How Does p & p construction Work?

ARTICLE6 February 2017

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.

When you’re building a construction business, one of the biggest growth hurdles you’ll likely face is the ability to secure payment and performance bonds, commonly known as P&P bonds. It’s tough to successfully secure a P&P bond when you’re a young construction entrepreneur or still growing your business because you might not have enough financial stability to convince a bonding company you’re worth the risk.

However, general contractors and project owners will often contractually require this for subcontractors—so if you can’t get bonded, you can’t take on the projects you need to grow your business.

Here’s what you need to know to become eligible for a P&P bond as a subcontractor so you can land larger (and more) projects to keep growing your business.

What is a P&P bond, and how does it work?

Issued by a surety bonding company, a P&P bond is actually two separate contractor bonds grouped together.

A payment bond is what guarantees you will pay any suppliers, subcontractors, and laborers based on contractual obligations. A performance bond ensures the satisfactory completion of a project within the stipulations of the contract.

If you fail to perform all aspects of the contract or cause damage to the property while performing your work, the GC or project owner could file a claim against the performance bond to recoup the cost. The bonding company would pay the claim and seek full reimbursement from you, the subcontractor. Likewise, if you fail to pay material suppliers or laborers, they can file a bond claim to recoup what they’re owed. (The more claims filed against you, the less bonding companies are likely to work with you—something to keep in mind!)

These are granted on a per-project basis, so you’ll potentially need to obtain additional bonds for multiple projects. Rates for P&P bonds can range anywhere from 1-3% of the total scope of your work on a project, with 2.5-3% being the average rate. This means, if you land a $100k job on a commercial construction project that requires P&P bonding, you’ll need to factor $2500-$3000 into your cost of doing business. However, if you’re in a higher credit risk category, you can expect to pay upwards of 5% of your project revenue.

How do I get a P&P bond?

Due to the requirements for eligibility, securing a P&P bond can be a struggle for many subcontractors who are still building their financial strength. In order to get bonded by a surety company, you’ll need one of two essential items:

1. Collateral in the form of cash
2. A letter of credit from your financial institution 

In addition, surety companies may also require CPA-reviewed financials, or even a step above that, CPA-audited financials.

Without the ability to put up the cash or obtain a letter of credit from your bank for the full amount of that $100k job, and then to potentially have those financials reviewed or audited by a CPA, getting bonded can be difficult.

Those who simply don’t have the business finances that would support a P&P bond might opt for personal indemnity instead, which means putting your personal finances on the line to secure the bond. If you’re a small business owner either working alone or with only a few employees, this might make sense because your personal and business finances are so intertwined. However, your ultimate goal should be to have this eventually removed by the surety bonding company so that your business can stand on its own.

Three ways to become eligible for a P&P bond

So, how do you overcome these hurdles to entry if you just don’t have the financials yet? Here are three steps you can take now to become eligible for a P&P bond and position your business for success in the long run.

1. Develop a future-facing financial mindset

It’s important to approach your business with a financial mindset early on, with the future in mind. What will it take for your business to get bonded so you can avoid personal indemnity and accept the larger, more complex projects that will support growth? Keeping your financial records organized and up to date, adopting new accounting software and improving your cash flow will go a long way toward strengthening your financial position so you can gain the confidence of a surety company.

2. Partner with a CPA

Many general contractors and project owners use bonding as a tool to screen for credible, trustworthy subcontractors they’re willing to work with—so as your business grows, it will become a nonnegotiable fact that you either have to put up collateral or provide secure financials to get a P&P bond. Even if you currently have a small amount of work and don’t yet have the necessary financial clout, getting a CPA involved as early as possible is important so that they can start to prepare your financials.

In the meantime…

3. Stair-step your way to a P&P bond

Start small and put up personal indemnity if necessary. Over time, as you accept more and larger projects, work with your CPA, and maintain your financial records, it’s possible to build the kind of financial strength that will gain the confidence of a surety company.

Need better cash flow? Billd can help.

At Billd, we’re not in the business of insuring or bonding construction entrepreneurs—we’re construction industry experts who ease contractor cash-flow problems with an innovative, flexible payment solution for construction materials. When you work with us, we’ll help you pay for materials up front so you can have the confidence to accept more projects, take on bigger projects, and grow your business.

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