Performance and Payment Guarantees for P3s
For over a century, the United States government, all states and most local governments have recognized the value of the surety product, and surety bonds have become an integral part of assuring the completion of government projects. In recent years we have seen a significant increase in the requirement by private owners and lenders for surety bonds as well. Experience has shown that performance bonds are a cost-effective way for a procuring entity to protect against contractor default. Likewise, payment bonds historically have been and remain the most effective method to guarantee payment to subcontractors and suppliers. As public-private partnerships (P3s) become a more common method of project delivery, performance and payment bonds should be required for these projects.
Performance & Payment Protection
A surety provides protection first by seeking to avoid a default by providing prequalification services. The focus on default prevention that is built into the prequalification process provides direct and indirect benefit to all stakeholders on the project, including the private partner and investors. Unlike other insurance or financial products, at the end of the underwriting process, the surety provides a bond only to those entities that, in the surety’s estimation, are capable of performing the contract. To make that determination, the surety develops a relationship with the contractor, reviewing its entire work program and not simply the project at hand. As most contractors who default rarely do so on one project only, this broad knowledge is a key component in preventing default on the P3 project.
Performance bonds should be required on the construction portion of the contract for all P3 projects. Government entities do not have the expertise or resources to underwrite a construction firm to the same depth and accuracy as a surety. This also is true of the private partner and private investors. Because the surety ultimately is the risk taker for bonded projects, the surety delves more deeply and broadly into the ability of the contractor to perform successfully, not only one specific project, but also all of its projects, including bonded and unbonded projects. The surety assesses the contractor’s capital, capacity to perform all of its work, and character. If a surety chooses to support a contractor, it then puts the weight of its balance sheet behind that contractor. In the unlikely event that the bonded contractor defaults, funds to assure contract completion come from the surety, its reinsurers and its retrocessionaries who spread the risk and who, as regulated entities, must reserve for losses.
It also is critical that payment bonds be required on P3s to protect covered subcontractors, suppliers, and laborers, as they are on traditional public works projects. Subcontractors, suppliers, and laborers often are small businesses that cannot afford the risk of delayed payment or non-payment. Since liens cannot be asserted against public property—which mostly likely will be the case with P3s—these small businesses need to be fully protected by payment bonds. Even if there were a lien process, bonding provides for direct rights against the secondarily liable surety and with proper documentation assures payment.
Renewable surety bonds of limited duration also could provide similar value on the operation and maintenance phase of the project.
Another benefit that surety bonds bring is that surety credit is balance sheet neutral to the contractor and preserves liquidity that otherwise would be required to support the securitization of the project with a different instrument, such as a letter of credit. This preservation of liquidity increases the likelihood of contract completion, payment of subcontractors and suppliers and payment of liquidated damages.
The Value of Bonding in the Claim Process
Sureties are in a confidential relationship with their contractors and are not often in the position to advertise their value. In a tough situation, no contractor wants to admit that funding from its surety is supporting it. While there have not been major publicized P3 construction defaults in the U.S. to date, the claim history of failed large civil contractors can be illustrative of how a P3 failure would be managed under performance and payment bonds. The facts remain that sureties not only provide liquidity, but also often provide capitalization to allow negotiations to occur and often are the first to bring order to a tumultuous situation. Within the last 20 years, surety bonding has supported the completion of troubled and defaulted contracts for some of the most high profile contractors in the history of construction. Billions of surety dollars were used to support failed contractors like Morrison Knudsen, J.A. Jones, Guy F. Atkinson, and Modern Continental as they completed these projects.
Surety dollars keep projects moving every day as sureties provide for overhead costs and even payroll when companies do not have the cash flow. More specifically, if a contractor runs into financial issues, it is not uncommon for its surety to provide financial assistance. This early intervention is one of the unseen services of a surety. Often, default is averted because of the surety company’s expertise in seeing projects to completion. In these situations, the surety may: provide trained experts—such as engineers, construction management specialists, and accountants; pay subcontractors and suppliers to keep the job moving forward; and/or offer financial assistance to the contractor to reverse cash flow problems. The surety’s expenditure will be apparent in the surety’s financial records but because the contract is being satisfactorily executed (no performance issues), the surety’s invaluable assistance may never be known to the procuring entity or its financiers. This approach demonstrates the ability of a surety to bring immediate liquidity to the contractor and the project.
In a recent construction default claim involving Ballenger Construction, an ENR magazine article revealed that Liberty Mutual, as an initial step to assist its contractor, “loaned $10 million to the contractor pending a possible sale. The money was to be used to complete projects and pay subcontractors and suppliers.” This invaluable surety claim support is included in the surety premium, and the loss and expense dollars are borne by the surety industry.
Construction failures that involve unbonded contractors are equally illustrative. The City of Harrisburg chose to construct an incinerator project with Barlow Projects Inc. After going through the surety prequalification process, the contractor was unable to secure bonding of the contract. The City was granted authority to waive the performance bond. When the contractor ran into difficulty, the City released the 10 percent retainage, the only real security available for the project. Many articles point to the lack of a performance bond as a key driver in the City of Harrisburg’s bankruptcy filing, and those familiar with the risky nature of construction question how a city could decide not to bond a large infrastructure project.
The facts remain, no public procuring entity, entrusted with taxpayer dollars, is prepared for or capable of handling a large default, and those that have faced these situations had projects sitting idle for years or, as in the City of Harrisburg case, went bankrupt because they were not equipped to deal with all the issues that come with a major construction company default. This is what the surety industry was created to do. The risk of default may be infrequent, but the impact could be catastrophic for any taxpayer-supported budget. When compared to the potential financial loss, the cost of a surety bond (generally 0.5-2 percent of the contract price) is nominal. In the event of a default, surety bonds are the best value and completion option available in the U.S. While on-demand instruments, such as letters of credit may sound enticing, getting jobs completed and workers paid is not only compelling but also what taxpayers demand.
With performance bonds in place on P3s, concessionaires, owners, and taxpayers enjoy the performance guarantee for the design-build phase of the project in an industry where one in four contractors fails. Other risk management tools may make available a sum of money in case of default, but surety bonds are the only form of security that assures contract completion and payment for covered subcontractors, laborers, and suppliers. From railways and toll roads to airports and schools, surety bonds have supported the building of America’s infrastructure for over 100 years and should be in place to support the future of American infrastructure as well.