The Importance of Due Diligence Before Underwriting a Construction Bond
California-based surety bonding firm American Contractors Indemnity Company is suing several companies and their executives for the financial losses it incurred after the defendants allegedly failed to reimburse the surety firm on the claims made against a construction bond it issued on behalf of the accused.
American Contractors, which issued the performance and payment bonds as Texas Bonding Company, filed the lawsuit before the Galveston Division of the Southern District of Texas. The company identified the defendants as Expert House Movers Inc., John P. Matyiko, Mary P. Matyiko, Suzanne Matyiko, EHM Properties LLC, Matyiko Properties LLC, Old Dominion Properties LLC, and Matyiko Design & Build LLC.
Texas Bonding said the defendants failed to fulfill their obligations as specified under the terms of their indemnity agreement.
The case stemmed when Expert House Movers applied for a performance and payment bond from Texas Bonding for its several construction projects worth over the $5 million. As issuer of the bond, Texas Bonding, guarantees suppliers of Expert House compensation in case it fails to complete the job as stated in the contract terms.
In its court filing, Texas Bonding accused of Expert House of failing to reimburse the company after the surety suffered losses when it paid Expert House's suppliers and subcontractors $1,717,472.28. Apparently, the suppliers and subcontractors of Expert House filed a claim against the bond when the contractor failed to pay them.
Texas Bonding further alleged that the defendants not only failed to finish their projects, they also did not and refused to pay its debts that accumulated because of the unfinished projects. They also failed and/or refused to reimburse the bonding firm the necessary amount to settle the claims against the bond.
American Contractors Indemnity is seeking the court to compel all the defendants to settle the amount and relieve the surety company from their liability.
The case of Texas Bonding underscores the need for surety firms to conduct a thorough scrutiny of all surety bond applicants by conducting an in-depth due diligence about the applicant's capacity to finish the project as specified in the contract, as well as conduct due diligence on its financial capability.
As what happened in the Expert Mover's case, the surety had to assume payment for the claim made against the bonds posted by the contractor. It now has to rely on the courts to get reimbursement, which could have been avoided if a complete scrutiny was made.
A Surety Bond provides additional protection to clients of contractors by giving them increased level of guarantee, but sureties must also do their homework to ensure they won't go bankrupt when a contractor fails to meet its obligations.
When scrutinizing a the capacity and financial capability of a Surety Bond applicant, sureties must first determine the rate at which the contractor can obtain the bond and the bond line using applicant's personal credit score.
It is important for surety firms to establish that an applicant maintains a credible personal credit score and use this information to gauge his or her capacity to pay any claims against the bond as well as the applicant's likelihood of triggering one. Having a high credit score ups the applicant's credibility that he or she will be able to manage any claim that may arise and assurance that a default on the project is unlikely.
However, keep in mind that even if an applicant has a high credit score, it does not provide sufficient guarantee that he or she can handle projects amounting to over $350,000 or even millions. As part of their due diligence, surety firms must conduct extra scrutiny before extending bond lines. A surety agent must then compel the applicant to provide all the information you will ask from them the agent can determine if bond limit could be raised and if the applicant could take on much bigger projects. There is the so-called "three Cs: of bonding, or character, capacity and capital of your company that determines a lot about your bond limit.
Character is about applicant's company's overall track record, performance, as well as the company's successes and failures in their projects. Capacity is about the skills, resources, equipment and experience the company is bringing on the table, while capital is basically the contractor's credit score, including the working capital, cash flow or balance sheet. Sureties must conduct a thorough investigation on all these three Cs to determine the limit (raise or lower) the bond capacity.