THE BOTTOM LINE

Atlantic Coverage Corp.

EXCELLENCE IN SURETY BONDS

Spring 2004 Volume 6, Issue 2

Where Have All The Sureties Gone? “Famous Quotes” “The man who complains about the way the ball bounces is likely the one who dropped it.” Lou Holtz American Football Coach “See Everything, overlook a great deal, correct a little.” Pope John XXIII “They say a reasonable number of fleas is good fer a dog-keeps him from broodin’ over bein’ a dog.” E.N. Wescott “If you owe $50, you’re a delinquent account. If you owe $50,000 you’re a small businessman. If you owe $50 million, you’re a corporation. If you owe $50 billion, you’re the government.” Lynn Townsend White, Jr.            For many commercial contractors, surety bonds are a part of the construction landscape. With the Miller Act and Little Miller Acts established by the Federal and local governments most public projects over a certain size require surety bonds. As with all businesses the surety industry has its ups and downs, which have a direct effect on the construction business. When the surety industry is peaking it is not as difficult to obtain surety bonds. The reverse of this is true when surety business hits a valley. How high the peak or how low the valley determines the ease or difficulty contractors will experience when looking to obtain surety bonds.           It’s not news any more that surety carriers have substantially tightened their underwriting criteria. We are in a deep valley. However, many contractors are finding out that the attitude of these markets has also changed. Surety underwriters no longer need to cater to contractors or surety agents anymore. In fact, the pendulum has swung completely to the other side, and the contractors and agents are the ones that need to go through hoops for their bond companies. The reason this is happening is not the obvious answer; that the marketplace has tightened. When taking a look at the complete picture it becomes clear that the true cause of this change in the underwriter’s approach is that there are substantially fewer surety markets, especially in the standard market arena.           Since the early to mid-nineties the surety market had been moving towards a peak of great heights. It crested in the middle of 2001 and started moving slowly down towards the valley since end of 2001. Since the mid-nineties when all was well, surety companies were competing for market share. There were a number of mergers (Reliance-Travelers; Travelers-Aetna; St Paul – Seaboard; USF&G and St. Paul/Seaboard, and the latest Travelers-St. Paul) to name some of the standard market mergers. How does this effect contractors and how underwriters approach their business?           Of the top 10 sureties in 1995 six of those top 10 are no longer in existence. Whether it was from mergers or leaving the business, six major surety companies have left the market since 1995. Taking this a step further 8 of the top 15 surety markets of 1995 are no longer providing surety bonds. More than half of the top 15 markets have left the industry in just about 10 years. Contractors have fewer markets to provide for their surety needs and these markets are fully aware of this. Anyone remember the names of Kemper, Reliance, USF&G, Aetna Life and Casualty, Amwest, Fireman’s Fund, Frontier Insurance, Intercargo? All have gone through mergers or attrition.           Adding to this overall surety dilemma is that contractors who do business in the New York City region have even fewer surety markets. Why? Many sureties have decided not to write business with NYC agencies due to the difficulty of doing business with these agencies. Of course, contractor loss records and labor issues that are magnified in NYC substantially added to these decisions as well. For small to medium-sized contractors who perform the majority of their work in NYC there are a total of between four and six surety companies willing to write their bonds. Some of these firms are not “A” rated. Most have adapted minimum standards as to what it will take for a contractor to be considered for surety credit in NYC. Small to medium-sized contractors in this region are those contractors with a net worth of $1,500,000.00 and below. There are exceptions of course, but these exceptions are few and they have sacrificed the majority of their tax planning ideas for the sake of improved surety credit.           In attending bid openings recently throughout New York and New Jersey the frequency of seeing contractors bidding with a certified check instead of a bid bond is growing. Many of these contractors who are going without bid bonds and or restricted bond limits are very good contractors. Most have not been coached by professional surety people about how to find the proper balance between their needs for surety credit and their goal of tax planning. Many contractors have been resistant to change, believing they will find some agent that has that “special” surety market. Sorry folks, but if you want to see fantasy go catch Lord of the Rings.           If you want to grow and be in a better situation than your competitors, and there are contractors who are doing this, remember these buzzwords for surety. Proper accounting, profitable trends, keeping money in company, analyzed net worth and working capital, complete indemnity, sufficient bank line of credit, and professional agents who knows how to maximize your surety program in a market where surety companies change their criteria or leave the market without much notice. There are no more overnight remedies to the surety crisis we are facing. If you are to heed any advice, please heed this: Don’t make your decisions based on how a surety was in the recent past. Speak to your accountant and agent and realize how it works today. Plan accordingly and you should be in better shape.

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THE BOTTOM LINE

“People react to fear, not love. They don’t teach that in Sunday school, but it’s true.” Richard M. Nixon “You can get more with a kind word and a gun than you can get with a kind word.” Al Capone “A whipping never hurts so much as the thought that you are being whipped.” Ed Howe “Drive thy business or it will drive thee.” Benjamin Franklin “The emphasis in sound discipline must be on what’s wrong, rather than who’s to blame.” George S. Odiorne “To err is human, but it is against company policy.” Anonymous “The doctor can bury his mistakes but an architect can only advise his client to plant vines.” Frank Lloyd Wright “One accurate measurement is worth a thousand expert opinions.” Grace Murray Hopper Admiral, U.S. Navy Pay Attention To Work-In-Progress Reports           Typically, a construction firm must provide a schedule of work-in-progress and completed projects quarterly to its surety. Why do they require this and what are they looking for?           For starters, understand that this has become one of the most important pieces of information that you provide to a surety (after considering the corporate financial statements and maybe the details of your banking relationship).           The underwriter at the bonding company is looking for such things as the dollar amount of estimated costs to complete, gross profits on individual projects, overbillings and underbillings.           What will they do with this information? Such things include: They will look at your current backlog in relation to the bonding program that they believe you qualify for. Remember, they look at bonded and unbonded work when calculating the aggregate program. They will compare it to prior reports provided either by you or by your CPA firm as schedules in the financial statements. They are looking for such things as changes in gross profit and the progress of the projects. They are looking at what projects may be underbilled as this may signify lower actual gross profit levels than are indicated on the schedules. This item is receiving the greatest scrutiny lately. Underbillings are the item on your balance sheet known as “Costs and Estimated Earnings in Excess of Billings”. They will look at the overbillings. Since this is often considered ‘job borrow’ and treated as a liability on your financial statements, the underwriters will look to see that the contractor’s liquidity levels remain strong. They may try to forecast what your next income statement may look like. They are looking for increases in the contract price. Since their premiums are calculated based on contract price, they are looking for bonded projects that require additional premiums to be billed.           In the preparation of these reports, our recommendation is to remain conservative. An example will better illustrate our point. In this example, assume that a particular project closes out with a 20% Gross Profit Margin (GPM). In one scenario, the project was reported at a 10% GPM in the various schedules and ultimately closed out at 20%. The bonding companies reaction is very positive, congratulating you on a great job. If, however, you told them that you were going to make 35% on the project and it closes out at the same 20% GPM, their reaction would be quite different. They would not be congratulating you; they would be questioning you on what went wrong.           Our recommendations then are to prepare the schedule carefully. Review it. Compare it with the last one provided. See if there is anything that requires further investigation before it leaves your office, and then advise your surety with the report. Your thoroughness will make their job easier and, as such, will be appreciated. Seek input from your bond broker. If they do not know how to review this, find another broker (hopefully our firm!). Book Review           In an attempt to coordinate our training program with the training program of one of the national bonding companies that we do business with, it came to our attention that a particular book has been incorporated into their underwriters’ training program. As you know from prior issues of this newsletter and from discussions with us, you know by now that bonding companies are very sensitive to those things that, historically, have caused construction firms to fail.           This book is called A Contractor’s Survival Guide: Managing with Confidence. The author is Thomas C. Schleifer; published by Aslan Press (137 pages). He brings 25 years of lessons and experience in contracting and consulting to the preparation of this book.           Considering these uncertain times that we are in, this book is very relevant and we believe that it has a lot to offer to its readers. It reviews the typical causes of contractor failure, including, but not limited to increase in project size, unfamiliar geographic areas, accounting problems, and managerial immaturity. It is very easy reading.           It is very important for a contractor that needs surety credit to attain its business goals and see how a bonding company views certain things, especially the causes of contractor failure. This book will help do that since it is part of at least one national training program. This is in addition to the first-hand benefit that one might gain from such a book.           It is not perfect. It was written in 1987, so some of the items mentioned in it are outdated, such as the conversion from manual to computerized accounting systems. However, certain correlations can be made with such things as conversions to new accounting systems.           We found availability at www.borders.com / www.amazon.com ( a used copy for $23.40), but I am sure that www.bn.com (Barnes & Noble) or some similar site would be just as helpful. No… we do not get any commission from the sales of this book.

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THE BOTTOM LINE

“Managers must have the discipline not to keep pulling up the flowers to see if their roots are healthy.” Robert Townsend “Without a yardstick, there is no measurement. And without measurement, there is no control.” Pravin M. Shah “Rules are for the obedience of fools and the guidance of wise men.” David Ogilvy “We are not looking for fear. We are not looking for love. We are looking for respect..” Lawrence Gibbs Commissioner, U.S. IRS “Discipline is the soul of any army. It makes small numbers formidable, procures success to the weak, and esteem to all.” George Washington “In Skating over thin ice, our safety is in our speed.” Ralph Waldo Emerson “If it ain’t broke, don’t fix it.” Bert Lance Why All The Questions? It’s Only a Bid Bond!           We have heard this so many times that we realized that we needed to do a better job in communicating what the bid bond obligation is. While many of us have handled, signed, and submitted bid bonds before, most of us have never actually read the bond form. We encourage you to do so.           For starters, if a bidder does not provide a bid bond, most specifications allow the bidder to post a certified check as bid security. For discussion purposes, let’s assume that the specifications call for a 10% bid bond or certified check on a $5,000,000 project. One could easily equate the value of the bid bond to the $500,000 certified check that could be provided in its place. So, right there, it is more than just the five pieces of paper that make up the bid bond.           The AIA Document A310 Bid Bond, a frequently used bond form, states that the Principal [the bidder] shall pay to the Obligee [firm to whom the bid is submitted] the difference (but not to exceed the penalty of the bond) between the amount specified in the Principal’s bid and such larger amount for which the Obligee may in good faith contract with another party to perform the work if the Obligee shall accept the bid of the Principal and the Principal does not enter into a Contract with the Obligee and give the required bond or bonds as may be specified in the bidding or Contract document.           As such, the bonding company issuing the bid bond must be very comfortable that they will approve the performance and labor and material / payment bonds if their client is awarded the project. Most of the bonding companies’ analysis is performed when a bid bond is requested. Barring any bid spreads, conditions not being met, or changes in financial position between the bid and award dates, the bonding company typically approves performance bonds rather routinely when they have issued the bid bond. This makes the bid bond a powerful prequalification tool for the Obligee.           We sometimes forget that the five-page document has significant monetary value. In the example above, the 10% bid bond for a $5,000,000 project has a $500,000 value. If the project is awarded to that bidder and they do not sign the contracts and post the requisite bonds, the bidder can be responsible for a sum of $500,000. If the bonding company pays, they will seek reimbursement from the Principal and its Indemnitors (stockholders, spouses, affiliated companies, etc.) under the General Agreement of Indemnity. This makes the bid bond a very serious obligation.           Remember that the exposure is not just the difference to the second bidder’s number. Even if the bid spread to the second bidder is 1%, the exposure could still be the full 10% if a 10% bid bond were submitted. The Bid bond does not obligate the Obligee to award the project to the second bidder. They only have to act in good faith. They may claim that the second bidder submitted a non-responsive bid or was otherwise determined to not be responsible.           Plus, in some bids, the owner requires that a “Consent of Surety” be provided with the bid bond. This makes it even more serious since the terms of the typical consent require the surety to issue the Performance and Payment Bonds if the project is awarded to the contractor, no matter what.           Without this consent, bonding companies can, and sometimes do, refuse to issue Performance and Payment bonds in those cases where they issued the bid bond. There are many examples of this. The most common instances are those when the financial condition changed between the bid and award dates, a claim or potential claim arose on another bonded project, conditions set at the approval of the bid bond are not met or there was a substantial bid spread (more than 10%) between the contract and the next highest bidder.           The bottom line – It is not just a bid bond; it is a whole lot more. Update Your Bonding File           Updated financial statements must be in the hands of your bond company by this time! You should now be submitting your quarterly Work-in-Progress Schedules along with anything that is renewing at this time such as a bank line of credit or your certificate of insurance. If you haven’t already done so, this would be a good time to let your bond company know of any major changes your company may be experiencing; new employees, real-estate purchases, additional subsidiaries, etc.           Keep your bond company aware of upcoming projects you may be interested in. This way you can work together to address any concerns before it becomes an issue. It is also important to have all your financial information submitted to the bond company in a timely manner for this same reason. Many sureties will not issue bonds past March without current financial statements! Don’t let your company get shut out of that dream project —keep your surety updated!

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