Performance Bonds: How to Avoid Collateral

Performance Bonds: How to Avoid Collateral

This is a nasty subject. Not because collateral for surety bonds is inherently bad, but because it is a subject of great angst for contractors and their insurance / bond agents. For example:

  • Why is the bonding company taking money from me when they can see I’m in a weak cash position? I need it to successfully perform the new project.
  • You don’t pay me interest on the money? Why not?
  • When the job is half done, you will not release part of the collateral?
  • You will not release the collateral upon acceptance / completion of the contract?
  • You will not release the collateral until the warranty period ends?
  • Etc. Plenty of aggravating phone calls and emails.

With all this aggravation ahead, why do some bonding companies require collateral? The reason is to protect themselves in the event of a bond claim.

When a contract surety loss occurs, the claims department hopes to have two dependable resources for financial recovery:

  1. The unpaid balance of the contract goes to the surety as they complete the work
  2. The surety sues the applicant / company and its owners to recover the loss

Collateral requirements arise when the surety wants to have certainty. If a problem develops, they don’t want to find that the client has no money left, or they declared bankruptcy… or left the country. If they are to write the bond, they want a guaranteed way of having financial recovery.

Bearing in mind that collateral is a dear price to pay for a bond, let’s look at an alternative approach that helps the surety, but doesn’t take a big bite out of the contractor!

“Retainage” is money the project owner hold back (retains) to assure the final completion of the project and payment of related bills. If the retainage is 10%, the contractor receives 90% of the funds they are owed as the job progresses. At the end, the contract owner / obligee will still be holding 10% to keep the contractor interested in reaching total, satisfactory completion. In this manner, the retainage money protects both the obligee and the surety – making a bond claim less likely.

“Surety Consent to Release of Final Payment” is a voluntary procedure obligees may use as a courtesy to the surety. The last bit of contract funds may be useful leverage to get the contractor moving for the final contract adjustments. There may be building cracks, broken glass, defective lights, painting errors – small stuff that the obligee cares about but the contractor may find annoying to correct. The Surety Consent is another way for the bonding company the avoid a claim. “Fix this problem or we will not agree to release your final payment.”

How can these two useful tools be incorporated to guarantee they will help the surety, and therefore replace the need for collateral?

The answer is to add a condition to the bond (mandatory compliance required by the obligee) stating that there may be no release or reduction of retainage or final payment without the prior written consent of the surety. Now the bonding company is guaranteed to have a financial resource available and the amount is known in advance – just like collateral. But the contractor didn’t have to drain the company bank account to accomplish it: Win-win!

What if the contract terms do not provide for a retainage procedure? One can be added by contract amendment. If Funds Control (an escrow agent) is in use to handle the contract disbursements, a retainage procedure can be added to the funds control agreement.

Keep this alternative procedure in mind if your bond underwriter needs help to be more creative with the underwriting solution.

Speaking of Funds Control, watch for our article next week “Performance Bonds: How to Avoid Funds Control.”

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