With project owners and general contractors becoming more risk averse, bonding subcontracts has become more prevalent than ever. Decades ago, many sureties viewed bonding subcontractors as more risky than bonding prime contractors.
Today, most sureties do an excellent job of mitigating their exposure to the unique risks within the subcontract market. As a result, there is increased surety appetite and capacity to bond subcontractors.
While subcontracts contain unique risks, the surety looks for the same basic qualities in a subcontractor as they do in a prime contractor: capacity, capital and character. The surety pays close attention to receivables and will want to see an aging schedule. It is helpful if the subcontractor has experience working for the general contractor and has established a good relationship.
Why Are Subcontractor Bonds Required?
Unlike prime contracts, bonds typically are not required for subcontracts by law on public works. Instead, each general contractor decides whether to require their subcontractors to bond. Prudent general contractors understand the importance of transferring the risk of subcontractor failure by establishing a subcontractor bond policy. The general rule of thumb is a subcontract exceeding $100,000 will require a bond; however, a general contractor can make this threshold smaller or larger, depending on the scope of the subcontractor’s work and the type of project. Chances are, subcontractors doing more than $100,000 on public work will eventually encounter a bond requirement.
Bid vs. Negotiated
Because subcontracts are usually negotiated, general contractors seldom require bid bonds. Instead, the general contractor may require a bond prequalification letter from its surety that states the subcontractor’s current bond capacity. However, there is a growing trend for large general contractors to require bid bonds. A subcontractor must be fully prequalified by the surety before obtaining either a bond letter or a bid bond.
The Devil is in the Details
General contractors try to shift as much project risk to their subcontractors as possible. Typically, the general contractor uses its own, customized subcontracts and bond forms. The surety will require the subcontractor to provide a copy of the subcontract and bond forms prior to approving the bond. The surety wants to make sure there are no unduly onerous terms and conditions for the subcontractor–and to them, by extension.
Here are a few examples of common subcontract clauses that sureties consider onerous.
- Extended discovery period. A general contractor should make a bond claim reasonably soon after it is discovered. An extended discovery period clause allows the general contractor to wait several years before filing bond claims or lawsuits against the subcontractor and its surety. Sureties usually take strong objection to this condition.
- No notice required. Often, subcontracts are amended as the work progresses. The surety may object to a subcontract that does not require the general contractor to notify the surety of contract changes that can significantly increase their liability. Sometimes, the subcontract language even allows the general contractor to default the subcontractor without notice. This can leave the door wide open for an unscrupulous general contractor to default and replace the subcontractor without giving the subcontractor and its surety a chance to cure the problem. If given proper notification, the surety can be helpful in defusing contentious disputes that might otherwise result in costly litigation.
- Pass-through liquidated damages. On large, high-profile projects, the liquidated damages assessed by the project owner in the event of a project delay can be substantial. For example, the liquidated damages for a $100 million project might be $50,000 per day. Most boilerplate subcontracts simply pass down the liquidated damages from the prime contract to the subcontractor. The surety will want to know the specific amount of liquidated damages and how much time the subcontractor is given to complete the work. Sureties will object to contract wording that allows the subcontractor to be charged with all the liquidated damages, regardless of who is responsible for the delay. The liquidated damages should be allocated proportionally to the amount of fault the subcontractor bears.
- Pay when paid. This clause has gained wide acceptance in recent years. It legally allows the general contractor to only pay the subcontractor after they have received payment from the project owner.
- Pay if paid. This is a newer twist to the pay when paid clause that allows the general contractor to be only legally liable to pay the subcontractor if the project owner pays the general contractor. The subcontractor is given legal remedies if this clause is enforced; however, specific actions must be taken that will require assistance from a good construction attorney. This is an especially dangerous condition for the subcontractor and may be difficult to bond.
Eager to take on new work, subcontractors often make the mistake of signing subcontracts without fully understanding the ramifications of its terms and conditions. Smaller subcontractors often view seeking legal advice as cost prohibitive. It is far less expensive to have an attorney review and negotiate a subcontract’s wording than it is to hire the attorney after construction starts and a dispute erupts into a costly, protracted legal fight. Most general contractors are willing to modify or even eliminate objectionable conditions.
Bond Before Starting Work
Sometimes, the general contractor allows the subcontract to begin work without the bond in place. It may be tempting for the subcontractor to start the job and worry about the bond later, but it is never a good idea. If the bond is required in the subcontract, it will be enforced eventually. Once the work starts, the surety will demand written confirmation from the general contractor that the there are no pre-existing performance or payment issues on the job. General contractors tend to recoil against this, often sending the request to their legal department. Meanwhile, the bond approval is kept in limbo, with the general contractor and surety locked in a stalemate. The general contractor may lose patience and refuse to pay the subcontractor. They can even default and replace the subcontractor for failure to provide the bond.
With a growing number of general contractors requiring subcontractor bonds, it is important for subcontractors to be prepared. To be successful, a subcontractor must enter into a subcontract with equal measures of enthusiasm and caution.