How Surety Bonds Work in Default
A surety bond can cover both an owner and a contractor when there are any issues interfering with the completion of a project. When a trade contractor first gets licensed, they are required to obtain a contractor bond that helps protect customers from unfinished work.
Default is an unfortunate aspect of the construction industry, and it is important to understand why default occurs and what happens when it does.
Why Default Occurs
Default can happen for any number of reasons, but they are not always foreseeable or manageable. A majority of contractor defaults are caused by:
- Contractor Performance
- If the contractor is behind schedule, over budget or does not have the management or trade skills required to finish the job, then it will likely lead to a default on the project. This causes major issues in regards to relationships with subcontractors, suppliers, vendors and customers.
- Financial problems
- When a contractor is faced with financial constraints, a default could happen. Problems with cash flow, poor job costing, overwhelming debt or even bad accounting services can be issues. This causes the contractor to halt construction because there is no money to finish the project.
- Overextension
- In this instance, a contractor takes on too much work and has too many projects going on at one time. Contractors that overextend usually have an unrealistic understanding of what the project entails in terms of the cost or time involved and their firm’s capabilities of handling the same. This ultimately forces one or more of the projects to suffer, resulting in default.
What Happens When Default Occurs
When a default does occur, a claim is often made against the contractor with the individual surety. The bond protects the Obligee from default in a financial sense. The surety company has some options it can execute to correct the issue for the customer.
- Finance the Existing Contractor
- Work with and assist the Principal on the defaulted project, allowing them to complete the job.
- Tender
- The surety agency will find a new contractor to finish the project. However, the company itself will not oversee the completion, and the Obligee will receive compensation if damages or losses have occurred. The new contractor is approved by the surety and the project owners, to ensure stability.
- Obligee Completion
- The surety agency can also suggest to the customer (Obligee) to find a new contractor on their own. The surety would pay compensation for damages and losses to the project owner up to the amount of the bond and recoup the cost from the original contractor. This is used when the owner’s plan for project completion is reasonable and does not expose any other risks.
- Pay the Obligee
- The Obligee is paid the penalty amount of the bond.
- Deny the Claim
- Deny any obligation based on known facts.
It’s important to understand how a default can affect your customers, your reputation and your bottom line. If you have more questions or need more information on how Surety Bonds work in default, call TSIB today at 201-267-7500!
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