Surety’s role in public construction

Virtually all public construction in America is accomplished by private sector firms. And, as the 1997 Dun & Bradstreet “Business Failure Record” reports, some of those firms are not financially sound. In fact, there was a 10.8 percent increase in contractor failures from 1996 to 1997, with liabilities increasing from $1.3 billion to $2 billion.

More than 80,000 contractors failed between 1990 and 1997, according to Dun & Bradstreet, leaving more than $21 billion in liabilities for unfinished projects. Clearly, there is a need to protect taxpayers from contractors that fold before completing a public project.

Surety bonds can do just that, often at less cost than letters of credit or certificates of deposit. Surety bonding is a rigorous process in which surety companies prequalify contractors and then guarantee that the contractors will complete their projects and pay first-tier subcontractors, laborers and materials suppliers (those hired directly by the general contractors). Construction projects can involve three types of surety bonds:

Bid Bonds. The bonds provide financial assurance that the bid has been submitted in good faith and that the contractor intends to enter into the contract at the bid price.

Performance Bonds. Should the contractor fail to perform the contract in accordance with its terms and conditions, the bonds protect the owner from financial loss.

Payment Bonds. Such bonds guarantee that the contractor will pay subcontractors, laborers and suppliers associated with the project. (Government property is not subject to mechanic’s liens, meaning that laborers, suppliers and subcontractors would be without redress if the contractor defaulted, and there were no payment bond.) Section 270 of the Miller Act, enacted in 1935, governs performance and payment bonds on federal construction projects.

Additionally, each of the 50 states, the District of Columbia, Puerto Rico, and almost all local jurisdictions have enacted legislation requiring surety bonds on public works projects. Generally referred to as “Little Miller Acts,” those laws often set minimum thresholds (ranging from $5,000 per project in Missouri, Alabama and Massachusetts to $200,000 in New Jersey) for which state agencies and local governments may require surety bonds. (Sometimes, no threshold is set, and the local entities themselves determine what minimum project value necessitates surety bonding.)

While surety credit is similar to obtaining bank credit, it still is a form of insurance. Surety bonds and insurance both are risk transfer mechanisms that are regulated by state insurance commissioners, and both provide protection against financial loss.

Unlike other lines of insurance, however, surety actually is a form of credit. Whereas bankers either lend money or extend a line of credit, a surety grants a “pledge guarantee.” The surety does not lend the contractor money but instead allows the surety’s financial resources to be used to back the commitment of the contractor; if the contractor defaults, the surety pays for completion of the contractor’s work.

The basic function of surety is prequalification. That process involves a surety underwriter taking an in-depth look at the contractor’s entire business operation and thoroughly analyzing the contractor’s financial strength and capacity to perform before credit is extended.

To issue a surety bond, the surety must be confident that the contractor has good character; experience matching the requirements of its contracts; financial strength; an excellent credit history; an established banking relationship and line of credit; and ownership of (or the ability to obtain) the equipment to carry out the contract.