Bonding

Bonding

The concept of bonding is simple. If the contractor defaults or does not pay its subcontractors and suppliers, then the surety will be responsible for those debts. The bonding company will then seek repayment by the contractor from the collateral or assets pledged by the contractor in securing the bond.

In some instances, the surety may assist or even step into the contractor's shoes and pursue claims against the owner for project issues that may have been responsible for the default. In other situations, the surety may simply preside over the liquidation of the contractor's assets. The bonding company then pursues the contractor and its ownership for repayment, generally under corporate and personal indemnity agreements.

However, as we will see, the realities of bonding and suretyship are far more complex.

There are two major forms of bonds, those that: 1) guarantee the payment of the general contractor's subcontractors (the so-called payment and materials bond); and 2) those that guarantee the actual performance of the general contractor (performance bond). Unlike insurance policies, the bonding companies are not absorbing the contractor's risk of non-payment or performance, which remains with the contractor.

In the event of insolvency or failure of performance of the contractor, the bonding company is obligated to complete the project and pay the subcontractors and materialmen, if the appropriate bonds have been written. It may seem that the surety takes the largest risks on the project, but that exposure is tempered by several factors. First, the surety writes a bond for the entire contract amount, a daunting amount. But at any moment in the project, the actual exposure of the surety is far less than the penal amount of the guarantee. At the beginning of the project, the contractor is still owed the entire revenue of the project, so the risk is that the project has been bid too low.

At the end of the project, the surety is responsible for completion costs, but that amount may only represent a small percentage of the overall project cost. The surety's greatest risk lies in the fog of war during the project, when the owner's payments should be keeping track with and applied to the contractor's progress and payments to its labor, materialmen and subcontractors. As such, sureties closely watch the progress of major projects, as well as the balance sheets and income statements of their contractor clients.