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Spot and Avoid Bogus Surety Bonds

Every time the economy slows into a recession, it seems to correlate to a higher incidence of fraudulent or bogus bonding. During the past three years, there has been an uptick in firms with very similar websites and verbiage. Contractors must take precautions to prevent being duped by unscrupulous brokers purporting to represent bonding programs willing to underwrite contractors “regardless of credit.”
For example, after a contractor obtained a “bond” for a federal project and pre-paid a 6 percent fee, the government advised the contractor that the bond was a fake. Though the bond purportedly was underwritten by a well-known and financially sound insurance company, the insurance company itself was unaware of its issuance. At that point, the insurance company contacted the FBI to pursue the matter (mailing a fraudulent bond constitutes mail fraud, a federal crime) and advised the contractor that the bond was fraudulent and not in force. The government client thus advised the contractor to replace it with a legitimate bond that meets government requirements.

In the meantime, the contractor contacted the originating insurance agency about being reimbursed or getting a substitute and legitimate bond. To date, the agency has not been helpful or addressed the problem. The client must now hope he can obtain a legitimate bond (which usually only costs between 1 percent and 2 percent of the contract value) or at least be reimbursed, which is not likely.

Following are tips for contractors seeking their first bond.

  • Get a referral to a legitimate agent from others in the industry. A good place to start is the National Association of Surety Bond Producers (NASBP), which enforces standards of ethics and professionalism. Check a minimum of four references for the agent.
  • Ask for a list of the surety companies the agent represents and verify they are legitimate.
  • Beware if the agent requires up-front payment for a bond. Typically, the agent will extend terms to allow for collection of the premium from the counter party (obligee).
  • Typical bond rates for first-time principals are between 1 percent and 3 percent. Anything higher is highly suspect.
  • Don’t trust any agents or websites that indicate they don’t need underwriting information (e.g., financial statements, tax returns or AR aging reports).
  • Surety is a credit product and credit information normally is needed for all but the smallest bonds (less than $250,000). The bond underwriting process generally should be similar to applying for a loan.
  • A.M. Best is the industry’s most well-known financial rating agency and rates most legitimate sureties. If A.M. Best does not rate a surety, be cautious and ask for an explanation.
  • The federal government authorizes corporate sureties annually in the Department of Treasury’s Listing of Approved Sureties (Circular 570). Be suspect if a surety is not listed.
  • Beware of sureties incorporated or domiciled outside the United States. Other jurisdictions typically have lax or non-existent regulatory requirements.
  • Check with the state insurance commissioner’s office to verify the surety is licensed in the state where the project is located.

Individual Surety Bonds
Individual surety bonds work similarly. These are bonds purportedly backed by the assets and financial strength of an individual, rather than a regulated corporate surety. This niche in the market exists because the federal government has no regulations that require licensure or authority over individual sureties. Moreover, under federal regulations, the burden of verifying contractor responsibility falls on the agency itself. As such, if an agency contracting official agrees to accept a bond from an individual surety, no federal law exists that prevents the contracting official from doing so.

As a result, these kinds of sureties have cropped up over the years, operating quasi-legitimately on the fringes of this regulatory loophole. The problem for the obligee is that it is difficult to determine whether the financial assets are liquid, sufficient and available for claims payment if a problem with the principal develops and leads to a bond claim. In fact, it can be difficult to determine if the financial assets are even real—they generally look and feel just like any other bond with official-sounding names, language, wet (real ink) signatures, corporate seals and powers of attorney attached. However, they also tend to be very expensive (2 percent to 6 percent of contract value).

These sureties are not required to be rated by independent rating agencies (which would rate for quality and financial strength), are not required to be approved by the U.S. Treasury and are not regulated or licensed by state insurance commissioners. However, because state regulators require companies operating in their state to be licensed and regulated, they generally will issue cease and desist orders when they become aware such sureties are operating in their state. Unfortunately, this tends to happen only after some damage has been done.

Further complicating matters, individual surety bonds sometimes are sold through corporate entities, making it difficult to recognize an individual surety until the very end of the process. But purveyors of such bonds have drawn the interest of regulators, courts and legislators, and eventually the loopholes allowing them to operate may close. Until then, contractors should validate the surety and avoid the temptation of using an individual surety.