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In the United States, the use of construction bonds is common in construction projects. It is issued
by an insurance company or by a bank.

Insurance bonds: types of construction bonds1

Difference between an insurance and a bond

An insurance is a two party contract, between the insured and the insurance company, designed to
compensate the insured against unforeseen adverse events. The policy premium is actuarially
determined based on aggregate premiums earned versus expected losses.

A surety bond is a three party contract whereby the surety assures the project owner (obligee) that
the contractor (principal) will perform a contract in accordance with the contract documents. When a
contractor requires its subcontractors to obtain bonds, the contractor is the obligee and the
subcontractor is the principal. The surety prequalifies the contractor based on financial strength and
construction expertise. Since the bond is underwritten with little expectation of loss, the premium is
primarily a fee for prequalification services.

Bid bond

Most obligees require deposing of a bid security in the form of a bid bond. The bid bond assures that
the bid is submitted in good faith and that the contractor will enter into the contract at the price bid
and provide the required performance and payment bonds. The amount of the bid security is usually
10%. But can range from 5% to 25% or more.

Final bonds

Final bonds are made up of a performance bond and a payment bond. In some cases they may also
include a maintenance bond or a warranty bond. These bonds must always refer and be part of the
terms and conditions of a specific contract. A contract bond is not a stand-alone document. The
premium is based upon the final contract amount and covers the performance bond, payment bond
and usually about one year of maintenance or warranty bond.

Performance bond

The performance bond protects the owner from financial loss should the contractor fail to perform
the contract in accordance with its terms and conditions.

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Sources: South Coast Surety, www.southcoastsurety.com
Surety Information Office, www.sio.org

The use of Construction Bonds in the US| February 2016 2

Payment bond

The payment bond assures that the contractor will pay specified subcontractors, laborers, and
materials suppliers associated with the project.

In public works contracts, the parties covered by the payment bond are specified in the Civil Code.

Maintenance bond

A maintenance bond guarantees the owner of a completed construction project for a specified time
period against defects and faults in materials, workmanship and design that could arise later if the
project was done incorrectly. It lasts typically no longer than one year.

Warranty bond

The warranty bond assures that the contractor will correct any deficiencies in material or
workmanship for a specified period of time, usually one year from the date of completion.

Often this obligation is considered part of the performance bond and a separate bond may not be
issued.

Cost of bonds

Surety bond premiums vary from one surety to another, but can range from 1% to 3.5% of the
contract amount, depending on the size, type, and duration of the project and the contractor. This
amount will be higher for new contractors who cannot provide the necessary financial papers.
Typically there is no direct charge for a bid bond, and in many cases, performance bonds incorporate
payment bonds and maintenance bonds. The bond premium is usually paid up front. Existing clients
can get credit (30 days).

When bonds are specified in the contract documents, it is the contractor’s responsibility to obtain
the bonds. The contractor generally includes the bond premium amount in the bid and the premium
generally is payable upon execution of the bond. If the contract amount changes, the premium will
be adjusted for the change in contract price. Payment and performance bonds typically are priced
based on the value of the contract being bonded, not necessarily on the size of the bond.

For contractors working on several projects at the same time, it is possible to get an aggregate bond
that covers several projects. The premium will be based on what it costs to finish the project, not on
the total project cost.

Every surety is filed with the State Government.

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How to begin

The surety bond producer

The first step is to contact a professional agent or broker that works for a Surety Insurance Agent.
They are also known as a surety bond producer because they specialize in contract surety. The
surety bond producer will guide the contractor through the bonding process, help establish and
foster a business relationship with a surety company, and assist in managing the contractor’s surety
capacity.

After meeting with the contractor and gaining an understanding of the firm’s business and needs, the
producer tailors the contractor’s submission for the specific requirements of the surety company.
The producer then submits the account to a surety company best matched to the contractor’s profile
and needs. The producer is an essential link between the contractor and the surety company and will
therefore maintain communication with both.

Value of a surety insurance agent

 Acts as a consultant in the selection process of other team members (e.g. banker, lawyer
accountant);

 Helps to establish and maintain your Surety Support;

 Helps the contractor with business planning, especially discussions on risk management;

 Helps the contractor grow his or her surety program;

 Helps the contractor to present the information as positive as possible to the underwriter.

Surety company underwriter

Once the surety bond producer collects all the necessary information, he or she submits it to a surety
company underwriter. The underwriter takes an in-depth look at the contract’s entire business
operations and must be satisfied that the contractor is capable of completing the project.

A surety underwriter’s primary goal is to prevent default. They make decisions on surety capacity
(experience, working capital and cash flow).

Prequalification process

Each surety company has its own underwriting standards and requirements, but there are shared
fundamentals common to the underwriting of most surety companies. Before a surety underwrites a
bond, the contractor typically undergoes a careful, rigorous, and thorough process, often referred to
as prequalification. The prequalification process takes time as the producer collects information,
answers questions the surety underwriter may have, and assists in verifying information.

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The surety must be satisfied that a contractor has the ability to meet current and future obligations,
has a good reputation, has experience meeting the requirements of the projects to be undertaken,
and has (or can readily obtain) the equipment necessary to perform the work. The surety also looks
for contractors who run a well-managed, profitable enterprise, keep promises, deal fairly, and
perform obligations in a timely manner.

Prequalification checklist

Here is what a contractor may need to provide:

 An organization chart of key employees and their responsibilities;

 Detailed resumes of key employees;

 Business and personal financial statements;

 Work in progress schedule as well as a history of the largest completed jobs;

 Evidence of a bank line of credit to augment working capital and to handle temporary cash flow
deficits or stains;

 Marketing material;

 Letters of recommendations or references from subcontractors, owners, architects, and

engineers on completed projects;

 A business plan outlining the type and size of work sought, prospects for such work, the
geographic area in which the company operates, and growth and profit objectives.

 Continuity and contingency plan outlining how the business will continue in the event of the
owner’s death of disablement.

Prequalification criteria – The 3 “C”

 Capacity: Can the contractor perform the obligations of the contract? Does the contractor have
the necessary structure, people and equipment?

 Capital: Does the contractor have the financial strength to fulfill the terms of the contract?

 Character: Historically, how has the contractor performed? What is the contractor’s reputation?
How are problems handled?

Capacity: Ability to perform

 Can the contractor perform this type of work;

 Analysis of past projects – size, profitability;

 Current workload – cost to complete;

The use of Construction Bonds in the US| February 2016 5

 Does the contractor have enough work crews;

 Does the contractor have the necessary equipment?

Capital: Financial strength

 In depth, detailed evaluation of the contractor’s financials strength:

o Business financial statement as of fiscal year end and current interim on the % of
completion basis;

o Personal financial statements;

o Bank line of credit;

o Alternative solutions to lack of financial strength.

Character: References and reputation

 Of the construction firm:

o Business relations with

 Primes, subcontractors and vendors

 Previous owners, architects, engineers

 Banks

o Credit reports

 Business Dunn & Bradstreet

 Personal credit reports of owners

Financial statements

Depending on how long the contractor has been in business, the surety will request fiscal year-end
statements for at least the past three years and may require a financial statement audited by a
certified public accountant (CPA).

Quality of financial statements

Financial statements are only as good as the accountant preparing them. That is why it is important
to select a CPA who is knowledgeable of construction accounting and the American Institute of
Certified Public Accountants’ Audit Guide for Constructions Contractors.

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Sureties prefer, and at certain levels require, audited fiscal year-end statements, but there are
occasions when a surety may accept a review or compilation statement.

Audit

The highest level of service performed by a CPA. An audit verifies relevant items, such as the balance
sheet, with internal and external investigations of their accuracy. The objective is to obtain
reasonable assurance financials that are accurate according to GAAP.

An audit can take 1 or 2 months and costs between 10.000 and 20.000 USD. It is usually required for
companies with revenue above 10 million USD.

Review

A middle level of service performed by a CPA. A review statement, which does not require the
outside verification present in an audit, consists principally of a thorough review of the contractor’s
financial records and the application of certain analytical procedures to the financial data.

The fee for a review is around 5.000 USD, and is usually required for companies with a revenue under
10 million USD.

Compilation

The CPA takes information from the management of the company and compiles it into a report. A
compilation, however, provides little or no assurance of the credibility of the figures presented and
would typically be accepted only for interim statements. The cost is generally a few thousand USD.

Maintaining the surety relationship

Start with smaller projects and grow the business. To maintain and increase surety capacity, it is
important for a contractor to develop and maintain an ongoing relationship with the underwriter and
producer. Developing a relationship requires commitment, trust, and above all communication.
Maintaining the relationship through open communication and timely reporting on the company’s
financial condition and job status builds trust with the surety.

Maturing into a growing partnership requires teamwork and an organized effort among the
contractor, the surety underwriter, and the surety bond producer. There may be difficult times, and
the surety may not always be willing to extend the surety capacity the contractor would like, but
maintaining a relationship with the surety company builds trust and increases the surety’s
commitment to the contractor over time.

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Conclusion

Even after all the information is provided to the surety there is no guarantee it will result in approval.
The bond will be approved only if the surety is confident the contractor is qualified to perform the
contract and work program successfully and has the financial capacity to withstand the numerous
risks involved in the construction business.

The decision to seek surety bonds should be based on long-term considerations.

For Belgian companies which are recently established in the US or which do not have any presence in
the US, it may be a challenge to get a surety bond. You can contact the brokers listed below to see
what is possible.

Surety producers

The following brokers have experience with assisting foreign companies to get a performance bond:

Steve Swartz, President

South Coast Surety, Insurance Services Inc.
1100 Via Callejon, Suite A
San Clemente, CA 92673
Website: www.southcoastsurety.com
Tel: +1 (949) 361-1692
E-mail: steves@southcoastsurety.com

Cynthia Baldonado, Contract and Commercial Bond Producer

Viking, Bond Service Inc.
22601 N. 19th Avenue, Suite 210
Phoenix, AZ 85027
Website: www.performancesuretybonds.com
Tel: +1 (623) 933-9334
E-mail: cynthiab@vbsbond.com

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Bank guarantee: Standby letter of credit2

This is an alternative to the surety bond issued by an insurance company. A Standby Letter of Credit
or Guarantee is a written undertaking given by the bank to the person with whom you are doing
business (beneficiary) to pay a specified amount of money in the event that you or a third party do
not meet specific financial or performance obligations.

Difference between a Standby letter of credit and a Commercial letter of credit

A standby letter of credit is similar to a commercial letter of credit used for import/export
transactions in that a bank substitutes its credit worthiness for that of its customer. The commercial
letter of credit facilitates trade through the use of documents evidencing performance and drafts.

The standby letter of credit, however, often represents an obligation of the issuing bank to the
beneficiary to 1) repay money borrowed by or advanced to or for the account party, or 2) make
payment on account of any indebtedness undertaken by the account party, or 3) make payment on
account of any claimed default by the account party in the performance of an obligation.

Note that in each of these cases, payment is effected against the beneficiary's claim that default has
occurred. In no case does the issuing bank agree to guarantee the completion of any project or
contract, nor is it bound to make determination of fact(s) regarding the underlying transaction. The
bank's liability is financial only.

What are they used for?

Bid bond

Contracting parties involved in sizeable projects frequently request contractors bidding on the
project to post a bond or standby letter of credit for a percentage of the contract amount. These are
used for the bidding process only, and assure the contracting party that the contractor they selected
will honor the original bid.

Advance payment bond

When the contractor, who has been awarded the project, begins work, an advance payment may be
required for materials, startup costs, or general working capital. The contracting party generally
requires a bond or standby letter of credit to ensure that the advance payment will be used for the
project. In the event of contract default, the payment can be recovered from the bank, which issued

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Bank of the West, www.bankofthewest.com

The use of Construction Bonds in the US| February 2016 9

the standby credit. These standby letters of credit can be issued to progressively decrease in amount
through the life of the credit.

Performance bond

Throughout the life of the project, the contracting party is interested in ensuring that the project will
be completed in accordance with its terms and conditions. A standby credit may be required to
provide financial reimbursement in the event of default by the contractor. These are generally
designed to decrease in amount over the life of the project.

The language in the standby

Bank customers, as applicants for a standby letter of credit, are encouraged to ask the beneficiary for
the language they want in the standby. Most beneficiaries, who regularly accept standbys, will
provide the applicant with an example of their format. Before the standby is issued, the customer,
bank, beneficiary, and confirming bank, if any, should all agree on the language to be included. This
prevents delays and saves amendment expense.

When/how is payment made?

To be paid, the beneficiary must comply with the standby's terms and conditions and submit the
required documents. When paying, the bank is interested only in the conforming documents
required by the letter of credit. In no instance would a bank investigate the accuracy or correctness
of any statement made by the beneficiary. Also, the bank is not interested in the underlying
transaction's terms and conditions.

Standby L/C procedures

Basics of Standby Letters of Credit

 Banks in the United States historically have not been allowed to issue guarantees. U.S. banks and
foreign banks operating in the U.S. issue standby letters of credit, which act as a substitute in
part for a guarantee.

 The drawing under the standby letter of credit is triggered by the beneficiary’s statement of
nonperformance of the underlying transaction.

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 Under letters of credit, banks only deal with documents. Banks do not research the “truth” of the
non-performance (i.e. unpaid invoices, late delivery of product, etc.) nor do they make
determinations of fact.

 The “trigger” language in the standby is the critical element of the standby letter of credit, and it
is basically a statement by the beneficiary that non-performance has occurred. Most
beneficiaries, who regularly accept standbys, have their own preferred text for the standby letter
of credit.

 The applicant and the beneficiary of the letter of credit should give Global Trade Services sample
language for the L/C as it relates to the underlying transaction, keeping in mind that the detailed
specifics in any underlying contract should not be repeated in the letter of credit.

Drafting the L/C

There are at minimum three parties who must agree on the text of the letter of credit: the applicant,
the beneficiary, and the bank.

Once the bank receives sample language, the bank will draft the L/C using your basic language to
conform to the rules of letters of credit, the UCP 600 or ISP 98, and their own internal requirements.

Since the text is custom drafted for each standby letter of credit, sufficient time must be allowed: to
draft the text, obtain your consent, the approval of the beneficiary, and make any agreed changes.

The time frame must also take into account your internal approvals as well as the bank’s credit
approval process. The final steps, which also take time, are the preparation of the actual L/C by
Global Trade Services; careful proof reading of the text, and the sending out of the L/C by courier to
the beneficiary or by authenticated SWIFT to the beneficiary’s advising bank.

We recommend that at least ten business days be allowed for the entire standby letter of credit
process, from drafting to receipt by the beneficiary of the issued L/C.

Credit approval

The issuance of a standby letter of credit requires specific credit approval for this type of transaction,
especially with regard to the length of time (validity) the standby L/C will be outstanding. Many
standby letters of credit involve a validity in excess of a year, which exceeds the maturity of the
annual line of credit. This may be solved by an automatic extension clause, which gives the bank the
option of extending or not extending the standby L/C.

Fees

Compensation for the credit risk is set by your bank and is reflected in the per annum percentage
issuance fee paid at the time of issuance. Check your bank for the minimum fee and processing
charge, as well as other out-of-pocket expenses. Depending on the complexity of the standby and the

The use of Construction Bonds in the US| February 2016 11

language supplied by you, there may be special handling/consultation fees assessed for the drafting
of the standby letter of credit.

Banks to work with

For Belgian companies, it takes time to build a relationship with a local bank. The following banks in
the US have special links with Belgium and provide special services to Belgian companies:

Julien Christiaens, AVP Business Development Officer Benelux, Central & Northern Europe
Bank of the West
International Clientele Department - RBG
180 Montgomery Street 9th floor
San Francisco, CA 94104
Website: www.bankofthewest.com
Tel: +1 (415) 399-8237
E-mail: julien.christiaens@bankofthewest.com
Bank of the West is owned by BNPParibasFortis

Bill Cavanaugh, Trade Finance

KBC Bank NV, New York Branch
1177 Avenue of the Americas, 8th Floor
New York, NY 10036
Website: www.kbc.com
Tel: +1 (212) 541-0761
E-mail: william.cavanaugh@kbc.be

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