Report: Bonds on Big Projects Often Fall Short of Full Contract Value
As public-private infrastructure projects across the U.S. grow ever larger, surety bond requirements have ballooned, effectively pricing out potential bidders.
In order to ensure competition for everything from new bridges and highways to light-rail lines, some states have resorted to cutting surety bond requirements from the traditional 100% coverage down, in some cases, to just a quarter or third of a project’s cost.
If not implemented correctly, this strategy also has the potential to backfire, as was the case with Indiana’s I-69 highway project, where the state’s financing authority wound up on the hook more than $100 million after the developer defaulted, notes Montreal-based WSP Global, a big player in the P3 sector, in a recent white paper on the issue.
There are many cases where state or local authorities reduced surety bond requirements on public private infrastructure projects without negative consequences, the white paper notes. But there are also safeguards public officials should consider when cutting surety bond requirements, including a thorough examination of the background of the private, joint-venture partner.
“Reducing the performance bond coverage requires project owners to accept a greater risk associated with a contractor’s default,” notes the WSP white paper, “Performance Bond Strategies for Project Owners. “Ultimately, a project owner must consider the trade-off between this risk and the increased competition in determining whether this is a viable option.”
In the case of the $325 million I-69 highway extension in Indiana, the Indiana Finance Authority inked a P3 agreement in 2014 with Grupo Isolux Coran.
The giant, Madrid-based construction, energy and industrial services company had not only submitted the lowest bid, but it was also 30% below its closest competitor.
However, by 2017, the Indiana Finance Authority had terminated the design-build-finance-operate-maintain (DBFOM).
The IFA’s decision to lower the boom came after four project delays and “multiple claims of non-performance,” the white paper notes.
But the IFA wound up covering millions in increased construction costs out of its own pockets due to the limited nature of the surety bond taken out by Grupo Isolux Coran.
The Spanish P3 developer was not required to buy a surety bond covering 100 percent of the costs, but rather a payment bond equal to 5 percent of the project’s capital costs and a performance bond equal to 25 percent.
The two payments totaled just $97.5 million. After extracting a $50 million payment from the developer, the Indiana Finance Authority has to pay out of its own pockets $12 million in costs to bondholders and another $115 million to cover increased construction costs.
The new stretch of I-69 in the Hoosier State was finally completed in the summer of 2018.
Frustrated by the project’s meltdown and the additional public expense, the Indiana Legislature went on to revamp the way the IFA vets bidders to include “previous project experience, U.S. project management experience, and a review of financial statements,” according to the WSP report.
Recommendation: More In-Depth Screening
The Indiana debacle points to the need for more in-depth screening of a developer’s track record if a project owner decides to lower the requirements for a surety bond to some amount less than the full contract value, the white paper recommends. The study would include not just the developer’s project history, but also any litigation the company has been involved in any previous issues with financial solvency.
Such in-depth screening isn’t typically a part of the underwriting process for surety bonds, which focuses on the “current financial capacity of the company,” according to the WSP report. Previous project history needs to be taken into account, and evaluation criteria needed to be adjusted to get a true assessment of the contractor’s likelihood of default, says the report.
But that's exactly what sureties already do, argues the National Association of Surety Bond Producers. While NASBP welcomes WSP's analysis of surety on big complex projects, it says WSP's white paper misrepresents the evaluation. In short, says NASBP, sureties always carry out a comprehensive assessment of the contractor's risk of default and don't make their analysis based only on the contractor's recent financial data.
The reduced penal sum doesn't imply that the surety will make a scaled-back evaluation of the risk, says Mark McCallum, chief executive of NASBP, whose members are bond agents and brokers. The surety "would still see the contract risk at the same level as a full-value bond, because on a performance bond the risk of default isn't restricted to the the face amount," says McCallum.
The surety always evaluates the potential that a default will create losses higher than the contract penal sum, perhaps as high as the full contract value. "The surety won't relax its underwriting," says McCallum.
And that underwriting, he says, would include the contractors' entire work portfolio and history, its management experience, equipment, trade reputation and credit risk.
This article was amended August 5, 2019 to include NASBP's response to the WSP white paper.