October 4, 2018

Bonds in construction, Part 1


Bonds are used in construction to provide the recipients of the bonds (and others) with security that certain obligations will be met. It is important to understand, as a starting point, that bonding agreements differ from insurance contracts. Insurance contracts are between two parties (the insurer and the insured), while bonding agreements involve three parties: the “surety” (the bonding company), the “obligee” (usually the owner of the project) and the “principal” (the contractor or subcontractor who posts the bond).

Where bonding requirements are in place, the principal is required to provide a bond to the obligee as a condition of bidding for or entering into a contract or subcontract for a project. Upon approved credit worthiness, the principal obtains the bond from a surety in exchange for the payment of a premium and some form of security. The bond in turn secures some or all of the principal’s obligations under an underlying tender document, contract, subcontract or payment obligation. 

CONTRACTORS AND SUBCONTRACTORS who wish to obtain bonding support from a surety must apply in much the same way a company would apply for credit from a bank. In assessing the application, the surety will establish the credit worthiness of the applicant. The surety will set up a credit file, perform credit checks with banks and suppliers and underwrite the financial statements for the applicant, usually looking back at least three years. 

The surety’s underwriter typically requires the applicant to provide detailed information about the company and its operations, including an organizational chart, financial statements of the major shareholders of the company, financial statements of companies related to the applicant, the contractor’s budget for the current or forthcoming year, a listing of accounts receivable and payable, work-in-progress reports, the applicant’s plans with respect to continuity and succession, the résumés of key personnel within the company, the terms and conditions of loans, leases or lines of credit held by the applicant. 

In reviewing the application, the surety will generally consider the quality, quantity and frequency with which the applicant keeps and maintains its financial records, the profitability of the company, the ratio of the company’s debt to equity and any financial changes which have occurred over the last several years. In addition, the surety will generally consider the applicant’s general reputation in the industry, how long the applicant has been in business and the extent to which the applicant has been successful on previous projects. The surety will also generally look at the quality of the applicant’s field superintendents and at the health of the projects that the applicant has on the go at the time of the assessment. 

The surety will then usually require the applicant to provide security for the bonding support. Generally speaking, the surety will require the applicant provide personal indemnities from its related companies and/or shareholders. The surety will also generally require that the applicant (as principal) allow the surety to step in under a performance bond to claim the balance of contract funds owed to the principal in the event of a default. The type and value of the indemnities required may be changed by the surety over time, as the credit worthiness and general financial health of the applicant changes.

ONCE THE SURETY DETERMINES the applicant is credit worthy for bonds and has acceptable indemnities in place, the surety will generally set up a program for the applicant based on single job limits. If a $5 million single job limit is established, for example, the applicant would be entitled to support for a contract of up to $5 million. The next stage in the bonding support involves aggregate limits, which place a limit on the total value of work that the applicant may undertake at any one time and still be entitled to bonding support. The limits may, of course, change over time.
Where a surety makes payment further to a claim under a bond, the surety will have the right, subject to certain defences, to recover those amounts paid, plus costs, from the indemnitors. Indemnitors may then raise defences to the surety’s claim, which defences might include: that the surety failed to mitigate its losses, that the surety has breached some duty owed to the indemnitor and that the surety has not properly proven that the amounts paid under the bond were necessary or in accordance with the bond in question.

Once a surety program has been set up for an applicant, the surety will require that the applicant under the program provide regular and ongoing financial disclosure as a condition of bonding support. This requirement generally includes, at a minimum, the provision of annual audited financial statements. Statements may also be required on a quarterly or monthly basis, depending on the needs of the surety. 

The surety will generally consider each individual request for bonding on specific projects. In addition to determining whether or not the bond request exceeds the limits established for the program, the surety will also generally review the risks associated with the project in question. The surety will require information relating to the obligee, the type and location of the project, the projected completion date for the project, the maintenance warranties and holdbacks and the percentage of the applicant’s work that is to be subcontracted. The surety may also request, if available, the bid prices of those who were not successful in tendering the project. 

IN MANY CIRCUMSTANCES the information which the surety requires in relation to a bonding request can be provided to the surety through or on the advice of a broker who, like an insurance broker, acts as the liaison between the applicant and the surety. The broker receives a commission from the surety on the premiums paid by the principal. The use of a broker can be very beneficial, as the broker is in a position to understand the applicant’s business and finances as well as the specific requirements of the surety. In addition, the broker may be able to put the applicant together with a surety whose products best meet the needs of the applicant. 

Once the surety decides to provide a bond, the surety will determine the premium to be charged to the principal. The premium is generally determined as a function of the value and duration of the contract which is supported by the bond. In our next column, we will review the various types of bonds available, and their role in construction. 
Robert Kennaley and Josh Winter practice construction law in Toronto and Simcoe, Ont. They speak and write on construction law issues and can be reached for comment at 416-700-4142 or at rjk@kennaley.ca and jwinter@kennaley.ca. This material is for information purposes and is not intended to provide legal advice. Readers who have concerns about any particular circumstance are encouraged to seek independent legal advice in that regard.