Surety and Fidelity Bonds

Every bond has three parties. The principal is the business that makes the promise. The obligee is the party the promise is made to: a city, a lender, a project owner, a state licensing board or an association. The surety is the company that stands behind the promise and pays the obligee if the principal defaults, up to the penal sum written on the bond.

The bonds property owners and their contractors meet most often fall into three groups:

• Contract bonds. A bid bond guarantees that a winning bidder will sign the contract and supply the final bonds. A performance bond guarantees the work gets finished on the contract terms. A payment bond guarantees that subcontractors and suppliers are paid, which keeps liens off the project. A maintenance or warranty bond holds the contractor to repairs for a set period after completion.
• Subdivision and site improvement bonds. Municipalities commonly require a developer to bond the public improvements in a new community, such as streets, curbs, water and sewer lines and storm drainage, before plats are recorded or permits issued. The city is the obligee, and the bond pays for the work if the developer walks away from it.
• License and permit bonds. Many states and cities require a bond before they issue certain licenses: contractor licenses, right of way and street opening permits, and some other regulated activities. Where a state's licensing rules call for one, a property management or real estate firm handling client funds may need a bond as well.

Federal work has its own rule. The Federal Acquisition Regulation, section 28.102-1, applying the statute once known as the Miller Act, requires performance and payment bonds on federal construction contracts above $150,000. Many states impose similar requirements on public work, with thresholds of their own.

Fidelity bonds sit apart from the rest. They protect an organization against theft by the people it trusts with money, and for associations they are often a requirement of the governing documents or the lender.

The most common misunderstanding about a surety bond is that it protects the principal. It does not. When a surety pays a claim, it expects to be paid back in full, and the general indemnity agreement the principal signed before the bond was issued gives it the right to collect. That agreement usually binds the company, its owners personally and often their spouses, and it lets the surety demand collateral the moment a claim looks likely.

A bond also leaves several exposures to other policies:

• Physical loss to the work. Fire, wind or theft at a project under construction is a builder's risk insurance on the structure being built matter, not a bond matter. A performance bond guarantees the contractor will finish, not that the work will survive a storm.
• Injury and damage to others. A passerby hurt on the site or a neighbor's fence knocked down by equipment is a general liability claim for injury and damage against the contractor.
• Contractor's own losses. A bonded contractor that loses money on a job gets nothing from its own bond.
• Amounts above the penal sum. The surety's obligation stops at the bond amount, whatever the obligee's actual loss turns out to be.

A license bond pays only for the violations the statute or ordinance behind it describes, and only to the people that law protects. A fidelity bond pays for dishonest acts by the people it names or describes, which is narrower than every way money can disappear from an account.

The obligee usually sets the bond amount, not the principal. A public owner commonly requires performance and payment bonds each at the full contract price. A city sizes a subdivision bond from the engineer's estimate of the remaining public improvements, sometimes with a percentage added for cost growth, and reduces it as phases are accepted. A licensing statute names a fixed bond amount for the license. An association's documents or its lender often tie the fidelity amount to the funds the association holds, reserves included.

What the principal controls is capacity: how much bonded work a surety will support. Sureties set two figures for a contractor or developer:

• A single job limit. The largest single contract the surety will bond.
• An aggregate limit. The total of bonded work, less what has already been completed, that the company may carry at once.

Both grow with the balance sheet. Working capital and net worth, as shown on financial statements the surety trusts, drive the number more than anything else, followed by the company's record on jobs of similar size and type.

Bond premium is charged as a rate on the bond amount, set by the size of the bond and the principal's credit and financial strength. Small license bonds are often written on a short application and a credit check. Premium is usually earned in full once the bond is issued.

Surety underwriters talk about the three C's: capital, capacity and character. Capital is the financial strength to absorb a bad job. Capacity is the people, equipment and systems to perform the work. Character is the track record of the owners in meeting obligations, including how they handled trouble in the past.

For contract bonds above the smallest sizes, expect to provide:

• Fiscal year end financial statements prepared by a CPA, reviewed or audited as the program grows, with the notes and the accountant's report.
• Interim statements during the year for larger programs.
• A work in progress schedule showing each open job, its contract price, the cost to date, billings, and the estimated cost to complete.
• Bank line details: size, how much is drawn, the covenants and the maturity date.
• Resumes of the owners and key managers, and a list of completed projects with sizes and owners.
• Personal financial statements from the owners who will sign the indemnity.
• The contract or bid documents for the specific bond.

The work in progress schedule is the document underwriters study most closely. Jobs showing gross profit fading as they near completion, or billings running well ahead of costs, tell the surety more about risk than the balance sheet does.

Small businesses that do not yet meet a surety's standards have another route. The SBA surety bond guarantee program guarantees bid, performance and payment bonds that participating sureties issue to qualifying small businesses, which can open bonded work to a firm still building its financial history.

A bond claim is brought by the obligee or, on a payment bond, by an unpaid subcontractor or supplier. The claimant gives notice to the surety in the form and time the bond or the governing statute requires, and those deadlines are strict. The surety then investigates, which means hearing from the principal as well as the claimant before it decides anything.

On a performance bond where the contractor has defaulted, the surety has several choices, usually set out in the bond form:

• finance the original contractor through to completion, if the problem is cash rather than competence;
• bring in a completion contractor and finish the work itself;
• arrange for the owner to sign a new contractor, with the surety paying the extra cost of finishing;
• pay the obligee up to the penal sum and close its obligation;
• deny the claim, where the principal was not actually in default or the owner breached the contract first.

Whatever the surety pays, plus its investigation and legal costs, becomes a debt under the indemnity agreement. That is why a principal facing a dispute should involve the surety early: the surety would much rather help resolve a dispute on the job than finish the job after a default. A fidelity bond claim works differently, because there the bond protects the association, which files a proof of loss for the stolen funds just as it would under a crime policy.

Build-to-rent developers bonding a new community meet bonds earlier than any other class we work with. Subdivision and site improvement bonds come with the plat, right of way bonds come with work in public streets, and a developer acting as its own general contractor may be asked for performance and payment bonds by a lender or a public partner. Capacity planning matters because a large community can tie up a surety's aggregate limit for years while phases wait for acceptance.

Condo and townhouse associations holding reserves need fidelity protection against theft by board members, employees or the management company. Many associations meet that requirement through an employee theft or commercial crime insurance for theft of association funds rather than a bond in the traditional form, so the board should check that the coverage names the management company as covered or carries an endorsement for it, and that the limit matches what the documents and the lender require.

Property management firms handling client trust funds may need a license bond where their state requires one for a real estate or property management license, and they often carry fidelity or crime coverage that the owners they work for ask to see. A management agreement may also require the firm to bond its employees who handle rents and deposits.

• Treating the bond as insurance. Owners who sign an indemnity without understanding that they personally repay the surety.
• No surety relationship before the bid. A firm that first asks for a bond the week a bid is due, with no financial statements a surety will accept.
• Statements the surety cannot use. Internally prepared or tax basis statements where the surety needs CPA reviewed or audited ones.
• Subdivision bonds left open. Improvements finished but never formally accepted, so the bond and its premium stay live and the capacity stays tied up.
• Fidelity coverage that misses the manager. An association policy that covers its own volunteers but not the staff of the management company that actually moves the money.