Responding to the difficulties in procuring construction bonds in today’s market

Why should I read this?

A major insurance company has recently announced that it will no longer be offering surety bonds to major contractors . This is in response to the increased number of construction insolvencies over recent years making it economically unfeasible to continue to operate in this market.

The irony is that in circumstances where surety bonds are most needed by Employers, Contractors are having increased difficulty in securing them. This article looks at what sort of risks surety bonds protect against and what alternatives are available.

What risks are covered by surety bonds?

A performance bond usually covers 10% of the contract price for the duration of the works, either until practical completion or the end of defects rectification period. In practice this safeguards the Employer against any financial disturbances that may arise if the Contractor defaults in any of its obligations under the building contract. As a surety bond is provided by a third party (a bank or insurance company), it can provide useful protection against the Contractor’s insolvency. They also are useful in international construction projects, where it might be harder to enforce other types of security across different legal jurisdictions.

What are the possible alternatives?

In circumstances where it is difficult for a Contractor to procure a surety bond, the following alternatives may be considered, although each may have some potential disadvantages depending upon the circumstances:

Option	What is it?	Potential Disadvantages
Parent company guarantee	This is where the parent company of the Contractor guarantees the financial obligations of the Contractor for the duration of contract. There is usually no additional cost involved in procuring a parent company guarantee.	If the Contractor becomes insolvent, it is likely that these financial problems have already spread to its group companies. This means that the parent company may also have become insolvent. Requesting a parent company guarantee from the Contractor’s ultimate parent (rather than immediate parent) company may provide some further protection, but is subject to the same risks.
Letter of credit	This is a financial instrument issued by a bank on behalf of the Contractor, as a guarantee that the Contractor will fulfil its contractual obligations. If the Contractor defaults, the Employer can draw funds under the Letter of Credit to cover any losses.	A Letter of Credit limits the Contractor’s credit line and its financial flexibility.
Cash retention	The Employer may wish to include or increase the retention it withholds from each interim payment under the building contract, which is released in a first instalment upon practical completion and a second and last instalment upon the end of the defect rectification period.	This is disruptive to the Contractor’s cashflow and will place an additional financial pressure on the Contractor if it is already feeling a strain and at risk of insolvency.
Escrow Account	The Contractor deposits money in a separate bank account, which is governed by a security agent and is available to the Employer upon the occurrence of certain defined circumstances.	This is an additional financial burden on the Contractor, as it ties up the Contractor’s cash and there is also a cost involved in setting up an escrow account with an escrow agent.

Conclusions

Exploring the alternatives to procuring a surety bond and the potential shortcomings with each option is a sobering exercise. It is essential to find a middle ground that allows the Employer to obtain its contractual protections, without imposing undue financial strain on the Contractor, which could elevate the risk profile of the project as a whole. For Employers, conducting thorough due diligence early in the tender process is becoming increasingly crucial. This step is key to assessing the financial vulnerabilities that may affect certain contractors and it may be worth considering whether alternative procurement strategies could distribute the risk more broadly among a larger group of SME contractors, who are more likely to secure a surety bond in the current market.

Written by Gemma Irving

For more information surety bonds, please contact Simon Chamberlain.