ dated _______. This Letter of Credit is not transferable or assignable without written consent of (name of issuing bank) ___________________________.

This credit is subject to the “Uniform Customs and Practice for Documentary Credits” (1994, or latest revision) International Chamber of Commerce, Brochure Number 500.

It is a condition of this Letter of Credit that it shall be deemed automatically extended without amendment for one (1) year from the present or any future expiration date of this Letter of Credit unless at least forty-five (45) days prior to such expiration date we notify you by certified mail that we elect not to consider this Letter of Credit renewed for such additional period.

We hereby agree that all drafts drawn under and within the terms and amount of this credit and accompanied by the documents above specified, that such drafts will be duly honored upon presentation to the drawee.

These are two examples of ILOCs. Let’s find out about these, and why they look so different.

“ILOC” stands for Irrevocable Letter or Credit. They may also be called a Standby Letter of Credit. These instruments are only issued by Commercial Banks. The purpose is to enable one party to draw on the account of another in connection with a business transaction. If the beneficiary makes a draft (draw) upon the ILOC, the bank records it as a loan to the account holder who is the subject of the letter (the contractor in a construction scenario). The beneficiary is not required to repay the bank.

A perfect example is the overseas practice to use an ILOC in the same manner we normally use a Performance and Payment Bond in support of a contract. The contract owner is entitled to draw on the ILOC in the event of the principal’s default.

The two examples above are actual suggested formats from those beneficiaries. The Wisconsin DOT is unusual because of its brevity. The City of Fredrick form is more typical of what you may see, particularly if using an ILOC to give collateral to a surety.

What are the important elements missing in the DOT form?

If the duration of the related business transaction is longer than the term of the ILOC, the beneficiary normally demands an “evergreen clause” which provides for automatic renewal. It means if no action is taken prior to anniversary, the instrument does not expire. This gives the beneficiary confidence that they will be formally notified prior to anniversary that the bank intends to non-renew, and they will have sufficient time to draw down (cash out) the entire ILOC so they remain protected.

It is also normal for the instrument to allow partial draws, and require the return of drawn funds that are ultimately unused.

It is important for the document to correctly state the party whose actions are the subject of the guarantee (the principal) and the circumstances under which a draw can be made should be standard.

Beneficiaries of these instruments must scrutinize the financial condition of the issuing bank. In cases where the FDIC rescues a banking institution, they have the ability to unilaterally nullify these instruments to aide in the bank rehabilitation. For bonding companies, this means they can lose their collateral even though they remain “irrevocably” obligated on the P&P bond. Check the bank strength here: http://www.fitchratings.com

Summary
We have covered what an ILOC is, the key aspects and what to look for.

What isn’t it?

For Obligees (the beneficiary of the bond) it may not be a good alternative to a Performance and Payment bond.

1. The bank does not pre-qualify the contractor’s ability to perform the work the way a surety does.
2. In the event of default, the project owner (obligee) must assess the contract status, arrange for a completion contractor and manage the process to a successful conclusion. With a bond, the surety may do all this.
3. An ILOC does not prevent liens against the project or provide the process to resolve them.

Owners may accept an Irrevocable Letter of Credit as an alternative to a surety bond. However, the fact remains that an ILOC does not match the comprehensive protection of a Performance and Payment Bond.

What about for Contractors and Developers?

  1. Bonds are not easy to get.  The contractor must pass a rigorous evaluation by the surety.  Bonded contractors and developers can promote the fact that they have the support of a surety: Bragging Rights!  Many include this info in their brochure along with their banking credentials.
  2. Having cash tied up for indeterminate time periods can put a strain on construction companies.  They need it to finance the start of new contracts and solve problems on existing ones.  Developers may lose out on opportunities to acquire new projects or property.  Reminder: Projects may be completed / released later than expected, meaning the cash remains tied up for how long?

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 #55: (2 of 4) Work In Process Schedules – Own Them!

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Finding the Degree of Completion

When analyzing the financial condition of construction companies, the Work in Process schedule is always a required item.

Much of this evaluation keys into the degree or percentage of completion of each project. When you read a WIP schedule there may be no column heading for this number, but it is easy to calculate. Noteworthy: There are some inaccurate ways to determine this percentage, so you will want to figure it yourself in any event.

Formula to find the % of Completion:
Divide the Costs Incurred to Date into the Total Costs to Complete. The percentage of the total costs that have been incurred so far is the degree of completion for that project. If the Total Costs to Complete are not shown, you may need to add the Costs Incurred to Date to the Remaining Costs in order to find the Total Costs. The degree of completion is based on a cost analysis because until you incur your last cost, you are not finished – regardless of the status of the billings.bookkeeper2

Common misconceptions about the % of completion:

1. The % of completion is based on the degree of Billings. (No, it is based on an analysis of the costs.)
2. It is always based on the original contract amount. (No, the Current Revised contract amount is used if a plus or minus change occurred.)
3. It is based on the original estimate of total costs. (Incorrect, the Current Revised Estimate of Total Costs is always used.)

With all this in mind, what is the degree of completion on this contract?

Contract Price / Original % GP /      Billed    / Costs to Date / Remaining Costs
$1,100,000     /          10%          /$550,000 /  $350,000     /    $700,000

Raise your hand if you got 50%.

OK, that’s wrong… The typical short WIP schedule doesn’t show everything. It may not give you the Current Estimate of TOTAL Costs. First, you must find that.

So $350,000 + $700,000 = $1,050,000 Current Estimate of Total Costs

350,000 / 1,050,000 = .333 or 33.3% Did I hear someone say “Why didn’t I pay more attention in math class?!”

So the project is 33% complete based on the portion of the total costs that have been incurred so far.

Knowing the percentage of completion is important for a number of reasons. From a project management viewpoint, it is normal for the contractor to establish a projected timetable to assure on-time completion of the project. By periodically reviewing the degree of completion, the project manager can confirm they are on track. There may be financial rewards for early completion or a punishment, “liquidated damages,” if they’re late.

There are other important uses for the % of completion. We’ll go over them in the next segment… with the haunting title: “3 of 4!”

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 #54: (1 of 4) Work In Process Schedules – Own Them!

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Short Form WIP Schedules 

In the next few articles we will explore a somewhat complicated and often misunderstood element of the contractors file, the Work In Process or “WIP” schedule (also known as Work On Hand “WOH”).

Why is the WIP schedule important?

bookkeeper1

For Contractors
The WIP schedule is a critically important project management tool, or at least it should be.Contractors use this info to increase revenues and profits.
For Sureties
Underwriters use this form to manage the account and help avoid claims and losses.
For Agents
As the intermediary, the agent must appreciate both points of view and be the facilitator who creates the “win-win” strategy.

Before we explore the details of this subject, let’s review some of the key terms that are used.  For the purpose of this article, we are focusing on a “Short Form WIP schedule.”  There is a long version of the document (more columns of info) that may be too complicated for many contractors to complete without professional assistance.  Since you are likely to see the short form, that’s what we’ll discuss.

The following terms commonly appear on WIP schedules and on company financial statements.  There is a row of column headings across the top.  Download a blank form: FIA Surety WIP Sched. Let’s go over them:

  • Project Name: This is the name of each individual contract
  • Start Date: Date the contract commenced
  • Original/Revised Completion Date: This is the completion date required in the contract, or as subsequently changed by contract amendment.
  • On Time Completion Expected?
  • Bonded?
  • Current/Revised Contract Price: It is not uncommon for the contract price to be changed after the work has commenced.
  • Original Gross Profit Percentage: This ties into the performance bond request form.  In order to facilitate analysis of the contract going forward, this number must be expressed as a %, not a dollar amount.
  • Billed to Date (including retainage): This is the sum of all the amounts invoiced to the project owner (bond obligee) by the contractor.
  • Cost to Date (including approved change orders): These are labor and material costs incurred by the contractor in the performance of the project.  They are “direct costs” exclusively, and do not include any expenses considered Overhead.
  • Revised Remaining Costs to Complete: Current reevaluation of the project costs based on the current / revised contract price. This is a revised cost estimate for only the incomplete portion of the project.

From surety to surety, you will find slight variations in the column headings on a Short Form WIP.  For a more complete analysis, additional columns are needed.  When viewing a WIP schedule prepared by a CPA, you may see the longer version which we will discuss later in this series.

An Analytic Tool

Let’s talk about the nature of this document.  Like all businesses, construction companies are in business to generate revenues and produce a “bottom line” profit for the company owners (meaning after all expenses have been paid).

Construction companies engage in individual contracts or projects, and are paid periodically during the progression of the work.

These payments are normally monthly and are a result of an invoice, or “monthly requisition,” the contractor gives to the project owner for work completed in the preceding period. When the requisition is owed or outstanding, it is an asset on the Balance Sheet called accounts receivable (meaning it is billed but the funds have not come in.)  The dollars become part of revenues or sales (top line of Profit and Loss Statement) when the dollars are received.

The construction industry is highly competitive and often contractors must bid to acquire projects, and only win them if their prices are the lowest.  This means for many contractors, margins are thin.

From a management perspective, construction companies must know if their projects are proceeding as expected.  They need to monitor the progress to assure that the work goes as planned and yields the profit expected.  Contractors must be vigilant to protect the success of the project, and avoid unprofitable contracts that drain funds from the company. The WIP schedule is the document that shows the current status of all open (incomplete) contracts, including their past and future projected financial results.

Keep in mind that financial statements (FSs) of a construction company may be prepared on one or two set dates every year (such as 12/31 and 6/30, etc.,) but they  perform contracts all year – meaning that on 12/31, some projects are partially incomplete.  In order for the financial presentation to include everything worth knowing, there must be a way to show these open jobs. That is the relevance of the WIP schedule for bond underwriters and other grantors of credit.

In number 2 of this series we will go over some of the info that is revealed on the short form WIP schedule.  You’ll agree, this document is absolutely essential!

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 #53: Funds Control vs. Tripartite Agreements

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You may have heard these terms used in connection with Performance and Payment Bonds.  The concepts are similar in some ways, but have different purposes.  Let’s talk about them and how they can help you as a surety bond producer.

Funds Control

Also called Funds Administration or Escrow, it is a procedure that always originates at the request of the surety.  The contractor applying for the bond (the Principal) is receiving a “conditional” approval.  The underwriters are confident there is sufficient expertise, labor, equipment, etc. to perform the bonded contract, but the contractor has some financial issues.  The underwriter is willing to bond the performance obligation, but has reservations regarding the handling of money and payment of bills (the Payment Bond exposure).  Funds Control can provide a level of protection for the surety by taking the money handling responsibilities away from the contractor.

Normal contract, the project owner (Obligee on the bond), is required to pay the contract funds to the Principal.  This is usually in monthly payments, each for the work recently performed.

With Funds Control, the money handling is taken away from the contractor and moved to a party chosen by the surety and empowered by the Principal.  The surety will require that the contractor execute a letter of instructions directing the obligee to pay the Funds Administrator instead of them.  The administrator becomes the paymaster on the project paying all suppliers of labor and material, and paying the principal, too.  This procedure eliminates most of the risk of claim on the Payment Bond.   (#Why not 100%?)

There are companies that are professional Fund Administrators.  They may be well known to the surety and handle a series of contracts with them.  A dedicated bank account is opened for the contract, and checks are issued each month which are then distributed by the principal to the vendors.  In some cases, the surety may perform the Funds Administration in house.

Tripartite Agreements

This arrangement also involves the contract funds being redirected to a third party, instead of being paid to the contractor.  And similar to Funds Administration, the point is for the Tripartite Administrator to be the paymaster on the contract.

The primary difference between the concepts is that there is no bond when a Tripartite Agreement is used – it is in lieu of a P&P bond and actually only replaces the Payment Bond.

  • Funds Control is required by the surety providing the P&P bond.
  • A Tripartite Agreement is stipulated by the obligee in lieu of bond.

Review federal regulations regarding Tripartite Agreements: A tripartite escrow agreement.  http://www.acquisition.gov/far/html/Subpart%2028_1.html

“The prime contractor establishes an escrow account in a federally insured financial institution and enters into a tripartite escrow agreement with the financial institution, as escrow agent, and all of the suppliers of labor and material. The escrow agreement shall establish the terms of payment under the contract and of resolution of disputes among the parties. The Government makes payments to the contractor’s escrow account, and the escrow agent distributes the payments in accordance with the agreement, or triggers the disputes resolution procedures if required.”

This procedure may be used for contracts between $30,000 and $150,000. The Performance Bond may be waived at the contracting officer’s discretion.

Conclusion

These procedures have different implications.  Let’s examine them.

FC= Funds Control

TA= Tripartite Agreement

The Obligee:

  • FC – They are getting Payment protection and a Performance Bond. The surety will monitor the project and step in to keep things on track (and prevent a claim or default) if necessary. In the event of failure, the surety completes the project.
  • TA – Even unbondable contractors can be awarded work. A TA may be less expensive than a bond with FC. Limitation: There may be no Performance guarantee.

The Principal:

  • Both processes result in the contractor successfully obtaining the project but with no handling of the project funds.
  • TA – No need for personal or company indemnity.  No collateral for the surety. Financial reporting, legal fees and other expenses may be less.  Limitations: Federal only permits TA on small contracts.  Fails to build a track record of “performing under bond”

Subs and Suppliers:

  • Under both procedures they are paid by a professional intermediary, which may be more dependable and faster.
  • FC – They can make a claim against the Payment Bond
  • TA – Limitation: No opportunity to claim against a surety bond if they are unpaid, or not fully paid.  What is their recourse?

Agent and surety:

  • TA – No Bond!  (Beans for supper again?)
  • FC – A normal P&P Bond is issued

# If the principal fails to list any subs or suppliers during the set-up process, they will not be under the protection of the funds administrator.  However, they WILL still have the right to make a claim against the payment bond!

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 #52: “It’s Only a Maintenance Bond”

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Maintenance Bonds can be troublesome, even though you could say the risk on them is relatively low.  So what’s the deal on these?

A Maintenance Bond normally follows a Performance and Payment (P&P) Bond that guarantees a construction contract.  In many cases the Performance Bond may also cover defective materials and workmanship for some time period after acceptance of the work.  This is referred to as a maintenance period, and the bond that may specifically cover it carries the same name.

There are times when the obligee (party protected by the bond) wants two years of maintenance.  If that is longer than the performance bond provides, a separate maintenance bond is needed.  There are also cases in which no maintenance period is automatically provided by the P&P bond, so there must be a maintenance bond if the protection is desired.

Why is the Risk Relatively Low on a Maintenance Bond?

Assume “Surety A” provided a P&P bond on a contract.  They already faced the risk of the project not being performed properly.  Having now passed that exposure, it is a small step to guarantee the materials and workmanship that went into the project.  For this reason, a Maintenance Bond following a P&P Bond issued by the same surety, may be much less expensive than the related P&P Bond, and would be freely given.

Sometimes They Play Hard to Get

There are a couple of factors that can make these bonds difficult to obtain.

  • No P&P Bond – If no P&P bond was issued, the underwriter will be justifiably suspicious if a maintenance bond is requested.  Perhaps the obligee regrets not having obtained a P&P bond or was unwilling to spend the money for one.  Now they want a cheap alternative that can still cover the entire project.  Maybe they observed a suspected defect in the work and belatedly want the protection of a surety bond.
  • Different sureties – If Surety A wrote the P&P bond, Surety B will obviously ask why “A” is not also handling the maintenance bond.  Maybe “A” knows there was a problem on the contract and they want to run away from it while they can.  The only good candidate for the maintenance bond is the surety that got paid on the P&P bond.
  • Low percentage maintenance obligation – often the maintenance bond is issued for less than 100% of the contract amount.  It may be for 20%.  You have a low dollar amount, but it still covers the entire project.  This is an unappealing situation for the surety.  But it is one they will tolerate If they already reaped the benefit of issuing the P&P bond.
  • Low rates – Maintenance bond rates are normally lower than P&P bond rates because… (*why do you think?) This makes them less rewarding for the surety.
  • Difficult guarantees – Some maintenance bonds cover efficient or successful operations instead of the normal “defective materials and workmanship.”  This is a far more difficult guarantee for the surety to provide.  Many are unwilling to provide such bonds.

Solutions

The only alternative to a bond may be a “cash” type alternative such as a Standby Irrevocable Letter of Credit issued by a commercial bank. The client may not think this is a great solution, and there will be no commission for the agent, but there are not many options at this point.

One consolation is that maintenance bonds are often written for a small percentage of the contract amount.  So cash in lieu of bonds may be feasible.

Maintenance bond rates may be lower than P&P bonds because the work is already in place and has been accepted by the architect and / or owner.

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 #46: Turn IRON into GOLD

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When contractors apply for Performance Bonds, the underwriting review always includes a financial analysis along with other elements.

Two key components of the financial analysis are Working Capital (WC) and Net Worth (NW).  WC is a measure of short term financial strength.  NW is the ultimate value of the company upon liquidation.

The inspiration for this article came from a new bond account we recently reviewed.  The company is a trade contractor, the kind that normally performs their own work rather than subcontracting. This means their financial statements should show appropriate levels of labor, plant, and equipment.

In this case, the Profit and Loss Statement (P&L) showed sales in excess of $10 million, not a small company. The Balance Sheet showed an acceptable amount of WC, but NW was low – resulting in some weak ratios.

Another element caught our attention: On the Balance Sheet, the net value of the equipment asset was only $65,000! This made us wonder how a company could perform $10 million in sales with so little in physical resources.

There could be a couple of explanations:

  1. They could be subcontracting most of their work.  This is unlikely, however, because they themselves are subcontractors. Typically there is not enough profit to share between two firms. A review of this company’s P&L statement did not indicate extensive subcontracting.
  2. They could be renting almost everything (instead of owning).  This doesn’t sound like a practical approach with sales as high as $10 million, and the P&L did not show high rental expenses.
  3. The equipment could be substantially depreciated resulting in a low net value on the Balance Sheet.  This did turn out to be the scenario in their case.

Let’s talk more about #3. But first off, what is depreciation?

IRS definition: http://www.irs.gov/Businesses/Small-Businesses-%26-Self-Employed/A-Brief-Overview-of-Depreciation

It says in part, “Depreciation is an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.”

This means when a $100,000 backhoe is purchased, its value as an asset on the Balance Sheet goes down each year as the depreciation progresses.  Bear in mind, this is an accounting entry.  It is not an indication of the current market value of the asset.

Eventually, the asset is depreciated to zero. However, even if it is valueless on the Balance Sheet, it may still be out on a job site working and producing revenues.  It may still have a market value. So therein lies the Gold.

Assets such as heavy equipment (referred to as “Iron”), may have value that is not reflected on the Balance Sheet. So the question is: How to recapture that value and help the bond worthiness of the account?

One way is with a professional appraisal.  Even if the backhoe is depreciated to zero, if the current market value is $25,000, that represents NW that can be added to the financial ratios.

Imagine the effect for the company in question.  Upon further review, we determined that the cost of their equipment was nearly $2 million.  They had a lot of it and it was older so depreciation had reduced the net value on the Balance Sheet to $65,000.  However the current market value was actually $500,000!

Q. Based on these facts, what value should the bond underwriters use for the equipment:  $65,000, $2,000,000, $500,000 or some other amount?

A. If you’ve been following along, that’s where the appraised value comes in.  You need an independent determination of current market value that recognizes the amount of cash these assets could bring.  If well maintained, they have a value higher than that shown on the Balance Sheet. ($500,000)

How else can the value be determined?  The client could provide a copy of their equipment floater as evidence of current value.  You could also get an informal appraisal from their equipment dealer.  Any of these options are better that living with the unrealistically low value shown on the Balance Sheet.

Going back to our example, if the backhoe’s market value is currently $25,000, give that info to the underwriter.  The newly found net worth for all such assets can be added to the bonding analysis.  You turned the Iron into Gold, a POT of Gold!  It can totally transform the ratios and the client’s ability to qualify for the bonds they desire.

Consider this technique for companies with a sizable fleet of mature equipment, especially when their Net Worth is less than desired for bonding purposes.  This analysis can also help strengthen the banking relationship.

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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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

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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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