3/25/2013 | Construction Blog
While statutory requirements will keep payment and performance bonds as a mainstay of the construction market for years to come, other viable options exist and should be considered by owners, contractors, and subcontractors as alternatives to bonding. These alternatives can create the same “net effect”.
The goal of bonding is to ensure that the contractor has sufficient assets to (1) pay its subcontractors and material suppliers and (2) finish its scope of work. In other words, they provide financial security to a project. The function of any approach used to replace bonds must be the same; but the way to get there can often be much more creative. Some possible options to consider are as follows:
- Real or personal property can be posted as security for either performance of the work or payment of subcontractors. The primary hurdle here is often the existence of a security interest, usually in the form of a mortgage, on the real estate or personal property. The party seeking to have some security loses a great deal if they are second in line behind a prior recorded secured interest. The key to making this strategy work is to ensure that the party taking the security interest is first in line and that the proper steps for establishing a security interest are followed.
- Another option would be to use a letter of credit. This is effectively a third party guarantee by a bank. Because the bank will likely demand a security interest to ensure it is repaid if the letter of credit is called, this approach can be somewhat similar to posting real estate. It has, however, an added bonus. The bank is likely to do its due diligence before issuing the letter of credit. This more closely resembles a bond in that the contractor is effectively “pre-screened”. Letters of credit come in different forms though, so care has to be taken to ensure the right one is written for the situation.
- A simple escrow agreement or a variation on the standard retainage provision can also work. It is often overlooked and/or not used because it is simply impractical. Under the right circumstances, however, a large sum of money could be escrowed to cover the costs associated with potential claims.
These are but a few of the options available to parties involved in a construction project in order to secure payment without the use of bonds. Payment and performance bonds are still the best answer on many projects – and on certain jobs bonds are the only permissible answer – but parties should not be “boxed in” to the thinking that bonds are the only possible method for a project. Parties should carefully evaluate the risks, how they are allocated on a project, how best to put security in place in the event of a problem, and feel comfortable with the methods being used. This is the case whether you are using bonds or another approach. Don’t automatically assume bonds are the only option though.