By James Bly, CPA, CPCU, AFSB
In today’s growing construction market project delivery methods are changing while job sizes are increasing. Public Private Partnerships (P3 projects) are gaining momentum throughout the U.S. as an efficient means to design, build, finance and maintain government construction projects.
Work in the energy sector is also on the rise where owners have typically relied upon letters of credit in lieu of surety bonds as a means to provide contract security for potential defaults.
As a result of these market trends, the surety market has responded with Expedited Dispute Resolution bonds that accelerate claim payments providing more liquid instruments to a market that is demanding them.
Under P3 projects, the concessionaire (developer) will generally engage a design-build contractor to complete the construction phase of the project. The security requirements for the design-build contractor are ideally structured to meet the needs of the concessionaire and it’s lender as well as providing the protection for subcontractors and suppliers for these projects. Since subcontractors and suppliers are unable to perfect a lien on P3 projects, surety bonds that include a performance bond with an expedited dispute resolution process or liquidity feature as well as a payment bond for the protection of the subs and suppliers remains the security of choice for the benefit of all project participants. If letters of credit are used in lieu of surety bonds for the security for the contractor’s performance, the subcontractors and suppliers to the contractor will have no recourse against the bank that issues the letter of credit, leaving the subs and suppliers exposed to the default risk of the contractor on P3 projects where liens are not permitted.
Two of the top three sureties have been leaders in the P3 surety market developing performance bonds that include an expedited dispute resolution process. Some sureties have developed a hybrid performance bond that includes a pay on demand feature for a percentage of the bond penalty with the balance of the bond coming under the expedited dispute resolution process. This EDR process guarantees a decision to the obligee within a short period of time (60 to 90 days) through the use of alternate dispute resolution involving a national arbitration firm as outlined in the bond form. Under this structure, the surety will pay any amounts due as a result of the arbitration decision while reserving their rights to litigate the outcome in the future.
The built in adjudication process included in the EDR bond form reduces the contractor’s exposure to a liquidity crisis. When an Irrevocable Letter of Credit (ILOC) is called the bank must immediately make payment while the amount paid promptly converts to bank debt. Contractors and their banks are not given an opportunity to dispute the reasons for the default and the contractor’s liquidity is impacted even when the contractor has a legitimate defense to the claim. With an EDR surety bond, the surety must weigh the merits of a surety bond default vs. the contractor’s defenses and decide if the case should be arbitrated or if they should immediately pay the amount owed. The EDR bond essentially gives the contractor its “day in court” before payments are made.
The surety has legal duties that must be followed including timely response to the demand, evaluation of the contractor’s defenses to the default and responding in good faith to the claimant. The surety must respond under the terms of a bond for all valid claims; including paying for damages up to the penalty of the bond, financing the defaulted contractor to completion or hiring a replacement contractor. However the surety cannot force the contractor to perform if the contractor has valid defenses to the default. The surety claim process has the advantage of preserving the contractor’s liquidity throughout the course of a dispute on a bonded contract until the facts are reviewed and a bond coverage determination is reached.
With the expedited dispute resolution features of the surety products now used on P3 projects, all parties will receive the benefit of prompt dispute resolution and payment of valid claims in a timely manner. We believe the use of EDR bonds will expand into the energy and industrial construction market, where leery owners that have had difficulty in collecting from surety bonds in the past can now demand an EDR bond with all of its benefits.
Sureties also recognize there are some owners or lenders that will simply avoid conditional payment surety bonds at all cost and will demand letters of credit in lieu of bonds. For those instances, a few sureties are also looking to provide bank syndication guarantees where the sureties become a participant on bank letters of credit (ILOC) guaranteeing up to 50 percent of the ILOC in a reinsurance agreement with the bank. To do so, sureties are participating on a quota share basis while sharing in the bank’s collateral package helping contractors expand their ILOC capacity through the use of the surety market.
As sureties write products that have higher liquidity features to them, they are becoming more sophisticated creditors through the use of inter-creditor agreements that clearly define the first and second security positions for the banks and bonding companies. These types of agreements can help the surety expand capacity with these new products.
Given the choice of security requirements in today’s market, the surety market continues to provide the product with the best combined benefit for contractors and their customers.
Jim Bly serves as managing director of subcontractor default insurance and surety analytics for the Construction Services Group at Alliant. Jim has over 34 years of experience servicing contractors throughout the country. Jim provides risk management advice on property and casualty contractor default insurance, surety and wrap-ups, in addition to detailing the potential benefits of contractor captives.