Construction lenders on large commercial construction loans customarily require payment and performance bonds. At the loan commitment letter stage, this condition rarely concerns a borrower. Later, however, when the requirement materializes into a line item in the contractor’s budget, the borrower might have second thoughts. We attempt to define and appraise the payment and performance bond (P&P Bond).
Let’s assume our borrower wishes to construct a $14,000,000 office building. With the land purchased, rezoning complete, tenants committed, and ink almost dry on the plans and specs, the borrower need only finish negotiations with the decorous loan officers and leathery contractors. From the borrower’s standpoint, any expense that can be reasonably cut improves the financial viability of the project. The borrower and contractor have placed the $145,000 P&P Bond on the chopping block.
WHAT IS A P&P Bond?
A P&P Bond is a guaranty issued by a surety company (Surety) for the benefit of the owner. Subject to momentous exceptions, it assures the obligee (in our example the owner/borrower) that the Surety will cause the project to be completed and bills paid, even if the contractor fails.
The once ubiquitous 1984 form of AIA A312 P&P Bond was revised in 2010, partly to address a surety-unfriendly Maryland court ruling. The AIA form’s long running du jour status was met, post 2010 revision, with mixed reviews. The change fostered the use of alternative industry forms, including the ConsensusDocs forms and a host of Surety forms tailored to address perceived risks and the lack of uniformity among state laws. All forms are not created equal.
WHAT GOOD DOES IT DO?
The borrower will contend that the contractor is preeminent and the plans and specs impeccable, thus rendering the P&P Bond superfluous and the cost profligate. What good does the P&P Bond do?
1. Underwriting. The Surety is nobody’s fool. It has a credit unit remarkably similar to a bank’s credit department, albeit less empathetic or well-dressed. The Surety reviews the contractor’s financial statements, scrutinizes its management and operations, dissects contracts, and evaluates the contractor’s sustainability. Even after rigorous prequalification, the contractor must enter into hidebound agreements that include representations, warranties, covenants and, as needed, guaranties and collateral documents.
2. Protecting Against the Improbable. At a project’s inception, one can easily fall into trap of thinking “nothing” is the answer to the rhetorical question: “What could go wrong?” Projects and bonded contractors fail with disquieting regularity. The Surety and Fidelity Association of America (SFAA) publishes eye-opening statistics of contractor failures and claims paid by sureties.
The construction business is exacting and unforgiving. In literature on “Why do contractors fail?,” critics mention material pricing escalations, changes in ownership and management, rapid growth, poor controls, labor and material shortages, subcontractor failure, bad weather, economic downturn, and bad contract terms.
3. Big Brother. If anything goes wrong, big brother Surety is there. The Surety has the expertise and financial wherewithal to right the sinking ship. Its mere shadow motivates the contractor to remain in line and on time. Once a Surety steps in, the contractor can expect a reckoning.
Hence, the mere issuance of a P&P Bond evidences a meticulous vetting of the contractor, introduces an 800+ pound gorilla with an HP12C into the mix, and provides contractual assurances the job will be completed.
A Word from the Bank Regulators. Long before bathroom access became a hot topic, the feds had already addressed P&P Bonds. The OCC “Commercial Real Estate Handbook” (August 2013) states “The bank’s [lending] policy should require [P&P Bonds] for all projects of a material size.” On December 18, 2015, the trio of federal bank regulators issued a missive entitled “Statement on Prudent Risk Management for Commercial Real Estate Lending,” which berated lenders for increasing instances of “underwriting policy exceptions.” In summary, a bank should require a P&P Bond for a project “of material size.”
The Dual Obligee Rider. The typical surety contract involves three parties: the surety, owner and contractor. The lender indirectly benefits from the P&P Bond, but is not a party to the surety contract unless added pursuant to a dual oblige rider. This rider gives the lender important contractual rights, including the ability to file a claim. Whether a lender really wants to be a party to the P&P Bond is problematic. Arguably, the dual obligee rider might impose a duty on the lender to fund a defaulted loan and/or subject a lender to additional defenses.
Coverage and the Claims Process. The methodology by which the Surety solves a problem, and the degree and timing of any cure, are far beyond the scope of this article. An obligee’s recovery may be limited by the form of the bond including, inter alia, the bond amount, conditions, and formidable claim procedures.
Pricing. The SFAA cites P&P Bond premiums ranging from 0.5% – 2% of the contract price, and recognize that the range takes into consideration the size of the project (a declining scale), the contractor’s rating with the Surety, and the specifics of a project. The perceived risk determines the premium.
New Lien Laws. Mississippi adopted new construction lien laws in 2014. Mississippi Code §85-7-431 protects a project from liens by subcontractors and material suppliers on a fully bonded project.
What else? There’s more. Definitions of “subcontractor” and “materialman” aren’t as clear as one would hope. Bond forms vary coverage. Subcontractors can also be bonded. It pays to review the surety’s rating by A. M. Best Company. HUD loans require a government bond form, which is significantly tougher on the surety. Title insurance companies now inquire about P&P Bonds as part of their mechanics’ lien risk assessments.
CONCLUSION. A P&P Bond is a standard condition of a commercial loan for large construction projects, and offers considerable protection. In many instances, a bank will not be able to waive a P&P Bond requirement. Whether you get what you pay for may depend on the surety’s rating and the fine print in the P&P Bond.