How Surety Bonds Work When a Contractor Defaults

Through the end of 2016, the construction industry employed more than 10 million individuals in the United States alone. While some construction professionals work for large construction companies, others are licensed contractors that work through their own business structure to complete projects. When construction contractors first get licensed, part of the process is to secure a contractor bond that helps safeguard clients from unfinished work.

However, there are situations where construction contractors default, leading to significant losses for both the contractor and its customers. When a contractor defaults, there are several remedies that the surety bond company can employ. However, it is first necessary to understand why default occurs to begin with and how it can be avoided by contractors from the start.

Why Default Occurs

There are several reasons driving contractor default, and each has its own degree of severity for both the contractor and the customer. Some issues are avoidable while others cannot be foreseen or efficiently managed as part of the business operations. However, the majority of construction contractors ultimately cannot finish a job as promised because of the following:

• Performance problems. when a contractor is behind schedule, over budget or does not have the skills necessary to complete a job, performance issues arise and ultimately lead to a default on the project. This can lead to substantial, costly issues as well as broken relationships with vendors, suppliers, and most importantly, customers.
• Financial problems. there are times when construction contractor default takes place due to financial constraints. In these cases, contractors may run into cash flow issues, either due to slow business, overwhelming debt or bad accounting practices. As a result, contractors may be forced to stop work on a project because there is no cash to complete it.
• Overextension. contractors may also overextend themselves when taking on new projects. Having an unrealistic understanding of what the project entails, the cost or time involved, or having too many outstanding projects at one time can lead to overextension that forces a job to cease.

When Default Takes Place

Any combination of the issues mentioned above may lead to a default by a construction contractor. When this happens, a claim is often made against the contractor with the individual’s surety agency. A surety bond for a licensed contractor is meant to protect the customer from default, from a financial perspective. The surety agency initially investigates if the default claimed is real or not; if it is founded, the company has a handful of solutions it may implement to correct the issue for the customer.

In some cases, a surety agency will effect a takeover or a tender of the project to ensure its completion. With a takeover, the company responsible for the contractor’s bond assumes control over the project and hires a licensed contractor to finish where the original contractor fell short. This is the most common solution when a project is near completion. With a tender, the surety agency still secures a new contractor to finish the project, but the company itself does not oversee its completion. When a tender takes place, the customer may ultimately receive compensation if damages or losses have taken place.

Surety agencies may also opt to assist to the original contractor to finish the job. Assistance may come by way of additional subcontractors or financial help. In these cases, the intended outcome is to finish the project as agreed without any additional harm or losses to the customers. This also helps maintain the original contractor’s ability to get a new affordable bond in the future if needed, and potentially sustain a relatively strong reputation in the industry.

Finally, surety agencies may simply allow the customer to find a new contractor on their own. In this scenario, the surety may pay compensation for damages or losses to the project owner, and recoup the cost from the original contractor up to the amount of the bond.

The Bottom Line

Construction contractors must have surety bonds in place as part of the licensing process in nearly all states, although the amount varies from location to location. Having the right surety bond enables construction contractors to get the jobs they want, but it also protects the project owners should things go awry over time. Surety agencies can take several steps to remedy a claim against a bond, either utilizing the original contractor or allowing for a new one to step in. Regardless of the reason for the default, construction contractors need to be aware of the ramifications of default on a project, and how their surety agency will help when required.