Surety Contracts

Surety bonds

This is a contract that has three parties.  Instead of a typical contract with two parties, there is a third party that guarantees the performance of another party.  The party that is doing the guaranteeing is the surety.  The party being guaranteed is the principal, also known as the obligor.  The party being indemnified is the oblige.

Surety Insurance

Why are surety bond contracts used?

They are really a way to avoid risk in the marketplace.  Instead of placing all of the risk on one party (the owner or oblige), the contract instead provides that there is a guarantor.  This takes the risk away from a party that has very little ability to actually understand the risk.  Further, that party really also cannot afford to have any losses one these types of contracts.  Owners of a project are typically very much at the end of their financing – as they have expended most of their funds for the purchase of the property, design elements, etc.  Thus, they cannot simply just take a huge hit by a party not performing to the terms of the agreement. 

Another place that they are used is in federal government work.  This is due to the Miller Act, which requires a surety bond on any project greater than $200,000.  Unlike a private owner of a piece of property with a development on it, the government can actually afford a loss like this.  However, the government is completely unable to accurately assess and mitigate risk in these situations.  So, instead of having the government assess risk, a surety bond is used to transfer that risk to another party.

The surety company itself can be any type of entity – from a private corporation to a public entity to an individual.  However, in modern society, the most typical type of surety is a corporation.  Even more than that, there are not a lot of private companies that serve as sureties.  Instead, most surety companies are large insurance companies, like AIG, Zurich, Liberty, Philadelphia, etc.  These large insurance companies have a branch that deals solely with surety bonds.  The branch division is usually well capitalized and has a long history with loss runs in the industries that they underwrite.  Although bonds are written on a zero-loss basis (that is, they assume that the company will perform and, if they don’t perform, have enough collateral to cover the loss), losses can still occur.

  They use this historical loss amounts to understand the inherent risks and then work to mitigate those risks. Since the dollar amounts on large construction projects can be very large, it usually takes a large corporation to cover the inherent risks on these type projects.

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Bills, Bonds and other Business

On Wednesday, the House Small Business Committee went and approved several bills aimed at contracting reform.  This legislation included bills that would increase the agency’s goals of helping to direct work to small businesses.  The plan is to raise the goal from 23 to 25 percent of small businesses that contract and then to establish another goal of 40 percent for subcontractors that small businesses.

“Greater small business involvement in federal contracting benefits companies and taxpayers alike,” said panel Chairman Sam Graves, R-Mo., who sponsored the bill outlining the new contracting goals. “Small firms are innovative, and increased competition often leads to savings for the taxpayers.”

The bills that were approved are going to be felt within the construction industry.  Thus, we expect there to be a spike in contractor bond requests and other surety bond issuances. Another bill that was passed is aimed at helping small businesses by discouraging the bundling of contracts.  Given that large companies are able to more easily meet all the requirements of bundled contracts, small construction contractors are forced to either form a consortium or try only for a part of the business.  Further, Bills sponsored by Rep. Richard Hanna, R-N.Y., would restrict the government’s use of reverse auctions in awarding construction contracts.  Further, this bill is also structured so that it increases construction companies’ access to surety bonds, which is a necessity in federal procurement work.  Surety bond companies have got to love that.

Another interesting bill, sponsored by Rep. Mike Coffman, R-Colo., is designed to transfer the responsibility for verifying the status of disabled veteran-owned businesses from the Veterans Affairs Department to the Small Business Administration.   This is probably a great thing as the SBA is much better able to determine all that surrounds these businesses.

Two more bills are aimed at boosting the training and education services delivered by Small Business Development Centers as well as promote equality for women-owned small businesses, which would be done by creating a single standard in SBA’s procurement operations.

Unfortunately, not everybody is pleased with the legislation.  In particular, the bills aimed at directing work to smaller companies drew criticism from the Professional Services Council - a contractors group. Stan Soloway, the group’s President stated that “Prior to raising any of the contracting goals, it is important for federal agencies and policymakers to understand the total small business participation in federal contacting….To do so, clear and accurate data is needed of not just prime contracting dollars flowing to small businesses, but also federal dollars flowing to small businesses via subcontracts. However, such subcontracting data still does not exist in any meaningful or accurate form.”

We believe that the legislation will have both good and both effects on contractors and the corresponding bond market.  We see that more small contractors will be given work from these contracts.  However, given their smaller nature, the need for a contractor surety bond will also increase.  We also believe that there will be more construction bid bond requirements due to the increase in small firms that will be bidding.  Surety bond companies and going to be busy, for sure.

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