“Industry Insight” articles like this one below are submitted to NASBP by those knowledgeable of important industry topics who are providing their insight for the benefit of NASBP members, affiliates, and associates.

Beware the Law of Unintended Consequences: Welcome to the World of Shrinking Bond Protections

Defaults happen. Whether on public or private construction, defaults can have very serious impacts. The risk of default has always been endemic in contracting. Surety bonds are the longstanding and important mechanism to shift risk and mitigate against such potentially crippling consequences.

Bid bonds protect against abnormally low bids. Performance bonds assure that the contract will be completed. Payment bonds assure subcontractors and suppliers that they will be paid. The fact that a contractor can present a surety bond lends assurance to a public owner that its contractor is responsible because a surety has already vetted that contractor’s finances and abilities and is willing to stand behind its principal.

Yet, we find ourselves caught up in the cross currents of the present financial challenges and realities. In particular, state and local governments face hard choices in contracting for services, new construction, and maintaining an aging infrastructure. When budgets tighten and no one wants to raise taxes, what might be sacrificed? When public owners see the surety bond requirements primarily in terms of “added project cost” or as impediments to a small contractor’s ability to bid, might that “something” be the rollback of surety bond protections? Faced with these choices, do our elected decision makers really understand the importance of the risk protections that surety bonds provide? Have they considered the consequences of a project default? How might contractors and sureties respond to these challenges?

Enter “the law of unintended consequences.” The law of unintended consequences is sometimes said to be the one law that politicians may overlook but can never repeal. It has roots in Adam Smith’s “invisible hand” metaphor. Adam Smith used the metaphor in the context of government regulation of markets, but the term “invisible hand” might equally apply to any individual action that has unintended consequences. The metaphor has often been used to refer to the sometimes perverse effects of otherwise well intended legislation or regulations.

Sociologist Robert Merton’s 1936 paper, “The Unanticipated Consequences of Purposive Social Action,” identified a number of possible causes for unanticipated consequences. These primarily include “ignorance,” rooted in an incomplete understanding of variables that result in one’s failure to anticipate an outcome, and “imperious immediacy of interest,” or the desire to achieve the intended consequences so much that the actor willfully disregards the negative consequences that are likely to follow. Either way, good intentions may get misdirected. Today, we may well be seeing Merton’s thesis operating in the current debates about surety bond protections in public contracting.

In public contracts, there are a number of well-intentioned policy decisions that may well produce unintended consequences. One example is the increasing use of multiple prime contractors under the orchestration of a construction manager. Where that construction manager is not “at risk,” and therefore probably not bonded, the payment and performance bond requirements evolve to the separate prime contractors. If these multiple prime packages have been separately bid, the owner has the advantage of getting the lowest price for each part of the work. Smaller bid packages arguably have the positive effect of opening a project to a greater spectrum of smaller and emerging contractors. At the same time, however, the economy has put those smaller contractors under increased stress. These contractors may roll the dice and bid aggressively simply to get the work. At the same time, the surety industry in general is examining its loss experience. The weak financial condition of many small contractors may compel sureties to raise the bar to qualify for bonding. In these cross currents, how might the public owners respond, again with the best of intentions? The response has been for elected officials to increase the threshold contract amount at which surety bonds will be required. Over time, these threshold amounts have been creeping up. The federal Miller Act threshold is now up to $150,000 and is tied to a “consumer price index” increase through the Federal Acquisition Regulations. Minnesota recently raised its threshold amount for state and local public contracts from $75,000 to $100,000 and indexed that threshold to a separate statute governing municipal contracting. Some states such as Wisconsin, Indiana, and Florida have even higher contract thresholds of $200,000, or even $250,000, for state contracts.

The outright waiver of bond requirements may be another response. In Florida, the public officials awarding city and county projects have authority to waive the bonding requirements. In Wisconsin and Indiana, football stadium construction is exempted from bonding requirements. Under the legislation for the new Minnesota Vikings’ billion dollar stadium, a performance bond is mandatory but the payment bond is not. The legislation provides that the public stadium authority “may secure surety bonds.” The requirement is not a mandatory one.

In another example, under financial pressures Ohio’s 2009 budget legislation contained a provision waiving bonding requirements for minority contractors on up to four state projects. The original version of the proposed law contemplated contracts up to a threshold of $600,000. After input from the surety industry and others, the final version of that legislation trimmed this back to $300,000, still a significant amount. Bond waiver legislation serves one set of public policy goals, but may overlook a major potential for pernicious unintended consequences.

By waiving bond requirements, or by raising threshold amounts for bonded projects, a public owner can remove surety bond costs from perhaps a substantial part of a project while opening competition to a wider field of contractors. This can have the effect of driving bid prices even lower, but may also reduce a contractor’s margin for error. At first glance, this benefits the public purse, but it also carries the unintended consequence of increasing the risk of a costly default by a distressed and unbonded contractor. Without a performance bond, the public owner must shoulder the cost to replace a defaulting contractor. Applying Murphy’s Law, that contractor may well be doing work on the critical path for the entire project. A critical path default could slow or stop progress altogether. The owner’s single-minded drive to reduce apparent project costs up front by negating or reducing bonding requirements becomes a painful example of Merton’s “imperious immediacy of interest” cause for dire unanticipated consequences. It may also illustrate the “ignorance” cause insofar as it betrays the elected leaders’ lack of appreciation of the default risk retained by their constituents, the taxpayers, as well as the potential downstream consequences that such default will have on unprotected subcontractors and suppliers.

Additionally, the “ignorance” may lie in a public owner’s shortsighted failure to fully appreciate that surety bonds, and particularly payment bonds, are a critical credit tool for subcontractors and suppliers. Day-to-day, every construction project runs on credit at all levels. The laborer extends credit for his or her labor to the subcontractor until payday. The subcontractor needs credit from a supplier to buy materials, and submits a pay application each month, and patiently waits for the contractor to pay. Faith in the efficient operation of this credit pyramid keeps the project moving. Where that faith is challenged or lost, there are consequences. On private work, subcontractors and suppliers typically have mechanics’ lien rights against the project if their contractor defaults. But most states do not permit liens on public projects. The substitute is often the payment bond. If there is no bond, the laborer, the supplier, and the subcontractor are each extending unsecured credit. If their contractor defaults, their losses can be total and often fatal. If the subcontractor or supplier is aware of such risk by the lack of bond protection, they may well raise their bid prices accordingly. The public owner’s perceived up front saving by squeezing surety bond costs out of the project may well have the unintended consequence of shifting a substantial part of the risk of a contractor default onto the laborers, suppliers, subcontractors and, ultimately, to the public.

Another challenge lies in the growing trend of public-private partnerships (P3s) as a delivery method to address a public owner’s infrastructure needs. Simply put, a P3 agreement is a contract combining elements of design-build and finance. The agreement usually shifts the risks of design, construction, and operation from the public owner to the private “partner.” The “partner” may well then try to shift its risks down to its suppliers and subcontractors through traditional contract “flow down” clauses. What may be “overlooked” in this risk shifting is the important role of surety bonds. While bonds to secure the long-term performance of such projects is a separate issue, requiring traditional bid, performance, and payment bonds are even more important in the P3 setting because this public-private partnership hybrid falls into a gap between state mechanics’ lien laws for private work and state bond statutes for traditional “public work.” The legislative underpinnings for development and use of P3 agreements are still in their infancy and are very much in flux. Until realistic bond requirements are made part of P3 legislation, there is great potential for “ignorance” of the ripple impacts and the “imperious immediacy of interest” generated by a big dollar P3 project to create potentially significant unintended consequences.

What is the take away from all this? Unfortunately there are no simple answers. The cross currents of competing economic interests have been and will always be in play. The historic safety net of mechanics’ lien laws and surety bond protections provide a counter balance. However, under growing economic pressures the pace of change is accelerating. The stakes in dollar terms are growing as are the pressures on state and local governments. The surety industry needs to continue its vigilance, and must continue to promote education about the benefits of surety bond protections. Since changes to surety bond thresholds and enabling P3 arrangements require legislative action, contractor and surety organizations must remain involved to assure that their voices become part of the debate.

Risk shifting is not without cost. There are good reasons why surety bonding protections have been woven so deeply into public contracting over such a long period of time. The road to disaster is often paved with good intentions. Fostering awareness of the potential challenges of Merton’s “ignorance” and “imperious immediacy of interest” should help all segments of the public contracting universe mitigate against the dangers of the ever insidious “unintended consequences.”

The opinions expressed in this article are those of the author and do not necessarily represent those of NASBP.

This article is written by Jim Sander, who is a member of the Minneapolis, Minnesota law firm of Hammargren & Meyer P.A. and licensed to practice in both state and federal courts in Minnesota and Wisconsin. Sander, a 1976 graduate of the University of Minnesota Law School, has practiced law in the Twin Cities for more than 35 years with a focus on construction law, surety claims, mechanics’ liens, and creditors’ remedies. He is a past chair of the Construction Law Section of the Minnesota State Bar Association. He has been an author and a frequent speaker on a variety of topics to industry groups and lawyers through a number of business and educational organizations. Sander can be reached at:  jim@hammarlaw.com. Hammargren & Meyer P.A. (www.hammarlaw.com) has brought together a team of experienced surety, construction, real estate, and business lawyers who represent regional and national clients from offices in Minneapolis and Alexandria, Minnesota. The firm has an established reputation of excellence in surety law, construction law, business, real estate, and alternate dispute resolution throughout the upper Midwest. The firm’s attorneys are active participants in many local, state, and national surety and construction trade organizations.