Mitigating Sub-Trade Risk through Surety Bonding
Establishing and following a rigorous sub-trade pre-qualification practice is a key part of risk management for all general contractors; however, the implementation of such a practice can be challenging at the best of times. The common rationale of ‘we know these guys’ is something to watch out for. While most generals likely know the history and performance capability of many of their sub-trades, they may not be aware of any financial challenges they are facing. With pressures mounting from labour shortages and material cost increases, maintaining successful performance and healthy margins can be a challenge for any trade. There is also concern in the industry about a possible slowdown and it is difficult to predict if and when this will occur and how it will impact sub-trades across the industry. To manage these concerns and avoid defaults, it is prudent for general contractors to give themselves the full degree of protection from performance or default issues. One of the more comprehensive risk management tools for generals to consider is to request surety bonds from key trades on larger projects.
How can bonding help with the sub-contractor selection process?
As most generals are aware, in order to qualify for bonding, companies are put through a thorough underwriting review on an annual basis, and often more frequently. These reviews include a careful look at the company’s backlog to see how profitable their work is, a review of any receivable issues that could hinder future performance and a careful evaluation of their ongoing financial results.
As noted by Andrew Cartwright, VP Surety, Trisura Guarantee, “I would argue that the Surety assists in the process by giving an owner or general contractor additional comfort that the sub-contractor has been vetted, by a third party, from a financial and ability to perform standpoint. This helps owners and general contractors narrow in on contractors that are qualified financially and technically to complete their scope of work. The surety is pre-qualifying the contractor.”
The Surety will always be looking at the contractor’s ability to perform from a holistic viewpoint. A great example of this would be to consider the failures of a couple of large contractors over the past twelve months. A general contractor may not be aware if a sub-trade they are working with, or considering working with, is carrying any receivables from one of the struggling or failed contractors, while the Surety would be typically aware of such a concern.
When should you request bonds from sub-trades?
From a risk mitigation standpoint, requesting bonds from all major trades would be the ideal scenario. The general consensus in the surety industry is that bonds should be considered for all major trades that represent either a large percentage of the total job, or from trades that are completing a critical path of the project. While there is a cost associated with this, usually around 1% of the contract value, it is not a high cost when considering the protection that bonding provides.
We asked Nelson DeQuintal, Vice President of the Guarantee Company of North America, to provide some deeper insight into this risk mitigation practice.
“When a Surety company is asked to underwrite a specific project for a general contractor, there are many factors considered in the underwriting process, including how the general contractor intends to manage and mitigate the risks associated with sub-trade performance. Given today’s economic uncertainty and challenges associated with labour supply in the marketplace, we would certainly recommend that a GC consider subcontractor bonding.
The following are a few of the factors in considering the bonding of a sub-trade:
- The GC’s familiarity and past experience with the specific trade
- Magnitude of the specific sub-trade’s contract value in relation to the overall project, and the potential impact on the project’s critical path.
- The sub-trades prior experience with the size, scope, location, and owner of the project.
- Specialized nature of the work performed by the sub-trade. Are there readily available replacement contractors or suppliers in the event of default?
- Projects with a constricted timetable for completion, particularly when significant liquidated damages clauses are included, that can materially increase the risk for the GC and sub-trade.
General contractors should also consider asking sub-trades to provide the SAC Headstart Subcontractor Performance Bond (“Headstart”), or the SAC Enhanced Performance Bond. Headstart, for example,enhances the claim handling process and provides the GC with the opportunity to present to the Surety a project completion proposal that can accelerate the re-start of the work and minimize the impact of the sub-trade default on the project schedule, which is likely a critical consideration.”
What Happens When A Default Occurs?
Although sub-trade defaults are rare, when they do occur they can be devastating to the construction schedule of a project and also cause considerable financial stress on the general. As Mark Skanes, Vice President of Western Surety explains, having bonds from a trade can provide considerable protection and peace of mind.
‘When bonding is in place for a sub-trade and there is a default, the assistance provided by the surety is really threefold. Firstly, if the sub-trade is bonded, a surety would have already completed a prequalification process. This will ensure that even though the sub-trade is in default, you have a much better chance of dealing with a sub-trade that has some sophistication and financial standing which would help mitigate the default and reduce the chances of it occurring in the first place. Secondly, the Surety can help facilitate discussion between the sub-trade and the general contractor to keep the project moving. Lastly, under an indemnity agreement, the surety can, in a worst case scenario, step into the shoes of the defaulting sub-trade to provide financing and expertise to keep the job moving forward. There are also some new and innovative bond wordings that can provide speedy project restart in comparison to the more traditional model.‘
What is the SAC Headstart Subcontractor Performance Bond?
From the Surety Association of Canada, Headstart was designed to deal specifically with the needs of a general contractor and offer a strong value proposition for this customer segment. The defining feature of the Headstart approach is the flexibility that it affords general contractors in controlling the claim resolution process. Upon submitting a notice of claim, contractors are given the option of choosing:
- The “traditional” CCDC Performance Bond surety solution; whereby the surety conducts its investigation and if liability is accepted, proceeds to rectify the default, exercising options similar to those set out in a standard bond form; or
- The “Headstart” option which allows the general contractor to implement its own claim mitigation solution upon providing the surety with an acceptable completion proposal.
While the industry remains cautiously optimistic about the future, it is wise to begin more prudent practices of risk management in case the feared slowdown does occur. Surety bonding for sub-trades is just one aspect of a strong risk management toolbox that should be considered, especially for larger critical path trades. The stakes are just too high.