Portage Place

Contract bonds offer low cost guarantee

Guarantee subcontractor performance for less than a 1% cost
Wednesday, February 2, 2022
by Fred Moroz

Whether you are a general contractor, developer, owner’s rep or an owner, a big part of assuring the success of a construction project involves mitigating risk. The first step is to assess the risk. If all of the subcontractors successfully perform their contracts, there is a high likelihood of a successful project. But if even one subcontractor fails to perform, it can affect your overall schedule and overall budget. Some contractors are more critical to your schedule and budget than others. Usually these contractors have the largest contracts. But it can also include smaller contractors who are specialized or in very high demand and hard to replace. The success of these large and specialized contractors represent the greatest impact on the level of success of your project.

There is a risk mitigation product that is available that usually costs less than a one per cent premium on the subcontractor’s contract amount, and it has been guaranteeing Canadian construction contracts for over a hundred years. They are contract bonds. Often called construction bonds because more than 90 per cent of contract bonds that are issued are guaranteeing construction contracts.

The two types of contract bonds are: performance bonds and labour and material payment bonds. Getting a performance bond from a subcontractor guarantees the performance of their contract. Getting a labour and material payment bond from them guarantees that they will pay all of their subs and suppliers. This vastly reduces the number of liens filed on bonded jobs vs un-bonded jobs.

Many owners who want to mitigate contractor risk throughout the entire project, bond the general contractor. Or, they can choose to take a more selective approach. Whether they have their own construction managers or hire a GC, it is becoming common for the owner and PM/GC to discuss risk management of the subcontractors and determine which subs represent a greater risk. Receiving bonds from those higher risk subs would add a minimal cost to the overall project and potentially save millions of dollars if even one of those subs default and need to be replaced. Every subcontract represents a different relationship history, a different potential impact to the schedule and a different cost to replace.

As result of the challenges resulting from the pandemic and the supply chain disruptions, the number and value of contractor defaults has increased over the past few years in Canada. Trying to identify which businesses will be significantly impacted has also become more difficult. The newer that a contractor is, and the smaller they are, correlates negatively to the likelihood of defaulting on a contract and becoming insolvent. But even well-establish large contractors can run into problems. It is often hard to know which subcontractor on your project will run into difficulties and how much it will impact your schedule and cost budget.

The usual due diligence into subcontractors includes years in business, previous projects and reference checks. Those give a pretty good indication of the quality of contractor. But, they won’t tell you if that contractor is in financial difficulties or has overextended their work program beyond their capabilities. However, their bonding company knows that information. If their bonding company will provide bonds stating they will guarantee their contract with you, then you know not only the contractor’s likelihood of default is much lower, but also that if there is a breach of contract, the bonding company is legally obligated to help the contractor finish the contract, hire a replacement contractor, or pay the bond penalty.

The statistic that is most telling is a non-bonded construction enterprise is more than 10 times more likely to become insolvent than bonded companies (Surety Association of Canada research study).

But even among bonded contractors, they do not bond all of their contracts. The contracts that they do bond receive more attention and have less disputes than their un-bonded contracts. There are two reasons for this. Un-bonded contracts only have the liability of the operating company at risk. Contracts backed by a bond, risk not only the OpCo, but all other companies and persons that indemnify the bonding company. Therefore, the contractor has a vested interest to prioritize the successful performance of their bonded contracts, over their non-bonded contracts. Secondly, if you make a claim against a subcontractor’s bond for non-performance, the bonding company legally must respond within a limited period. Therefore, the bonding company will immediately contact the subcontractor to discuss the claim and how it can be resolved quickly. The bonding company will not allow the contractor to drag out a dispute that may result in a bond claim.

The current situation of delays of delivery of construction materials and their consequential cost increases has created a surge in the requests for bonds to guarantee delivery dates and material costs. Understandably, many subcontractors and suppliers are not willing to guarantee these risks. But if a sub or supplier is willing to guarantee delivery dates and prices, a supply bond would be a very good purchase in today’s supply chain climate.

Construction bonds are not new. But many people who manage construction projects either do not know much about them, or just think they are an added cost. Many contractors do not want to tell you about them because it represents a higher obligation to them. Or, maybe they do not qualify for a bond facility. But for managers of construction projects, there are not many things that can add certainty and reduce significant risk, for only one percent or less of a subcontractors contract.

 

Fred Moroz is vice president of Construction Contract Bonding at BFL Canada Risk and Insurance Services Inc. in Vancouver. fmoroz@bflcanada.ca

 

 

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