Subcontract Bonds are an effective form of risk management on a project.
The Principal on a Subcontract Bond is the Subcontractor. They are responsible for fulfilling the contract obligation. The Obligee on a Subcontract Bond is the General Contractor or it could also be an Upstream (higher tier) Subcontractor. The Surety is a third party bond company that is guaranteeing the Principal’s obligation.
Subcontract Bonds are not a requirement by The Miller Act. Instead, they are used by contractors as a way to prevent Subcontractor Default and to keep the projects free of mechanic's liens.
Subcontractor Failure is one of the biggest risks faced by contractors. Subcontract Bonds can be a cost effective way to help mitigate this risk.
Subcontract Bonds may also be required by other parties such as a Contractor's bond company or lender. It is common for a bond company to require Subcontract Bonds on critical path trades, unique scopes of work or subcontracts over a certain value such as $250,000.
The cost of Subcontract Bonds depends on the type of work being performed, and the qualifications of the Subcontractor (also known as the 3Cs). Generally this coat is between 0.5% - 3% of the Subcontract amount. You can read more about the price of these bonds here.
Subcontract Bonds are often needed even when the General Contractor provides Performance Bonds and Payment Bonds on a project. The General Contractor's Performance Bond protects the Project Owner by making sure the project is finished according to the contract.
However, it does nothing to protect the General Contractor. The Subcontract Performance Bond protects the General Contractor by making sure a Subcontractor finishes their scope of work according to the underlying contract.
A General Contractor's Payment Bond does protect some parties but not all. Under a typical Payment Bond, 1st and 2nd tier Subcontractors are protected along with 1st tier Material Suppliers.
However, that leaves lower tier Subs and Suppliers without protection. By requiring Subcontract Bonds, Payment protection can be extended to lower tier Subcontractors and suppliers.
Subcontract Bonds are underwritten like other forms of Contract Surety Bonds. Subcontract Bonds $1 million and less can usually be written with a simple application and a credit check of the owners.
Larger Subcontract Bonds require company financial statements, stockholder financial statements, project information and an application.
There are some additional risks that make Subcontract Bonds more challenging than construction Bonds written to General Contractors. These are discussed below.
The biggest challenge to writing Subcontract Bonds is Onerous Terms from the Upstream Contractor. A look at some common ones are below.
A Flow Down Clause or Provision makes the Subcontractor bound to the same terms and conditions as the General Contractor. This can be a challenge for a Subcontractor and their Surety Bond company as they have no direct connection to the Project Owner.
Surety Bond companies prefer that Subcontracts spell out Liquidated Damages. However, some contracts require a Subcontractor to share in the Liquidated Damages that the General Contractor incurs. This creates extra risk and uncertainty for the Subcontractor and their surety. It is preferable to have a set limit in the subcontract.
Payment Terms are a major concern for all Subcontractors and are scrutinized closely by surety bond underwriters before writing Subcontract Bonds. Slow payments create stress on cash flow and can put a contractor into a bond claim.
Surety Bond companies frown upon contingent Payment clauses such as "Pay-if-Paid" and "Pay-when-Paid" language. In fact, it is likely that a bond company will not want to write a Subcontract Bond if Pay-if-Paid language is in the underlying contract.
There are a number of alternatives to Subcontract Bonds and each carries advantages and disadvantages.
Subcontractor Default Insurance is an insurance policy taken out to protect the General Contractor against Subcontractor Default. Two big advantages to SDI are the speed at which claims can be paid and that the General Contractor can profit from good loss management.
The downsides to SDI are that it is not first dollar coverage meaning the General Contractor must share in the loss. Also, it does not usually offer any protection to other parties. More can be read about SDI vs Surety Bonds here.
Subcontractor Pre-qualification is the process of reviewing a Subcontractor to determine if they have the capability to finish the contract without defaulting.
A typical Pre-qualification process involves reviewing a Subcontractor's financial history, insurance, and experience.
Pre-qualification is a great tool and required by most SDI policies. The biggest drawbacks are that it provides no financial reimbursement if a Subcontractor defaults and it can be costly to perform.
Like all surety bonds, Subcontract Bonds Require Indemnity. That means if the bond company pays a valid loss, they will seek reimbursement from the Principal Contractor and any other indemnitors.
Subcontract Bonds remain an important risk management tool to ensure that Subcontractors complete their projects and pay their bills. These bonds are easy to obtain for most Subcontractors contact Axcess Surety anytime for all your surety questions and needs.