SURETY BOND GUARANTEE PROGRAM

INTRODUCTION

Background

Congress passed the Federal Miller Act (FMA) in 1935, as a result of its concern over the high failure rate of public works contractors to adequately perform and pay their obligations.  This act required performance and payment bonds on federal construction projects whose cost were greater than a specified amount.  Over time, small and small disadvantaged businesses adopted the position that surety companies were unwilling to take 100% of the risk to write bonds for them, since the former typically lacked the combination of financial strength and bonded work track record necessary to obtain bonding.  Faced with this dilemma, Congress authorized SBA to issue surety bond guarantees to sureties on behalf of small businesses, in 1968.  The Small Business Guarantee (SBG) Program's mission is to increase access to contracting opportunities for small and disadvantaged contractors by providing assistance that enables them to obtain the required bid, performance, and payment bonds which they could not otherwise acquire without the agency’s assistance.  The SBG Program continues to serve as the incentive for sureties to write these bonds, which are now required by the FMA on any federal procurement over $100,000.

What is Suretyship? 

Suretyship is a contractual relationship whereby one party (a surety), agrees to answer for the debt, default, or miscarriage of another (contractor). 

What is a Surety Bond? 

A surety bond is a three-party written agreement where the surety company assures the obligee (project owner) that the principal (contractor) will perform the contract according to specifications and will pay all subcontractors and suppliers or labor and materials on the project. 

Parties to the Bond:

Obligee - is the project owner (beneficiary) of the bond (the sponsoring Federal agency, under the SGB Program).

Principal - is the contractor who is responsible to perform the contract for the obligee or pay monetary damages.

Surety - is the party who joins with the contractor and guarantees the obligee that the contractor will  perform the contract. 

Guarantor - is SBA  and the party that guarantees to the surety, the contractor's performance under the contract and agrees to reimburse the surety for losses and expenses paid if the contractor defaults or fails to pay subs and suppliers on the project. 

Types of Surety Bonds 

Bid - prequalify the contractor to bid on specific projects, provides financial assurance to the obligee that the bid has been submitted in good faith, and the the contractor will enter into the contract at the price bid and provide the required performance and payment bonds. 

Perromance - protect the oblige from financial loss if the contractor fails to perform the contract according to all specified terms and conditions there-in.

Payment - guarantee that the contractor will all subcontractors and suppliers that have provided labor and materials for the projects

Through the prequalification process, a surety company conducts an underwriting review, which is an analysis of a contractor’s entire business operation to determine if the contractor has the ability to meet current and future contract and financial obligations.  That analysis includes the contractor’s capacity to perform, financial strength, track record/company history, organizational structure and reporting, business continuity plan, subcontractor and supplier references, and all projects already underway.  The surety will issue the bond if it is satisfied that the contractor possesses good character, experience matching contract requirements, financial strength, excellent credit history, a good banking relationship with a line of credit, and the necessary equipment to perform the contract. 

The contractor and surety each sign the bid bond and the contractor delivers it to the obligee at the bid letting. Later, if the contractor is the lowest qualified bidder and awarded the contract, the firm will deliver the payment and performance bonds before the project start date.

If there is a default on the contract, it is the surety who will have to pay up to the penal sum of the bond (to cover the obligee cost of completing the contract) or complete the project themselves by either financing the defaulting contractor or bringing in a replacement contractor:

PROGRAM SPECIFICS 

Contract Parameters 

When required by the procuring agency or private party, SBG Program bonds will be issued for construction, service, and supply contracts up to $2 million dollars. 

Business Eligibility Requirements

The applicant must be a small business.

Average annual receipts for the past 3 years can not exceed $6 miilion (including affiliates).  This limit is waived for 8(a) contracts). 

Small Business manufacturers, as defined by SBA’s size standard for the primary industry in which it is engaged that need performance bonds. |

SGB Guarantee Amounts

The following guarantee percentages are available under the SBG Program’s “Prior Approval” option: 

90% guarantee for:

contracts $100,000 or less;

minority and disadvantaged businesses

(including 8(a) contractors); and

Hubzone contractors 

80% guarantee for:

All other small businesses on contracts exceeding $100,000 

Under the SBG Program’s Preferred (PSB) option, sureties are given a 70% guarantee.  Prior Approval and Preferred options convey the same benefits and costs to the Principal. 

Costs

The charge to a contractor for a surety bond is called the bond premium.  Generally, there is no charge for the bid bond.  The performance and payment bond premium is typically between 1% to 2.5% of the contract amount.  Again, the surety bond premium is a fee for the surety’s underwriting services and does not cover potential losses.  Unlike insurance that anticipates a loss, sureties execute bonds because the DON’T anticipate a loss.  The rates vary depending on the size and type of contract and the contractor’s bonding capacity as determined by the underwriting. 

In addition to the premium charged by the surety, SBA charges the contractor $6 per thousand dollars of the contract amount (or .6%) for the guarantee.  SBA also charges the surety 20% (will escalate to 32% effective April 1, 2006) of the premium that the surety collects from the contractor.  All of the contractor and surety fees collected by SBA are deposited in the SBG Revolving Fund at the US Department of Treasury, which is used to pay claims.

“Risk” and Surety Bond Underwriting 

Construction contracting is a high risk industry and even an experienced, well financed company can encounter difficulty and unexpected conditions from which financial losses due to disputes, claims, liens or default can arise.

Contract bonds are those that guarantee the performance and payment obligations of a contract. Some examples are contracts for the construction of a new school building, tenant renovation of an apartment building, re‑roofing City Hall, the building of sewers and roads or the supplying of food services to an Army Base.  These contract bonds are known to be among the most hazardous of all bonding and, and it is the surety company that takes on the responsibility and risk of a properly completed contract on behalf of the contractor. 

The contractor pays a bond premium in exchange for payment and performance bonds. However, surety companies are restricted by law from setting these premium rates at a level that would cover losses, if any occur.  Some contractors believe that this bond premium is similar to insurance premiums. The difference is that while the insurance premium is actuarially set to cover future insurance losses, the bond premium only covers the overhead expenses of underwriting and will not be adequate to cover losses. 

Another important distinction between bonds and insurance products is that insurance coverage may be cancelled during the term where the surety's bond obligation cannot.

Surety bonds have also been compared to bank loans in that both are similarly based on the extension of credit. However, suretyship goes well beyond the granting of bank credit because it guarantees performance as well as monetary obligations.

Since Surety Company assets are on the line, without the protection of an adequate premium, they will suffer losses if they are unable to determine those applicants who are not qualified to perform the contract obligation. This naturally requires an extensive review of the applicant as mentioned above.

Sureties want to see a contractor have a financial cushion in the event of impaired cash flow, a significant loss on a job or a lengthy period of time without adequate work where vesting capital is consumed by overhead.

Without a contractor cushion and under a loss scenario, the surety would have to pay out under the bond and their final right of recovery from the contractor would be in vain.

Surety companies generally consider a firm to be at risk if they are a start up or have not yet been in business for at least three years. They must have a good credit history and a track record of job completion in their specialty. The contractor will have a difficult time qualifying for bonds if their balance sheet shows poor cash flow, low equity, is highly leveraged or they have been unprofitable.

Many small to medium size contractors fit this description and it is the SBG Program that can provide the solution by taking on the majority of the surety's risk through the bond guarantee. In this role, the SBA is indemnifying the surety. 

 Active WMDAO SBG Program Agents (FY05)