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Performance Bonds: How to Avoid Collateral
This is an unpleasant topic. Not because surety bond security is inherently bad, but because it is of great concern to contractors and their insurance/bonding agents. For example:
Why is the bond company taking money from me when they you may see Am I in a weak cash position? I need it to complete the new project successfully.
You don’t pay me interest on the money? Why not?
When the job is half done, won’t you release some of the collateral?
You will not release the security upon acceptance/completion of the contract?
You will not release the security until the warranty period is over?
etc. a lot of aggravating phone calls and emails.
With all this deterioration to come, why do some bond companies require collateral? The reason is to protect themselves in the event of a bond claim.
When a loss of contract warranty occurs, the claims department hopes to have two reliable resources for financial recovery:
The unpaid balance on the contract goes to the bond when they finish the job
The surety is suing the applicant/company and its owners to recover the loss
Collateral requirements arise when the guarantor wants to have security. If a problem arises, they don’t want to find that the customer has no money, or has declared bankruptcy…or left the country. If they have to write the bond, they want a guaranteed way to financial recovery.
Given that collateral is an expensive price to pay for a warranty, let’s look at an alternative approach that helps the warranty but doesn’t take a big bite out of the contractor!
“Retention” is money that the project owner withholds (retains) to ensure the final completion of the project and the payment of related bills. If the retention is 10%, the contractor receives 90% of the funds owed to him as the work progresses. Ultimately, the contract owner/obligor will still hold 10% to keep the contractor interested in achieving full, satisfactory completion. In this way, the seized money protects both the creditor and the surety – which makes a bond request less likely.
“Guarantor Consent to Release Final Payment” is a voluntary procedure that obligees can use as a sign of respect for the guarantor. The last portion of the contract funds can be useful leverage to get the contractor to move toward final contract adjustments. There may be cracks in buildings, broken glass, faulty lights, paint mistakes – small things that the debtor cares about, but the contractor may find it annoying to fix. Consenting to suretyship is another way for the bonding company to avoid a lawsuit. “Fix this problem or we won’t agree to release your last payment.”
How can these two useful tools be incorporated to ensure that they will assist the warranty and therefore replace the need for collateral?
The answer is to add a condition to the bond (mandatory compliance required by the creditor) stating that there can be no release or reduction of lien or final payment without the prior written consent of the guarantor. Now the bond company is guaranteed to have a financial resource available and the amount is known in advance – just like the collateral. But the contractor didn’t have to drain the company’s bank account to achieve it: Winning!
What if the terms of the contract do not provide for a retention procedure? A person can be added by amending the contract. If Funds Control (an escrow agent) is used to process contract disbursements, a hold procedure may be added to the funds control agreement.
Consider this alternative procedure if your bond underwriter needs help being more creative with the underwriting decision.
Speaking of funds controls, watch for our article next week, Performance Bonds: How to Avoid Funds Controls.
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