Security Bonds: What Bond Producers and Their Construction Clients Need to Know

I heard a story recently about a public owner in the state of Texas using a security bond in an attempt to force a general contractor (GC) into executing a guaranteed maximum price (GMP) contract amendment at a price no greater than the Initial GMP (IGMP), even though there had been scope changes subsequent to establishing the IGMP. These scope changes increased the project costs that were initially contemplated at the IGMP stage; however, the GC unfortunately signed the owner’s security bond form, which not only obligated the GC to provide performance and payment (P&P) bonds, but also obligated the GC to execute the GMP amendment at an amount no greater than the IGMP. To make matters worse, the security bond was equal to 100% of the IGMP, not the normal 5%-10%. As you would imagine, the parties are now in a dispute, as the GC has refused to execute the GMP amendment at the IGMP amount. Hopefully, the matter will be resolved equitably;but we can all use this unfortunate event as a learning experience about security bonds.

The original intent of a security bond is a good one. Certain delivery methods award a contract to a GC prior to the completion of the design phase and/or a firm contract price being established. In these instances, since P&P bonds are not intended to be provided until a firm contract price has been established, it would be inappropriate for P&P bonds to be required at this stage. Thus, the security bond was created. The security bond provides the project owner with a guarantee from the GC, and its surety, that they would provide the necessary P&P bonds required by contract to the owner once a mutually agreeable firm price has been established for the project. The key term here is “mutually agreeable.” We’ll come back to this later.

Security bonds are most used during a construction manager at risk (CMAR) project delivery method, but they could also be used in other delivery methods, such as design build. The security bond is the appropriate bond to be used when there is a design phase after a contract has been awarded, so the owner has a guarantee that the P&P bonds will be provided after the design phase, and prior to the start of the construction phase. Without this guarantee, the owner risks wasting many months working with a GC that may not be able to provide the required P&P bonds upon execution of the GMP amendment.

For those of you familiar with bid bonds, you’ll notice there are many similarities between bid bonds and security bonds. Like bid bonds, security bonds provide a guarantee to the owner that P&P bonds will be provided at a certain point. Both bonds are also typically equal to 5%-10% of the anticipated contract price. The reason bid and security bonds are usually only equal to 5%-10% of the anticipated contract price is because, if the selected GC could not provide the required P&P bonds, it would usually cost the owner about 5%-10% more to secure a contract with the second place bidder, or another qualified GC.

Like bid bonds, a security bond should not cost anything. If for some reason there were extraordinary circumstances where the surety felt inclined to charge a premium for a security bond, the premium should definitely be deducted from the normal P&P bond premium once the P&P bond is provided.

There are, however, a number of differences between bid bonds and security bonds. For example, traditional bid bonds are generally only used with lump sum/fixed price/competitive sealed proposals project deliveries where a firm price is provided on bid day. In these instances, the bid bond is required to be submitted along with the GC’s bid/proposal and guarantees the GC will execute the contract at its bid price and provide the P&P bonds.

Security bonds are different in that they are provided after the contract has already been awarded to the GC, not on bid day. Remember that security bonds are most often used for CMAR project deliveries, and in this type of project delivery, a firm price (GMP) is established following the design phase after the GC has already been awarded a contract.

Also, bid bonds typically expire after a 90-day period or less and usually only guarantee that P&P bonds will be provided upon contract award, which is generally within 30 days from the bid date. However, with CMAR projects, it would not be appropriate for P&P bonds to be provided at contract award, because there is not yet a firm agreed-upon price. On CMAR projects, there needs to be a mutually agreeable GMP established prior to providing P&P bonds, and this is the essence of the guarantee provided by the security bond.

Now that you know what a security bond is and when it is typically required, let’s talk about what you need to look out for. For starters, as with all required bonds, contractors must read the bond, just the same as they need to read their contract. The bond is part of the contract, and since the contractor is ultimately responsible for the bond obligation corporately (and sometimes personally) through the general indemnity agreement the contractor signed with its surety company, it’s really primarily the contractor’s risk and the surety’s risk is secondary. If you’re short on time, skip to the “Now Therefore” paragraph.

This is the paragraph that always outlines the guarantee that the bond is providing to the obligee (beneficiary of the bond). Any one bond obligation can be wildly different from another, even if it is the same “type” of bond, so contractors really do need to read the bond and discuss it with their professional advisors if any thing seems out of the ordinary.

Now for the most important part: As a reminder, the trigger for the guarantee on the security bond is that the P&P bonds will be provided once a mutually agreeable GMP amendment has been executed. Again, the key term here is “mutually agreeable.” If you never come to a mutually agreeable GMP, then there is no obligation to provide P&P bonds. Often times, this language is not included and could potentially expose the contractor to having the obligation to provide P&P bonds for a GMP amendment that may not be mutually acceptable.

As we saw with the GC in the opening story, some security bond forms attempt to have the security bond provide a guarantee that the GC will execute the GMP amendment, at some initial amount, like the IGMP. If a contractor sees anything like this, the contractor should make sure the language is modified or run in the opposite direction, as no one wants to expose a company to this type of obligation. This is not how security bonds were intended to be used.

The security bond is intended to provide a 5%-10% guarantee to the owner that, once a mutually agreeable GMP amendment is executed, the GC will provide the P&P bonds required by contract: Nothing more, nothing less.

When used appropriately, the security bond obligation is nothing out of the ordinary and very comparable to the normal bid bond obligation. However, be sure to keep your radar up for those security bond forms that attempt to onerously modify the bond obligation, possibly putting a contractor’s company in a very risky and precarious position.

Toby_Miclettebox_edit.jpgThe author of this article is Toby Miclette, Surety Bond Producer and Senior Vice President at Bowen, Miclette & Britt Insurance Agency (BMB). Miclette is responsible for managing BMB's Bond Department, which has annual bond premiums in excess of $30 million. He began his career in the surety industry in 2003 as an underwriter with The Hartford and joined BMB in 2006. He serves on the NASBP Executive Committee as an Ex Officio representing the 5-15 Leadership Committee, as a member of the NASBP Industry Relations Committee, as a Director for the Houston Chapter of the Construction Financial Management Association (CFMA), and participates on agent advisory boards for multiple surety companies. He can be reached at tmiclette@bmbinc.com or 713.880.7109.                       .