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25 February 2016

Why are Bonds so relevant to the Construction industry?

Why are Bonds so relevant to the Construction industry?
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Bonds are required in any sector where there is an obligation to deliver or perform contractually. This can be from construction, engineering, and right through to environmental waste collection. Any contract where there is a performance obligation could have a bond attached to it.

There are always three parties to the bond; known as a tripartite agreement.

  • The beneficiary or the employer who wants the work done.
  • The principal party i.e. the contractor or any company undertaking the contract.
  • The Surety such as a bank or insurer who guarantees the contractor's obligations under the contract to the beneficiary.

Example Scenario

An employer arranges for a contractor to build a new property. The commitment from the contractor will result in a ‘contractual obligation’ which will contain a requirement for a performance bond.  The performance bond will guarantee to the employer that the contractor will undertake their contract, and build it within the terms of the contract. Should the contractor fail to do so, the bond provider will become involved and potentially pay out under the bond.

Why constrain your company's working capital and ability to tender for future contracts.

Most contractors automatically approach their bank for a bond. However, the bonds they issue are effectively pound for pound borrowing - payable on demand of a first written request, which puts heavy constraints on a company's working capital and overdraft facilities. It also means that if the employer makes a demand on a bond, the bank will issue payment, even if the contractor does not feel that they have failed to comply with the requirements of the contract.

Bonds issued by the Surety Market however are usually on a conditionally worded basis, where default has been proven (e.g. insolvency) and damages quantified. This is one of the major advantages that they have over the banks.

Banks also regard bonds as part of a contractor’s banking facility which may tie up their working capital, stunting a contractor’s ability to plan future work.  Arthur J. Gallagher will look to issue a bond on an unsecured basis wherever possible allowing contractors to plan ahead and tender for new work in the knowledge that they have a facility available to meet other bonding requirements.

Performance Bonds:

A guarantee up to the value of a bond, which protects the employer against any loss and/or damages sustained as a result of the contractor failing to perform their contractual obligations. Performance Bonds will, typically, have a face value or bond penalty of 10% of the contract price. If the contractor fails to perform and the bond is “called,” the Surety Company will be asked to pay the net damages sustained up to the bond penalty, or arrange completion of the work in accordance with the contract depending on how the bond is worded.

Highways Act Road & Sewer Bonds:

Local authorities require by law that companies, typically housing developers, provide a bond to ensure that the roads and sewers they construct as part of a development are completed to an acceptable standard in order that they can be “adopted” and maintained at public expense thereafter. The bond amount usually represents the authority’s estimate of the total cost of the work.

A Specialist in our Field

In today’s fast moving economic environment, the ability to source competitive surety bonds quickly is increasingly important to modern businesses. We are a market leader in broking Surety Bonds and Guarantees for the Construction Industry.

At Arthur J. Gallagher, our focus is on delivering. The Sureties team will analyse information they need about a contractor - including financial information - and any terms offered will be a reflection of the perceived risk. It is vital that companies choose a broker who can guide and support them in order to establish a successful and healthy business relationship with their surety or sureties so that work can be tendered for safe in the knowledge that their bonding requirements can be met and at competitive terms.

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