subdivision bond

Secrets of Bonding #62: ILOC: What is it? What isn’t it?

Steve GoliaLeave a comment

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.

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

Secrets of Bonding #61: Solve This Problem

Steve GoliaLeave a comment

A key vendor / supplier is demanding that a GC provide protection for their purchase agreement. However, the project owner did not stipulate a Performance and Payment bond on the contract and none was provided. The work has started and the contractor needs to get materials delivered from the reluctant vendor.

What are the possible solutions that may satisfy the vendor?

Q. Can we issue a Payment Bond on the Purchase Agreement?
A. A vendors purchase agreement is not the same type obligation as a construction contract. A bond guaranteeing payment of the purchase agreement would be considered a Financial Guarantee Bond (Why?  See below *) They are more difficult to obtain than a Payment Bond, so that may not be the best solution.

Q. So what about issuing a Performance & Payment Bond on the Purchase Agreement?
A. This is also not an option due to the differences between the nature of a purchase agreement and a construction contract.  (Details below *).

Q. Can we bond the contract in a normal way (100% Performance & Payment)? That Payment bond would cover all vendors, so it would cover the one in question.
A. Bonding a started project is always a red flag. The underwriters initial question is “Why do they want a bond now?” It does seem suspicious, like there may be a problem with the performance of the construction work or the owner received some negative info on the contractor. The contractor could have a problem and the work may be in jeopardy.

Another issue is the cost. If a bond was not originally required, the bond cost was not included in the contract price. This means a bond purchased subsequent to the execution of the contract will be paid for out of the contractor’s profit margin. The Principal / GC will be looking for the most inexpensive solution possible.

Keep in mind that the purchase order amount is less than the contract price, so bonding the contract would result in a bond higher (and more expensive) than actually needed.

Q. Can we issue just a payment bond on the contract?
A. This too will be viewed as a red flag by the underwriters. Who asks for a payment bond but doesn’t want a Performance Bond? That would be unusual.

Summary
We have concluded that it will be difficult to retroactively bond the contract, the amount of the contract is more than the purchase order and only a financial guarantee bond can be issued on the purchase agreement, so a bond may not be the solution at all!

Our Solution

In this case, we offered Funds Administration instead of a bond. This was an inexpensive alternative, and provided an assurance for the vendor that bills would be paid in a routine manner. (The project owner pays the Funds Administrator who directly pays the vendor.)

Keep in mind, however, that the Funds Administrator has no obligation to the vendor. If there is an unexpected event, such as termination of the contract, the Funds Administrator does not guarantee to the vendor that they will be paid appropriately.  A bond would, if one had been written.

*The nature of purchase orders is different from construction contracts. When issuing a P&P bond on a contract, the surety depends on the fact that the obligee / beneficiary is paying for the work, and that money may be the key to solving any claim or default.

When bonding a purchase order, the obligee / beneficiary (vendor), is not paying – they are receiving payment. That is why a Financial Guarantee Bond must be used, and is why they are harder to obtain.

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 miss our next exciting article.  Click the “Follow” button at the top right.)

Secrets of Bonding # 59: Bonding Specifications, Boilerplate That Bites

Steve GoliaLeave a comment

Does anybody really read this stuff? YEP, WE DO!fine print

Just like on insurance, there are written specifications (specs) for bonds, and if you don’t know what they are in each case, you could be setting yourself up for a disaster.  There can be serious consequences if a bid bond is rejected and a contract is lost.

So how do agents protect themselves from such an outcome? Step one is to obtain the written bonding requirements in every case. You may find they are open or they may be very narrow and specific.

Here is an example of one spec we recently handled: “The surety company shall hold a current certificate of authority as acceptable surety on federal bonds in accordance with the United States Department of Treasury Circular 570, Current Revisions.” (Read Secret # 23 about the T-list). To determine if you are in compliance with such a requirement, find the name of the surety exactly as it appears on the bond, and look it up here: http://www.fms.treas.gov/c570/c570_a-z.html
If the requirement goes on to say the Circular 570 dollar amount must be sufficient, compare the “Underwriting Limitation” amount to the dollar value of the bond. It must be is equal to or larger than the penal sum of the bond.

“No modification or waiver of any of the terms of the contract to be performed will in any manner discharge any surety liability thereunder.” This is commonly accepted language meaning the bond follows the contract even if the amount or terms are subsequently changed.

Normally the specs require a Performance and Payment Bond equal to 100% of the contract amount. Occasionally you may see a request 110% bonds. This is troublesome for the surety and they will resist issuing on this basis.

The boilerplate may require a bonding capacity letter issued by an acceptable surety in lieu of a bid bond.

Also note, bid bond percentages vary. Federal is normally 20% of the bid amount. Others are often 10%, but some are 5%.

The bid could also require a surety consent letter, promising to issue the P&P bond if awarded the work.

Federal Projects
On all federal projects where the contractor has a direct (prime) contract with a federal agency, the surety must be on the T-List and for a sufficient amount. Other owners sometimes choose to use this as part their own requirements.

On a prime federal contract you are also required to use the government bid bond form (Standard Form 24) and performance (25) / payment (25A) bond forms. Get them here: http://www.gsa.gov/portal/forms/type/SF

A.M. Best Ratings
It is not unusual for the specifications to require a minimum A.M. Best rating.  To confirm that the surety has a sufficient Best rating, look up the exact surety name in the A.M Best site: http://www3.ambest.com/ratings/default.asp

State Licensing
Another common requirement is that the surety must be “authorized to do business in the state of…” This means the surety must hold a state insurance department issued license (an admitted carrier). To check this, go to the insurance department for the state where the work is located. In our home state of New Jersey, we go here: http://www.state.nj.us/dobi/data/inscomp.htm

Bond Forms and Documents
You may run into mandatory bond forms. These are more common on private contracts than on public work. However, mandatory means just that. So it is important to 1. know if mandatory forms are stipulated and 2. confirm that the forms are acceptable to the surety and contractor. Sometimes on private work, they are strongly slanted against them.

Summary
Referring again to Secret #30, there is a significant risk for bond issuers, especially on bid bonds. Important: Agents should not rely on the bond request form prepared by the contractor. We often find this information incomplete and/or incorrect. To be sure you are issuing a valid bid bond that the obligee will accept, you must directly review the written bonding requirements

All the fine points we discussed can lead to a bond rejection. So get the boilerplate and take a bite out of it, before it bites you!

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 miss our next exciting article.  Click the “Follow” button at the top right.)

Secrets of Bonding #30: The Greatest Danger

Steve GoliaLeave a comment

Bid Bonds, Performance Bonds, Payment Bonds. They each have a different purpose and include certain risks. So which one is the Greatest Danger for the surety and agent, and why?

Performance Bonds are an obvious choice.  We may think of Performance Bonds as the main reason a project is bonded – they protect against contractor default and assure completion of the work.

While this is certainly significant, it is not the Greatest Danger. Performance claims are usually preceded by events that give the surety a chance to respond.  A “Cure Notice” may be sent by the obligee alerting the contractor and surety that a deficiency exists and if left uncorrected, a bond claim may result.  Another event preceding claim is the declaration of default by the obligee.  (The contractor is thrown off the project.) This would be a major event and all interested parties would receive notification.

If the surety cannot help remediate the performance problem and a claim results, the unpaid portion of the contract amount is a financial resource that always helps the surety in addition to potential recovery via the General Indemnity Agreement.

The Payment Bond is actually the most common source of bond claims. There may be disputes about the performance of subcontract work or materials supplied.  Unjustified claims will be declined and for valid claims, the contract funds and Indemnity Agreement are resources for the surety.  Even though they have claim frequency, Payment Bonds are not the Greatest Danger.

So that leaves the lowly Bid Bond.  Some think of them as just incidental, like ordering a Builders Risk policy.  Their dollar amounts are smaller than Performance Bonds.  They are issued for free or for a small service charge.  Once produced, they are quickly forgotten like they were hardly valuable in the first place.  Nothing glamorous here.  But what are the dangers with Bid Bonds?

The first unique thing is that you get once chance to issue them correctly. On competitively bid work, such as government projects, the bid bond accompanies contractor’s proposal.  The bids are stamped for date and time when submitted, and if your proposal is late, it is rejected!  The bids are opened and examined by the contract administrators.  The bid bond and accompanying proposal can be rejected for technical errors such as the wrong project number, missing signatures, or any other details.  On the other hand, mistakes on Performance Bonds can normally be corrected without penalty.  The contractor already has the project, so there is no harm in allowing the bond to be adjusted. With bid bonds in a competitive situation, there is no chance to make a correction – the other bidders will not allow it! A bid protest or lawsuit would likely result.

In addition to accuracy and timely delivery, bid bond documents can result in a rejection if mishandled.  For example, the failure to use a mandatory bid bond form or the absence of a Surety Consent could result in proposal rejection.

Proposal Rejection – let’s talk about that.  The surety or agent makes one of the errors we described, the bid bond is deemed insufficient, and the contractor’s proposal is rejected. On public work the bid results are normally published, so the client will know if their rejected proposal would have been the winning number, and they would have acquired the contract.

In addition to the embarrassment of making an error, the loss of revenues, and maybe losing a customer, here’s the worst part: There have been cases where the contractor sued the surety for lost profits – the profits they expected to acquire from the project.  This is a constant threat on Bid Bonds, and the indemnity agreement doesn’t help if the error was solely on the part of the surety or agent.  A lawsuit like this could be for millions of dollars.

 

Bid Bonds are the winners!  They are the Greatest Risk for sureties and the agents who execute them.  We have one chance to get them right.  They must be perfect every time.

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 #10: Site / Subdivision

Steve GoliaLeave a comment

Site / Subdivision: Oh what a tangled web we weave…

Feel like you’re not an expert on these?  You’re not alone!  In this article we’ll cover the basics as well as some of the tricky stuff.

Site and Subdivision (Sub-D) Bonds are both similar for the surety.  A Site Bond is needed when a business expands their facilities whereas Sub-D arises on residential development projects.

In both cases, the property owner or developer has obtained zoning board approval to proceed, but is required to build certain elements the township wants such as sidewalks, roads or lighting.  Contractors call this “site work,” thus the name Site Bond.  Site bonds do not concern the construction of the buildings.  “Improved Lots” are property where such elements have been completed.

This required work is collectively called the Public Improvements.  A township engineer will prepare an “Engineers Estimate” with an estimated current cost for each item.  The bond amount is the sum of these costs plus an added cushion in case the bond is called at a future date when construction costs are higher.

The purpose of all Site and Sub-D Bonds is to guarantee that public improvements will be built at the developer or surety’s expense, not the taxpayers.  For example, if the developer fails to topcoat the road, the township makes a bond claim and the surety must complete the work.

How Site & Sub-D differs from Performance Bonds:

  • There is no contract with the obligee (township)
  • The obligee is not paying for the work.  It is self-funded by the principal (property owner)
  • There is no definite completion date

FIRST TANGLED WEB: Since the work is self-funded, the property owner must either have cash on hand or arrange for a construction loan. If the latter, it is likely that the property in question will be collateral for the lender. This means in the event of the principals failure (such as bankruptcy), the bank becomes the new property owner but the surety remains obligated to the township.

In the borrowers absence the bank has no obligation to disburse the remainder of the loan (the purpose of which was to improve and increase the value of property THE BANK NOW OWNS) – but the surety is still required to complete the work.

Untangle this by obtaining a “Set Aside Letter” from the lender prior to issuing the bond.  This requires the bank to continue disbursing funds to the surety in the event of the borrower’s failure – with no pay back required.  In this manner, the work can be completed as intended.

SECOND TANGLED WEB: When the property owner hires a contractor to build the public improvements, it is not uncommon to require the construction firm to obtain the Site / Sub-D bond.  After all, the contractor may already have a surety relationship.  Problem: In the event of the property owner’s default, the construction contract is terminated however the Site / Sub-D bond obligation remains in force.  No more money is coming to the contractor to complete the work. The contractor is now solely responsible to the township and the surety and must self-fund the completion of improvements for property they do not own.

Untangle this one by a) requiring the developer, not the contractor, to be the bond applicant, or b) at least get the financial statements and indemnity of the developer so the contractor is not solely obligated to the surety and township, and c) a set-aside letter or escrow account (for funding by cash) could still be required.

Summary: Key questions are:

  • Who will build the public improvements?
  • If built under a construction contract, is it bonded to the developer? (Performance and Payment Bond)
  • How will the work be paid for?
  • How will the surety be funded in the event of failure by the property owner?

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

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

First Indemnity of America Ins. Co.

(Don’t miss our next exciting article.  Click the “Follow” button at the top right.)