Contractor Default: When the Unexpected Happens

Written by Marla McIntyre

Sunday, 19 November 2006

Determining how project owners and developers can manage surety bond claims process. When an east coast construction company went bankrupt, the contractor left a high school, a state employees’ credit union, a luxury hotel, and a bank unfinished. The school, credit union, and hotel projects were protected by performance and payment bonds, and their surety companies took over those projects when the contractor defaulted. However, the bank was forced to take over the supervision of its own construction project and had to acknowledge delay and cost overruns. The developer of the hotel had taken advantage of a state loan guarantee program for tourism and recreation-related development projects. By doing so, the developer was required by the state to obtain a surety bond. So when the contractor filed for receivership, the developer and the state funding he was provided were protected, and construction was kept on schedule. “The bonding company took control of the project,” the developer told a local newspaper reporter. “You can see the virtue of having a bond. You never know [what can happen to a contractor].” The developer escaped costly delays when the surety company replaced the contractor and ensured the completion of the $10-$15 million hotel. Construction crews finished on time, and the hotel, which featured a ballroom, three conference rooms, and a 150-seat restaurant in two 19th century buildings, opened in all its grandeur. Had the hotel developer not bonded the project, the cost to complete it would have come out of his own pocket. Instead, the surety company absorbed the cost. Fortunately for owners and developers, surety companies have been absorbing these costs for years. From 1994 through 2005, in fact, surety companies paid almost $9.5 billion in construction claims, according to The Surety & Fidelity Association of America (SFAA). Usually it takes a combination of events to force a contractor into default. There are a number of outside factors that contractors can’t control, such as the weather, economy, and material prices. But there are also a number of internal risk factors contractors can control such as finances, equipment, staff, and capital. Surety company underwriters and surety bond producers are valuable resources to contractors and use their experience and knowledge to help them avoid extreme risks and overcome challenges—as discussed in “Why Do Contractors Fail?” (Land Development Today, October 2006). When a default occurs, the professional expertise of the surety company and surety bond producer is there. With the surety company’s technical knowledge, practical experience, resources, and the cooperation of the contractor and owner, losses can be minimized and the job completed to everyone’s satisfaction. Prequalification of Contractors A surety underwriter makes impartial judgments about whether a contractor can perform the construction contract and does not expect a loss. That said, losses can — and do — still occur. But a minimal number of defaults signify that surety companies have been successful in screening out unqualified contractors from the bidding process through the surety’s rigorous prequalification process. This is a comprehensive examination of the contractor’s financial strength and capabilities to perform the job. “A surety company looks at more than just a contractor’s financial structure,” advises Terry Lukow, Executive Vice President, Travelers Bond, Construction Services. “It looks at the whole picture including the strategic business plan. So it’s really looking at an organization not so much from a balance sheet perspective, but how are they going to manage all of the variables in the marketplace.” One of the most difficult variables to account for in the prequalification process is the interdependent nature of construction. Difficulties may occur on a contractor’s other projects, which ultimately can affect all of his or her projects—even yours. This is why it is important not only to have the prequalification process conducted by the surety, but also to have its financial backing in the event default occurs. What Project Owners Can Do There are proactive things project owners can do to keep a project moving smoothly. Roland Richter, Vice President, Liberty Mutual Surety, recommends owners: • Ensure that project designs, architectural drawings, and specifications are detailed and complete. • Use reasonable contract language in the contract; do not incorporate covenants and language in the contract that would be clearly objectionable if placed in the bond. • Use a reasonable bond form. • Give prompt notice to the surety when material issues arise during the construction process. • Be reasonable in expectations as to how quickly the surety can respond. • Expect the surety to limit performance to that which was originally contemplated by the contract; a default is not an opportunity to obtain an upgrade at the surety’s expense. • Provide information, documentation and access to owner personnel to assist the surety in its investigation. • Pay in accordance with the contract. • Use attorneys who understand and are familiar with construction and how bonds work. • Communicate consistently and responsibly with both the contractor and surety. Surety Claims Process If contractor default is unavoidable, the surety company has legal obligations to the project owner and the contractor. It first must investigate a claim before taking action to protect the contractor’s legal recourse in the event of improper declaration of default. On the other hand, the surety must keep in mind its obligations to the project owner. To expedite the claims process, project owners should clearly define default in the contract and communicate with the contractor and the surety company. Once notified of a default, the surety company independently investigates notices of disputes or claims and provides the project owner with its assessment. Since this investigation must be impartial and responsible to meet state standards as well as their own company service requirements, claims investigations are thorough and can be time-consuming. “The claims process is very complicated,” explains Henry W. Nozko Jr., President, ACSTAR Insurance Co. “For a surety to come into a situation to resolve a construction problem, it takes time. It doesn’t happen overnight. The surety has an obligation to investigate. It’s unrealistic to think a surety can take on a construction default in a week when the owner and the contractor and the architect have probably been working together for three years. The important thing for owners to know is the surety does eventually unwind the details, and it doesn’t cost the owners a penny more.” It is important to understand all of the different issues relative to a claim, adds Stephen Cory, President, National Association of Surety Bond Producers (NASBP), and President, Cory, Tucker, & Larrowe Inc. “A lot of times those unseen issues—whether they are personal or family—are important in terms of getting to the bottom of the problem and how we can put all of these things together to solve the problem,” Cory says. “You have to address it on multiple layers to really be effective.” Managing Claims There are steps project owners can take to help manage the claims process: • Verify the validity of the bond before awarding the contract. • Notify the surety of changes in the contract. • Know who to contact at the surety company. • Notify the surety as soon as problems become apparent. • If possible, allow the contractor time to cure the default before termination. • If default occurs, notify the surety company in writing and ask for a specific response. • Be reasonable and diligent in providing notice of default. • Request a face-to-face meeting to discuss the complaint. • Provide records and correspondence to the surety company. Through good communication and cooperation, project owners and contractors can work together to quickly identify and address problems and solve challenges. Project owners who understand the difficulties contractors face and how to get projects back on track when unexpected things happen can achieve a successful outcome. Sureties play an important role in problem solving and are prepared to help project owners and contractors mediate disputes and, if necessary, extend resources to complete the project. SLDT