Bid Bond Claims are rare but can present problems. Learn what scenarios lead to bid bond claims and what options are available to Contractors and Project Owners when a bid bond claim does occur.
Bid Bonds are a type of contract surety bond that protects the bid letting. A bid bond guarantees that a contractor will honor their bid price and enter into a formal contract for that price. It also guarantees that the bidding contractor will provide performance bonds and payment bonds for that contract if required to do so. In these ways, a bid bond serves a valuable purpose by helping ensure that contractors do not change their bid amounts or back out of their bids. You can read more about bid bonds here.
There are two types of bid bonds. These are Indemnification Bid Bonds and Forfeiture Bid Bonds.
Indemnification Bid Bonds serve to make an obligee whole for damages caused by the bidding contractor’s failure to honor their bid. This type of bid bond pays the cost between the first and second bidder’s price during a bid letting, if the winning contractor does not honor the bid. Usually, the bid bond’s penal sum is a percentage of the bid amount such as 5%, or 10%, but the actual reimbursement is the difference between the two bids.
Forfeiture Bid Bonds require the entire bond amount to be paid, regardless of the amount between the first and second bidders. As such, the obligee could actually profit from a bid bond claim. For example, a 10% Forfeiture Bid Bond on a $1,000,000 bid would require the surety bond to pay $100,000 on claim, even if the second-place bidder was $950,000. Although the obligee’s damages are only $50,000, a Forfeiture Bid Bond will require the surety bond company to pay the $100,000. For this reason, surety bond companies do not like writing Forfeiture Bid Bonds.
Bid Bond claims are very rare, but there are a couple common reasons why a bidding contractor may have a bid bond claim. These include the Surety Bond Company’s refusal to write performance bonds or payment bonds, and the Contractor’s Unwillingness to Execute a Contract.
Remember that a bid bond guarantees that if the bidding contractor is selected, they will enter into a contract and provide performance bonds and/or payment bonds if required. However, there are situations when the surety bond company that wrote the bid bond may refuse to write the performance and/or payment bond on the project. This can give rise to a bid bond claim. There are two common reasons why a surety may refuse to execute performance and payment bonds after writing a bid bond. These include a material change in the company, a large bid spread, or bidding over the approved amount.
As part of the bid bond underwriting process, contractors must submit information to the Surety showing their financial strength, capacity to perform the work and character. This process is known as the 3C’s. However, situations can change between the time a bid bond is written and when a performance bond or payment bond is requested for the project. A significant change may cause the surety to refuse to issue the performance or payment bond. Contractors are often surprised that a surety bond company can do this. However, this is commonly allowed under the Indemnity Agreement.
The most common material change that would lead to not supporting the project is financial in nature. Let’s look at an example of how this could happen:
A contractor is bidding on a project in July. As part of the normal underwriting process, the contractor has provided their surety bond company with their year-end financial statements. The surety bond company approves the bid bond, and the contractor is the lowest responsible bidder. The project is awarded in August and the contractor is expected to sign a contract and provide a performance bond and payment bond for the project. In order to do so, the surety bond company asks the contractor for their June interim financial statements. Between January and June, the contractor had trouble on a project and lost significant money, which impacted their working capital and net worth. The surety bond company may refuse to write the performance and payment bonds for the contractor which could cause a bid bond claim.
Another reason a surety bond company may refuse to write performance or payment bonds after issuing a bid bond is a management change. For example, the key owner of a company dies, and ownership passes to a spouse or family member. If the surety is unsure about the new ownership’s ability to lead the company and complete the project, it may refuse to issue the bonds. This could lead to a bid bond claim.
Another example would be a contractor bidding a project based on a key person. Suppose a general contractor who has been successful building commercial concrete structures wants to start building wood framed apartments. They hire a key person with experience in this space and the surety bond company supports a bid for this type of project. If that person leaves, the surety bond company may choose to have a bid bond claim instead of supporting performance bonds and payment bonds for the project.
A Large Bid Spread is a common reason for bid bond claims. Surety bond companies get very concerned when there is a bid spread of more than 10% between the first and second bidders. Although there are legitimate reasons for this happening, a contractor should be prepared to explain the bid spread and why they are confident in their bid. If a surety bond company believes the bid is bad, they may refuse to write the performance bonds and payment bonds, even though they wrote a bid bond. Often, bid bond claims can be avoided with a large bid spread by checking the accuracy of the contractor’s bid. The surety bond company may decide to employ an engineer or other third party in these scenarios.
Surety bond underwriters make decisions on how large of a single project they want to support, as well as the contractor’s total backlog. These decisions go into approving the amounts they will approve for a single bid bond. If a contractor exceeds those limits, it may be a reason for the bond company to refuse to honor the bid bond and enter into a contract.
For example, a surety bond company approves a contractor to bid on a $10,000,000 project and provides a bid bond for that project. Bid bonds are generally a percentage of the bid and do not prevent a contractor from bidding more. If the contractor bids $15,000,000 instead, the surety bond company may not be comfortable at that size and refuse to provide performance and payment bonds.
Generally, surety bond companies give a contractor 10% leeway on their bids. Larger increases should be approved. The level of comfort for exceeding approved bids depends on the contractor’s financial strength and relationship with the bond company.
Many contractors wonder why a surety bond company would knowingly refuse to provide performance bonds and payment bonds after writing a bid bond. Contractors falsely believe that it would be better for the surety to go ahead with the contract. However, paying a bid bond claim is relatively small compared to having a performance bond claim. This is because bid bonds are usually only written for a percentage of the bid amount.
Let’s look at an example. A surety bond company approves a 5% bid bond for a contractor. The contractor bids $2,000,000. The second-place contractor bids $3,000,000. If the surety bond company does not write a performance bond and payment bond, a bid bond claim could be made in the amount of $100,000 (5% x $2,000,000). This $100,000 is a significant amount and should not be taken lightly. However, there is a risk that the contractor had a poor estimate. By providing a performance bond and payment bond for the project, the bond company is guaranteeing that the project can be completed for the $2,000,000 amount. They are risking much more than the bid bond penalty if they believe the contractor has a poor estimate. performance bond claims can be significantly more expensive than bid bond claims.
One potential solution for contractors to avoid a bid bond claim when a surety refuses to write the performance and payment bonds is to find a replacement surety. In the industry, this is known as “jumping a bond”. Many surety bond companies will simply not jump another bond company’s bond as they believe there are too many unknown risks. However, some surety bond companies will if the contractor and broker can make a case for doing so. This can be an effective solution to avoid bid bond claims for contractors.
The second reason a bid bond claim may occur is the contractor’s unwillingness to enter into a contract after being the successful bidder. This generally occurs when the contractor has made a unilateral mistake in their bid. A Unilateral Mistake is one that is the fault of only the contractor and not the obligee. This does not include things such as mathematical or rounding errors. An example of a unilateral mistake may be that a contractor improperly estimated a portion of the project. A unilateral mistake could make a contract unprofitable for a contractor. In such cases, a contractor may prefer to have a bid bond claim and pay the penalty instead of entering into an unprofitable contract.
The Contractor and Surety Bond Company have some limited defenses when a bid bond claim arises. These defenses depend on the circumstances that caused the bid bond claim.
When a unilateral mistake occurs in the bid process, a contractor can either rescind or reform their bid.
Rescission of a bid, nullifies and cancels the contractor’s bid altogether. The obligee must then go to the second bidder. However, not all jurisdictions allow for the rescission of a contractor’s bid. In places that do allow rescission, certain obligations must generally be met. These include:
As you can see, many steps must take place to rescind the bid. However, prompt communication is the most important. My experience shows that it does not benefit either party to enter into a bad contract. The obligee and contractor are asking for problems if the obligee forces a contractor into honoring a bad contract. Contractors will be incentivized to prioritize other projects and/or submit change orders to make up ground. The best case for both parties is to usually move on to the next bidder in these situations and more experienced obligees are realizing this.
Reformation of a Bid occurs when a contractor realizes their mistake and is allowed to change their bid accordingly. Reformation is rarely allowed on public work as it would be deemed unfair to the other bidders. Exceptions can occur but most obligees prefer recission.
Other defenses to bid bond claims exist whether a mistake was made or not. These include all of the following:
An obligee breach occurs when the obligee does not honor the specified terms of the bid letting. Just as the contractor must perform all aspects of the bid specifications, the obligee must honor all specifications and laws. Should the obligee breach these duties, it may be a valid defense to a bid bond claim.
Bid Bonds are not meant to provide a long-term guarantee. Most bid bond forms and bid specifications require the obligee to award the project within a certain time period. Generally, ninety days or less is the norm, but can be longer. Should the obligee not award the project within the time period, the bid bond guarantee will cease to exist, and a bid bond claim cannot be made.
Many bid bond forms require the contractor and bond company to reimburse the obligee the amount between the first and second place bidders. Suppose the obligee selects the third-place bidder instead. This may be grounds to avoid a bid bond claim as the obligee is not selecting the lowest price.
Like all contract surety bond claims, if a bid bond claim occurs, the surety bond company has a responsibility to investigate the claim. If the surety pays a claim, they will ask the contractor and any other indemnitors to reimburse them for all costs incurred. This includes legal and other costs associated with handling the claim. This agreement is part of the General Indemnity Agreement that the contractor signed with the surety bond company.
In many cases, once the surety bond company receives notice of a claim, they may file liens against a contractor’s property to secure their position. They may also ask the contractor to post collateral to protect the surety in the event that the loss is paid.
Bid Bond claims should be avoided by contractors at all costs. When a bid bond claim does occur, certain defenses may be available. The best defense is usually quick communication with the obligee.
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