Bonding facilities are generally subject to both a single contract limit and an aggregate contract limit. These limits are determined by a multitude of factors such as the financial position of the company, the contractor’s past experiences and the profitability and progress of the contractor’s current backlog. While most consider these bond limits to be more of guidelines than firm limits, they do represent the amount of exposure the bond company feels comfortable taking on for any specific contractor.
This year, however, the rising costs of construction materials combined with prolonged contracts due to material and COVID delays have presented a unique challenge for both contractors and sureties. What happens when the dollar value of a construction project simply increases due to material costs rather than an expansion in scope?
XYZ Construction Company
Let’s use an example of XYZ Construction Company. XYZ has a $5 million single contract limit and a $10 million total aggregate work program supported by their bonding company. Last year XYZ successfully completed a bonded $5 million new office building for a private owner. The owner has returned to XYZ and asked them to build the exact same building across the street. XYZ calls all of its subtrades with the good news and asks for updated pricing. Despite this project being identical to last year’s build, the new pricing comes in higher at $6.8 million this time, with all the trades, especially the concrete and finishing trades, blaming higher material costs for the price increases. XYZ shares this information with the owner and the owner agrees to the higher price but reaffirms to XYZ that both a performance bond and a labour and material payment bond will need to be provided for this contract.
Next up, XYZ shares the good news of the contract award with their bonding company. Unfortunately, the bond company has immediate concerns with the dollar value of the contract citing the single limit of $5 million. XYZ also has also recently secured $5 million in other new bonded contracts that are just starting up, so adding this contract would also push XYZ over the aggregate bonding limit of $10 million. After a review of the contract, the bond company declines to issue the bond.
Their position is that XYZ has never managed a job over $5 million and has concerns about both their experience with larger contracts and their ability to cash flow the project alongside their current bonded backlog. As XYZ was unable to furnish the bonds as required, the owner pulls the contract and XYZ is left feeling very frustrated.
What did their bond company not understand?
This was essentially the exact same job they had previously completed and the rising costs of materials is something outside of their control. XYZ also has pay when paid clauses and plus this project is located in Ontario and falls under the new prompt payment legislation so cash flow will not be an issue.
This is just one example of a scenario where a contractor has lost out on a great opportunity due to a lack of sufficient bonding capacity. When these situations occur, it is important to understand what options contractors have at their disposal to expand their bonding capacity.
Character, capital and capacity + relationships and trust
If you recall from previous Surety Corner articles there are the “three C’s to surety” – character, capital and capacity. We also believe that R and T – relationships and trust – are fundamental to any successful long-term surety/contractor partnership as well. In the same token, there are times when a contractor/surety partnership has reached its end and a new perspective is required.
Over the summer, Surety Corner will be exploring the various options contractors have at their disposal to increase their bonding capacity, both from a single contract perspective and an aggregate bond program consideration. The first part of this series will be focused on capital.
Part 1: Using capital to increase your bonding capacity
Bond companies focus heavily on the financial strength of a contractor at any given point in time and one of the key metrics they rely upon is working capital.
As noted in previous articles, working capital is a figure determined by adding a contractor’s cash position and receivables less any payables (trade payable, current debt payments, wages, etc.). Using the example above and standard surety leveraging for general contractors, contractor XYZ would likely require $500,000 in working capital to qualify for a $10 million aggregate limit bonding program. Upon review of XYZ’s most recent year-end financial statement, the surety has determined that XYZ had a working capital position of exactly $500,000, which meets its covenant for the $10 million aggregate.
So how can XYZ now proceed to increase the aggregate limit to $12 million so this new $6.8 million project will fit under its total bonded work program?
Over the next few Surety Corner articles, we will be answering this question and touching on ways to enhance your bond limits through augmenting capital, clearly communicating the capacity and sophistication of the operation and putting in place the mechanisms to build strong relationships and trust between the surety and the contractor.
Jamie Collum is the vice-president of construction for FCA Insurance. He has delivered numerous seminars and presentations on construction bonding and general industry updates in Ontario to various construction associations over the years. Andrew Cartwright is the vice-president of surety for FCA Insurance. With over 10 years of experience as an RVP of a large national surety company, Cartwright uses his expertise to help FCAs clients manage and build their surety capacity.
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I really liked this article and am looking forward to more in this series. Thank you!