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Performance Bonds: How to Avoid Collateral

This is a nasty topic. Not because surety is inherently bad, but because it is a subject of great distress for contractors and their insurance / surety agents. For instance:

  • Why is the surety company taking money from me when can see Am I in a weak cash position? I need it to successfully complete the new project.
  • Won’t you pay me interest on the money? Why not?
  • When the job is half done, won’t you give part of the warranty?
  • Won’t you deliver the warranty upon accepting / completing the contract?
  • Won’t you deliver the warranty until the warranty period ends?
  • Etc. Much aggravating phone calls and emails.

With all this aggravation ahead, why do some surety companies require collateral? The reason is to protect yourself in the event of a bond claim.

When a loss of contract warranty occurs, the claims department expects to have two reliable resources for financial recovery:

  1. The unpaid balance of the contract goes to the bond as they complete the job.
  2. The bond sues the applicant / business and their owners to recover the loss.

Collateral requirements arise when the guarantor wants to have
certainty. If a problem arises, they don’t want to find out that the customer has no money left, or that they have filed for bankruptcy … or left the country. If they are going to write the bond, they want a
guaranteed way to have financial recovery.

Considering that collateral is an expensive price to pay for a surety, let’s look at an alternative approach that helps collateral, but doesn’t take a big bite out of the contractor!

“Withholding” is money that the project owner withholds (withholds) to ensure the final completion of the project and the payment of related invoices. If the withholding is 10%, the contractor receives 90% of the funds owed to him as the work progresses. In the end, the contract owner / obligee will still have 10% to keep the contractor interested in achieving full and satisfactory completion. In this way, the withholding money protects both the obligee and the bond, which makes claiming a bond less likely.

The “Bond Consent for Release of Final Payment” is a voluntary procedure that obligees can use as a courtesy to the bond. The latter part of the contract funds can be useful leverage for the contractor to move into final contract adjustments. There may be cracks in the construction, broken glass, faulty lights, paint errors, little things that the obligee cares about but the contractor may find it annoying to correct. Bond Consent is another way for the surety company to avoid a claim. “Fix this or we won’t agree to release your final payment.”

How can these two useful tools be incorporated to ensure that they will help bail and thus replace the need for collateral?

The answer is to add a condition to the link (required compliance required by the obligee) indicating that there can be no release or reduction of retention or final payment without the prior written consent of the bond. Now it is guaranteed that the surety company will have a financial resource available and the amount is known in advance, as is the guarantee. But the contractor did not have to empty the company’s bank account to achieve this: Win win!

What if the terms of the contract do not provide for a retention procedure? One can be additional by contract modification. If Funds Control (an escrow agent) is in use to handle contract disbursements, a withholding procedure can be added to the funds control agreement.

Consider this alternative procedure if your bond insurer needs help getting more creative with the underwriting solution.

Speaking of fund control, see our article next week “Performance Bonds: How to avoid fund control.”

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