Surety Bonds&Construction Risk

Name of EventOrganizationDate

I – Construction Risk

“Then You Shall be his Surety”

William Shakespeare

Merchant of Venice

Construction Risk 2015

Construction Risk = Risk of Contractor Failure.The number and severity of contractor failures

increased in recent years.Recent Challenges:

Reduction of available work; oversaturated market = tighter margins

Onerous contract conditions. Downloading of risk

Paradigm Shift: AFP’s, P3’s

Construction Risk 2015From 2010-14, the Surety industry paid out almost

$800 million in claims; more than all of the previous decade.

2013 a year to forget: Loss ratio; 52% - industry unprofitable Premiums flat after two years of decline Across all lines and all sectors of the country

2014 showed improvement with lower loss ratios and premium growth … but….

2015 ? Impact of Oil Prices in western Canada and political and economic instability

Construction in Canada 2015Canada the new construction “mecca”.

Ongoing commitment to infrastructure Federal commitment $48B over 10 years.

By 2020 Canada to be world’s 5th largest construction market (9th in 2010)

Increased foreign investment from depressed areas (e.g. Europe)

Larger and longer projectsChallenges to small and mid-sized contractors

Protect Against Construction Risk

Surety BondsPerformance BondsLabour & Material Payment Bonds

Liquid Security Irrevocable Letters of CreditCash/Negotiable instruments on Deposit

Default Insurance Products

Unqualified Contractors; the lowest “irresponsible” bidder

Insolvency of ContractorContractor default for non-financial reasons:

Over ExtensionInability to completeIncapacity of Key people

Unpaid subs and suppliers resulting in liensWarranty problems

Why Contractors Fail

II – Surety Bonds What are They?

How do they Work?

Surety is not Insurance

Surety is not Insurance

INSURANCE 2 party agreement;

Insured & InsurerPremiums actuarially

determined Losses anticipatedNo recourse against

insured in the event of loss

SURETY 3 party agreement;

Principal, Surety & Obligee

Premiums only a service charge

No losses anticipatedRecourse against the

Principal via indemnity agreement

Surety Bonds: 2 Essential Services

Prequalification:Assurance that the bonded contractor is

qualified for the job for which they are contracted.

Security:Financial Protection in the event that the

bonded contractor should default on its obligation.

PrequalificationOngoing, Thorough & Value Added

Intensive:

Ongoing

Comprehensive:

Value Added

Standard Construction Bonds

Prequalification

Prequalification LetterBid BondConsent of Surety

Security

Performance BondLabour & Material Payment BondRenewable Multi-Year Bonds (service contracts)

Prequalification LetterNot a bond but a letter from bonding company to

the project owner confirming “bondability”.

Used during the pre-tender phase; i.e before contract terms, scope or pricing details are known.

Non-binding – surety and principal reserve the right to review the details before firm commitment.

Typically refer to the project at hand.

SAC standard form available on SAC website.

Bid Bonds

protection from the “lowest irresponsible bidder”provide assurance that contractor will:enter into contractprovide the required security

Typically required in the amount of 10% of tenderif contractor defaults, surety pays the difference

between successful bid and second bidderTender must be accepted within time frame set out in

tender documentsseven months to file suit

Consent of SuretyNot a bond at all; a letter of commitment from the

Surety to the Obligee to execute performance and/or payment bonds

No penal sum set out; payment not an option

Typically, bonds must be required within 30 days following award

No standard (CCDC) form in existence, many variations in wording

Performance BondsGuarantees Contractor will perform contract in

accordance with its terms & conditions.Contractor must be in default and the default must

be declaredOwner must perform their obligations 4 options available to Surety:

Remedy the defaultComplete the ContractArrange for new contractor to completeTender Payment

Two years to file suit

Labour &Material Payment BondsGuarantee that the contractor will pay all direct

subcontractors, suppliers for materials and services provided to bonded project.

Obligee is trustee on behalf of the claimantsClaimant must have a direct contract with the

PrincipalClaimants may only claim for goods and services

supplied to the bonded jobClaim must be filed within 120 days of the last day

worked or the date material shippedOne year to file suit

III – Surety BondsHow are they

Obtained?

Who Obtains the Bond? Lender Includes bonding requirement in loan

agreement with borrower (project owner).Project owner then includes bonding

requirement in tender documents or contract specifications

The contractor obtains the bondingSelects a professional surety bond broker or

agent who assists in submitting case to a surety underwriting company

How is a Bond Obtained?Contractor Submits Financial

Statements and other background information to Surety

Participates in prequalification process: an in-depth look at contractor’s business operations and financial structure.

Surety’s Financial AnalysisBalance Sheet

Working Capital / Net WorthRatio AnalysesReceivable/Payables aging analysisWork on hand; profitability, maturity, trending

Income StatementProfitabilityRevenueTrend Analysis; 3 to 5 years

Cash Flow AnalysisAccountant’s Opinion/Explanatory Notes

What Else does a Surety Need?Complete details on Affiliated / Related

Companies; ownership, financial information, etc.

Detailed Work on Hand SchedulesAged Listing of Receivables and PayablesOrganization Chart of Key EmployeesDetailed Resumes of Principal & EmployeesBusiness Plan & Contingency PlansSubcontractor & Supplier References

What Else does a Surety Need?Details of construction operations; areas of

expertise, list of key projects, key people, etc.Letters of Recommendations from OwnersEvidence and details of a Line of Credit from a

Financial InstitutionDetails of business continuity plans in the event

of death or incapacity of owners/key peopleReports on Similar Completed Projects

Owner, contract price, date completed, profit earned

IV– Surety Bonds Myths &

Misconceptions

Myths & MisconceptionsMyth #1: Sureties Don’t Respond to Claims.

A surety bond will provide:Professional prequalification to weed out

unqualified contractors.True performance security; i.e. provides owners

with a completed project in the event of default.Payment protection to subs and suppliers.

A surety bond will not provide:Cash-on-demand. There MUST be a default.Dispute resolution.A “magic lamp”.Protection beyond the scope of the contract.

Myth #1: Sureties Don’t Pay Claims.

Also….Owner must have fulfilled its contract obligationsL & M Claimants must comply with the terms of the

bond and be prepared to document claimProblems or questions? Contact the Surety

Association of CanadaPhone: 905-677-1353Fax: 905-677-3345email: sness@surety-canada.com

Myths & Misconceptions

Myth #2: A 50% Bond only provide 50% Protection

50 percent bond gives you 100 percent protection up to the bond amount

Example:Contract Price = $ 1 million50 % Performance bond ($500,000)Contract is 50% completeSurety arranges completion for $ 700,000Surety’s loss is ???

Myths & Misconceptions

Myth #3: Bonds are a “Barrier” (especially to small contractors). Barrier? Bonding companies need to write bonds.Sometimes a time problem – for contractors without a

bond company it takes time to establish a facility.Some sureties will ONLY bond small contractors,

others have small contractor divisionsSmall firms will secure bonding for jobs within their

realm of expertiseBonds are a barrier to unqualified contractors

Myths & Misconceptions

Myth #4: Payment Bonds Don’t Help OwnersEnsure that subs working on your jobs will be paid.

Many are local rate payers.Ease the Administrative burden in the event of default.Reduces the Owner’s Legal Exposure.More competitive prices from subs who are now certain

of being paidSpeedier resolution of a default; continuity of team.

Myths & Misconceptions

Myths & MisconceptionsMyth #5: We don’t need a bond; our contractor is huge.

Excerpt from “Why Contractors Fail” by Hugh Rice and Arthur Heimbach, FMI Corporation 2007

“Recent history has shown that construction firms are not too big to fail even though they may have annual revenues ranging from hundreds of millions to several billions of dollars.”

“There are bonding safeguards to protect project owners and others when a contractor fails.”

V – Surety Bonds What Happens when

a Contractor Defaults?

Before a Default is DeclaredSurety has extensive experience with contracts

and solving construction problems.

Surety has intimate knowledge of contractor and its operation

Can provide informal assistance to solve problems that can lead to a default

Will convene meeting or teleconference among the parties to address problems.

Assist in formalizing solutions.

ClaimsWhen A Contractor Defaults:

Surety will promptly acknowledge notice of default and being to gather information.

Surety will begin an investigation as soon as possible.

Surety will conclude the investigation as soon as possible.

If requested by owner, surety will provide periodic written updates on investigation status and best estimates as to completion date.

During and After the Investigation:

Surety will cooperate with the owner to protect work from damage or deterioration.

Surety will work with the owner to:Identify and implement a solution.Minimize delays, keep the job going and

protect the rights of all parties.Pay valid labour and material payment

bond claims as promptly as possible to ensure continuity of subs and suppliers.

Claims

How can the Project Owner Help

Comply with bond & contract terms! (e.g. proper notifications, payments and certifications)

Communicate: keep surety appraised of problems and provide default notice promptly.

Cooperate: Ensure surety has access to knowledgeable staff and relevant documents.

Keep expectations realistic.

Claim Example 1

Highway Development Project

Provincial Government Declares Default on

Highway ProjectCase Background:

The Principal, a road building company, was working on a provincial transportation project when it experienced financial distress and could not complete the project, valued at $5.8MM.

The Obligee, a Provincial Government transportation department held surety security for 50% of the project amount to mitigate both contract performance risk and labour & materials payment risk.

Claims Example 1Highway Development

ProjectSurety’s Action:

The Surety Company advised the Obligee it would start preparing the tender package to complete the work.

The Obligee expressed interest to choose its own completion contractor.

The Surety Company and the Obligee settled for financial payment; where the Surety paid the Obligee the anticipated completion costs.

Claims Example 1Highway Development

Project At the same time, the Surety Company paid out

multiple subcontractor and supplier claims under the labour and material payments bond.

Total amount paid out by the surety on this project were $3.3MM.

Claims Example 1Highway Development

Project“[this] is certainly a good example of the value of having a performance bond [and labour & materials payment bond] and we were pleased that the bonding company offered flexibility in coming to a solution that met our needs. The negotiated settlement provided advantages to us, as the Owner, in that it gave us control of the work, which enabled the completion to be expedited in an efficient manner…”

Owner Testimonial

Claim Example 2

Underground Contractor Defaults on 13 Municipal Projects

Claim Example 2Case Background:

The Principal, a sewer, watermain, curb/gutter, and roadwork contractor with approximately $10 million annual sales was forced into receivership when bank called its loan.

A regional municipality was left with 12 unfinished contracts. Another municipal owner was impacted with 1 uncompleted contract as well. Total value of the contracts underway were $7.4 million.

Project contracts were anywhere from $500 thousand to $3 million range.

Claim Example 2The surety:

worked with the owners to ascertain the status of each contract and identified the remaining work to be completed.

obtained quotes for completion of outstanding work, presented these to Obligees and arranged for completion contracts to be executed.

reviewed claims from unpaid 48 trades and suppliers. All claims settled within 72 hours.

total surety payout in excess of $6.7 million. All 13 Contracts completed with no loss to Obligee.

VI – Surety Bonds Unseen Services to

Owners & Lenders

Unseen Services of Surety Bonds

A surety can provide assistance and default prevention services to owners & lenders by:

Facilitating the resolution of construction performance issues that could lead to default

Providing management and business assistance to assist contractors with administrative issues.

Providing financial assistance to financially distressed contractors

Providing technical/engineering expertise if required

Confederation Bridge

New Brunswick to PEI

Unseen Services of Surety Bonds

Confederation BridgeFixed Link from PEI to mainland 12.9 km3 ½ year project; cost of $800 million. Opened

June 1997.Performance & Payment Bonds provided by a

three member co-surety pool.Owner: Public Works CanadaContractor: Strait Crossing Development Inc;

a private consortium of four companies.Senior Partner: Morrison Knudsen Inc. of

Boise Idaho – 35% share.

Morrison Knudsen; Established 1932, $2.86 billion in sales

1996 – MK files for Chapter 11 bankruptcy protection; threatens survival or project.

Sureties act quickly; arrange to finance MK through to completion to allow for the company to be sold.

Default prevented and project completed on time. NOT ONE DAY OF WORK WAS MISSED.

The local community, the general public unaware of any problems

Confederation Bridge

VII - Other Forms of Contract

Security

Liquid Security (LOC’s)Yield cash; not performanceProvide no prequalification assuranceAvailable in smaller; perhaps insufficient

amounts (5% to 10%)Deplete a contractor’s borrowing power and can

bring on the very problem they seek to avoidNo dedicated protection for subs or suppliersWork well for financial risks

Contractor Default Insurance (CDI)Introduced in 1996 to protect very large general

contractors from subcontractor default.Indemnity product – compensates for loss incurredSignificant deductibles and co-paymentInsured should have in house construction

administration experience and strong cash flow.Does a good job at providing the protection for

which it was designed; i.e. protecting large G.C.’s against construction default.

NOT designed to protect owners from risks associated with default of prime contractor.

Large general contractors approaching owners and lenders with a “cost savings” proposal.

Sign on to G.C.’s CDI policy

“better protection, more cost effective better management of subcontractors”, etc.

Save the bond premium.

The “CDI for Owners” Non-Solution

The “CDI for Owners” Non-Solution

What they don’t tell you….CDI is NOT an alternative to Surety BondsOWNERS NOT PROTECTED FROM G.C. DEFAULTOwners have limited or no access to CDI benefits

Endorsement only responds when G.C. is insolvent.

Contracts with unpaid trades are unenforceableIf Prime Contractor should default: No Protection“Cost Savings” are minimal or non-existent.CDI protects Contractors; NOT Owners

Waiving Final BondsOwners Save the bond premium by calling for bid

security and waiving requirements for final bonds.

Penny-wise; Pound Insane.

Contractor failure can bring catastrophic consequences if not adequately managed.

Contractor failures on the rise as the economy continues to struggle.

NO contractor; large or small is immune to financial and economic forces

Morrison Knudsen: from Fortune 500 to Chapter 11 in two years.

VIII – e-Bonding

Did someone mention “paperless” ??!!!

Issues and Challenges

Commercial

Legal

Technological

SAC’s Efforts to Address the Issues & Challenges

Electronic Delivery of Bonds

Commercial Issues & Challenges

SAC encourages and promotes electronic delivery of surety bonds.

Don’t Act on your own. Will only work with industry buy-in.

Flexibility; evaluate; establish criteria and standards, leave it to others to find a way to meet them..

Electronic equivalent of a courier.

Legal Issues & ChallengesPIPEDA passed by parliament in 2000.

Umbrella legislationEach jurisdiction followed with its own

legislation over the next two yearsChallenge: What about seals?Deed vs Contract - “Deemed” sealed, overt

act of sealing will constitute seal equivalent. Verbiage not sufficient.

Friedmann Equity vs Final Note – Supreme Court of Canada

Technological Issues & ChallengesTechnology is in place; systems have been

developed and marketed in Canada and U.S.

All systems are NOT created equal; different focus; different capabilities

Criteria:Integrity of content;Secure accessVerifiable / enforceable

SAC & e-BondingPublications on SAC website:

Designing Electronic Pathways Together.Vendors Guideline. Criteria checklist.

Position Paper: Surety Bonds in a Digital World.

Working with owners and vendors:Mock Tender – Defense ConstructionDevelopment of template language for

inclusion in tender documents.

Six e-Tendering Tips for Owners

1) Consult Consult Consult: Without Buy-in from other stakeholders, the advantages can be squandered.

2) Don’t Reinvent the Wheel: Learn from what’s been done. Are you in the software development business?

3) Insist on Verifiability… whatever the approach, know that the bond is valid and enforceable.

4) … But be Flexible About Everything Else: Allow vendors to find ways to meet the criteria and standards you set.

5) It’s Up to You: Initiative has to come from owners and end-users. SAC can provide guidance but only you can start the journey

6) Take the Time to Get it Right: Pilot projects; Phase-in implementation. Allow for time to work out the kinks and for the industry time to adjust. Mock Tenders.

Six e-Tendering Tips for Owners

IX – Surety Bonds &The New ParadigmDiscount Surety Company

Good News – I hear the paradigm is shifting

The New ParadigmThere are still too many contractors in the business and there will be a shakeout, but if you are good, there will be work for you. The market has favoured larger builders over smaller ones. The smaller guys are getting squeezed because the projects themselves have grown. Five years ago, who would have heard of a billion dollar project, but now there are two in the Toronto area alone and business models are changing too. Now you have to design, build, finance and, if you are smaller it’s become tougher.

Geoff Smith – President & CEO; EllisDon

Bigger, Longer & TougherNew Models of Project Delivery and Procurement

P3’s, AFP’sBundlingBuilding Information Modeling (BIM)

The need and the will to address Infrastructure deficit

Already here, small to mid-sized contractors feeling the squeeze

Just Starting

…and Faster - TechnologyLast 20 years, internet, social media…etc…

revolutionize business and life.Gen Y …Gen Z … the “WrRU” generationDemand for instantaneous information and

immediate satisfaction.Pressure for quicker, more expedient

resolution to construction and other business problems.

Evolving Political EnvironmentGlobalization of the construction industry

with the collapsing of trade barriers

Canada Europe Free Trade Agreement, Plurinational Trade Service Agreement

Participation of large multinationals will increase completion further.

liquid balance sheets and demand for liquid security

The New Paradigm

The business model is changing, but there is no way to really predict how it is changing. Ask our clients what they want from us, and they aren’t exactly sure yet. I spend a lot of time at night thinking, ‘Okay, how will it all work out?’

Geoff Smith – President & CEO; EllisDon

X – So What are we doing about it??

SAC Performance BondSAC consultations with Owners & Contractors;

More “certainty” in the claims process.More responsiveness to a claimMore frequent and effective communication

between sureties and owners.

New “enhanced” performance bond provides construction buyers with more timely &responsive claim service.

Has been used by owners across the country and will be adopted by CCDC as the new standard.

Provides more responsive services to owners by…..

SAC Performance BondPre-Demand Conference to allow surety and owner

to prevent problems from turning into a default. Timelines for Surety’s Response:

5 days to acknowledge a response & request info.21 days (from receipt of information) for surety to

respond to owner with their response.Emergency Remedial Work: Allows Owner to

address urgent issues (e.g. safety) under the bond.Post-Demand Conference: Mechanism to minimize or

eliminate work stoppages while surety investigates.Contact Coordinates: Contact information for all

parties to facilitate notices and communication.

Surety Bonds & P3 ProjectsComprehensive performance & financial security

against construction default on mega-P3 projects.Sufficient capacity for mega-projects.Broad and flexible protection packages which include:

Professional surety prequalficationSpecialty P3 bonds designed by member sureties:

Provide liquid / cash on demand protection. Built-in “fast-track” dispute resolution Early Response; surety involved pre-default.

Protection for trades & suppliers via the payment bond.Called for on Infrastructure Ontario Build-Finance and

Design-Build-Finance projects.

Renewable Multi-Year BondsOnly applicable to service contracts; e.g. Waste

Management, Snow Removal, etc. Initial Term is open. Renewal Terms are typically

1 year periods can be extended to two.Surety issues an annual Renewal Certificate.Failure to renew the Bond is not a ‘default’ under

the Contract or the Bond 2-year suit limitation – runs from earlier of expiry

of latest bonded ‘Term’ or date default declaredCan be modified to address O&M components of

P3’s

Headstart Performance BondTMCreated by The Guarantee Co of N.A. to protect GCs

from sub default (competitive alternative to SDI)Industry Solution: available for use by other sureties.Flexibility: Obligee given two mitigation options:

o Traditional Option: Surety investigates and implements solution (as in standard bond); or,

o Headtstart Option: Obligee implements its own solution upon surety’s acceptance of Obligee’s completion proposal.

Responsiveness:o First dollar protection(no deductible or co-payment).o Surety will respond in 3 days from receipt of Claims letter.o Standard claims notice and mitigation agreement.

SURETY ONLINE LEARNING CENTREThe Surety Online Learning Centre accessible

from SAC website; www.suretycanada.com.

Five learning modules that introduce the basics of surety bonds and the suretyship process

Learn at your own pace.

Ideal for review or for colleagues who can’t attend a “live” information session.

It’s FREE

Contact UsPhone: 905-677-1353

Fax: 905-677-3345

email:surety@suretycanada.com

or visit our www.suretycanada.com website: