The current economic downturn and credit crisis is causing significant problems for the construction industry. As new projects become scarce, competition for the limited work increases as companies seek to keep their employees working. This sounds like a “good” deal for owners but it comes with some added risks. Owners must balance the desire to accept the lowest bids received with the risk that the contractors submitting those bids are under-estimating costs and may default before the project is complete. This is also a risk to general contractors who rely upon low bids from subcontractors desperate to get new work. As such, owners and contractors on both public works and private construction projects must implement risk management strategies to minimize the risk of default.
Performance bonds are almost always required for public works projects as a way to protect the public while accepting the lowest bids through an open, competitive bidding system. Performance bonds are agreements among and between at least three parties: (1) the principal – the primary party who will be performing the underlying contractual obligation; (2) the obligee – the party who is the recipient of the principal’s obligation; and (3) the surety – the party who guarantees that the principal’s obligations will be performed. Under these agreements, the surety guarantees to the obligee that the principal will fully perform the underlying construction contract between the principal and obligee. In the public works context, the obligee is the government entity, the principal is the general contractor, and the surety is the bonding company. The bonding company guarantees to the government entity that the contractor shall perform in accordance with the terms and conditions of its underlying contract. If the contractor fails to meet its obligations, the surety becomes liable to the amount of the bond.
As in the public works arena, owners and contractors can also protect private construction projects by requiring performance bonds. The decision generally depends on two factors: the added cost of requiring the bonds, and the financial stability of the contractor or subcontractor submitting the bid. In times of economic hardship, the second factor becomes more important for several reasons. First, the cost of replacing a defaulting contractor or subcontractor is often much higher than the original bid. This is even more pronounced when the original bid was submitted at or below the actual cost to perform the contract. Second, the party who absorbs the cost of hiring the replacement contractor or subcontractor may have little or no luck collecting from a defaulting party who files for bankruptcy or closes its doors.
The increased cost on a project due to performance bond requirements is another important factor to consider. The cost is a premium based on the amount of the underlying contract and is adjusted as the contract amount changes. The owner generally pays this additional cost because it passes through the contractor’s bid and change orders.
Owners typically contract only with one prime contractor on a project. They must decide whether to incur the additional costs of requiring a performance bond to protect against the failure of the prime contractor to fully perform the work. Prime contractors, on the other hand, have multiple subcontracts with many different trade contractors on each project. Thus, in addition to evaluating the financial stability of each subcontractor, they must decide whether to incur the added cost of bonding each subcontractor or whether to bond on certain portions of a project. At the very least, contractors should take the time to identify which portions of a project, if abandoned by the subcontractor, would cause the most serious financial contract with the owner.
Owners and contractors can reduce the potential financial risk arising from a defaulting contractor or subcontractor by requiring performance bonds on a project. The rights arising under a performance bond may be lost, however, if the claimant does not comply with the bond’s technical claim requirements. As claim requirements are defined by the bond itself, owners and contractors should become familiar with its terms and conditions. Great care must be taken in providing all required notices to the appropriate parties in a timely manner. Additionally, bond claimants should retain detailed documentation regarding the defaulting party for the bonding company’s review. Finally, a lawsuit to enforce bond rights must be filed within the deadlines established by the bond.
Hard economic times create more competition in the construction industry. Thus, owners have the opportunity to contract for construction projects at a discount. By understanding and preparing for the risks that accompany this increased competition, owners and contractors can avoid turning a potential bargain into a substantial loss.
(Published in the Idaho Business Review, February 2009)