Bid Bond Claims are rare for contractors. Unfortunately, they do happen at times. This article discusses in detail what causes bid bond claims, what options there are and how to avoid one.
What are Bid Bonds?
Bid bonds are a type of construction surety bond that helps prequalify accounts for a project. Bid bonds simply guarantee that if the contract is awarded to the low bidder, they will sign a construction contract and normally provide performance bonds and payment bonds. Bid bonds save Owners and other Obligees time and money by prequalifying bidders. Instead of having to employ a staff to prequalify each contractor, obligees rely on a third-party surety bond company to prequalify the contractor. As part of their underwriting process, the surety bond company normally make sure the Principal (bidding contractor) has the financial resources, labor, equipment, and technical support to complete the contract. This underwriting method is referred to as the 3 C’s. Because of this underwriting, bid bonds fill the requirement on many public and private jobs that the bidder be responsible and responsive.
Bid bonds also serve to compensate the Obligee and cover the costs of another bid letting should the Principal or Surety Bond Company not sign a contract and provide Performance Bonds and Payment Bonds.
Two Basic Types of Bid Bonds
Generally, bid bonds fall into one of two categories. They are either indemnity bid bonds, or forfeiture bid bonds. Indemnity bid bonds are meant to make the Obigee whole by putting the Obligee in the financial position in would have been in if the Principal had fulfilled the bid bond obligation. On the other hand, forfeiture bid bonds have a set penalty regardless of the Obigees damages. Surety bond companies prefer indemnity bid bonds to forfeiture bid bonds. We will look at claim examples for both type of bid bonds both later.
Reasons for Bid Bond Claims
There are two broad reasons for bid bond claims. Each of these reasons may have many causes which we will cover below:
A Contractor (Principal)’s Mistake
– Bid days are usually very hectic for contractors. Many times, pricing from material suppliers and other ‘ come in at the last minute and there is not much time to put the final bid together. This can lead to a mistake in calculations, transposing figures, judgement, or even leaving something out altogether. If this, happens, a contractor may turn in a bid that does not accurately reflect the project. That may lead the contractor to refuse to sign a contract and trigger a bid bond claim.
Refusal to Write the Performance and Payment Bonds By the Surety Bond Company
– A lot can change between the time a bid bond is approved by the surety bond company and the time that a contract is awarded. Significant changes in circumstances could lead the surety bond company to refuse to write performance bonds and payment bonds on the project, even though a bid bond was issued. Contractors are often surprised and upset that surety bond companies have the right to do this. This situation can lead to a claim on the bid bond. Further, complicating matters, is that even if they do not write the performance and payment bonds, the surety bond company can seek reimbursement for the bid bond claim under the General Indemnity Agreement.
Refusal by the surety bond company can be caused by a variety of reasons. Some of these include:
- A change in the Principal’s financial condition.
- An unexpected change in ownership.
- A change in management, or a key person.
- A Principal bidding over the approved bid amount.
- A large bid spread.
- Unacceptable Contract Language or Bond Form.
A Change in the Principal’s Financial Condition
For active contractors, bid bonds are being continuously issued as they need to keep replenishing work to replace the backlog they have run off. Surety bond underwriters expect regular financial updates to support the contractor’s surety bond program. However, a contractor’s financial picture can change quickly. Suppose that a contractor’s year-end financial statement looks great. They were profitable and have a strong balance sheet. The next financial statement the surety bond company may receive is an interim financial statement, six months later. In that time period, the surety bond company has approved many bid bonds for the contractor but upon receiving the interim statement, they discover that the contractor has lost half of their net worth due to poor project performance. If the surety bond company feels that this is an ongoing problem, they may decide not to write any additional performance and payment bonds for the contractor, even if they wrote bid bonds for the projects. The thinking is that it would be better to pay smaller bid bond claims than risk getting into a performance bond claim with the Principal.
An Unexpected Change in Ownership
A key part in surety bond underwriting is ownership of the company. Surety bond companies spend time getting to know the owner(s) experience and character. If something suddenly forces a change in ownership, that could change how the surety bond company views the Principal. The new ownership may not have the same experience or values as the previous ownership. This is one reason continuity planning is so important to surety bonds. A sudden change in ownership could cause the surety bond company to refuse to write a performance bond and payment bond and cause a bid bond claim.
A Change in Management or Key Person
Another reason a surety bond company could decide not to write a performance bond or payment bond after writing the bid bond could be a change in key people. Here is an example. Suppose a General Contractor typically does school projects. However, they want to branch out into healthcare, so they hire a superintendent from a competitor with significant experience in medical facilities. Because of this superintendent’s experience, the surety bond company decides to support a contractor’s bid on a surgery center. The surety bond company provides a bid bond and the contractor is low bidder. However, before the contract is signed, the superintendent leaves and goes back to his former employer. The General Contractor and the surety bond company are now faced with a difficult decision. Do they sign the contract and issue performance and payment bonds, or do they refuse and pay the bid bond penalty? Given the Principal’s inexperience with healthcare, and the increased risk of failure, the surety bond company may decide that a bid bond claim is better than a performance bond claim and refuse to move forward.
A Principal Bidding Over the Approved Amount
Bid bonds are normally written as a percentage of a contractor’s bid. These percentage usually range anywhere from 5% of the bid to 20% of the bid. The reason is because prices change rapidly during bid day and this gives the contractor some leeway with final bid price. However, most surety bond companies do not want their Principal exceeding the approved bid amount by more than 10%. For example, a Principal submits a bid bond request for $1,000,000. The contractor can typically bid up to $1,100,000 or 10% over that amount before they need to get additional approval from the surety bond company. In most cases, bid bonds to not have a capped amount, however. That means the Principal can usually bid an amount that is significantly higher than the approved bid amount.
Here is an example. A General Contractor submits a bid bond request to build a water treatment plant in the amount of $10 million. It is a 5% bid bond. The bid would be the largest project the contractor has taken and represents the high end of the surety bond company’s comfort level with that contractor. The surety bond company approves the bid bond but asks the contractor not to exceed an $11 million bid. During bid day, the price of the project keeps increasing. Material and equipment prices are more than the Principal thought they would be, but the contractor believes it to be a good project and bids $15 million. If the contractor is the low bidder and awarded the project, the surety bond company may decide not to support the contract. The project was already at their maximum comfort level and the now it has increased by over 30%. The bid bond claim could be significant, but the surety bond company may decide that it is less costly than issuing the performance and payment bonds.
A Large Bid Spread
A bid spread is the difference between the bid amount submitted by the contractor with the lowest prices compared to the bid amount submitted by the contractor with the second lowest price. It is generally assumed that contractors looking at the same project will have comparable material prices. Contractors can differentiate themselves by their profit margins, overhead structure, etc. Even so, bidding on most construction project is usually close. Surety bond companies know this and give contractors an acceptable bid spread of 10% on most projects. Anything over 10% will be heavily scrutinized. The surety bond company wants to make sure their Principal did not make a mistake or leave something out. Even if a mistake was not made, the Principal missed an opportunity to gain an additional 10% or more in gross profit. Legitimate bid spreads do exist and that should be explained to your surety bond company. However, a large bid spread may also be a reason the surety bond company does not want to support performance bonds and payment bonds on a project. This could lead to a bid bond claim.
Unacceptable Contract Language or Bond Form
Another reason a surety bond company may refuse is difficult contract language or bond forms. You can read about some of these terms here. Here is an example, suppose upon reviewing the final contract for their Principal, the surety bond company notices that liquidated damages are $35,000 per day. This can be common on some large-scale projects. The Principal on the bid bond may be a small contractor without the ability to absorb such large damages. The surety bond company may not feel comfortable providing performance and payment bonds. This is one reason a contractor should try to get all this information before the bid.
What Are the Amounts of Bid Bond Claims?
As we discussed above, bid bonds are typically written on a percentage of the bid amount. Most public owners require a 5% bid bond while private owners can have unique requirements such as 10% or 20%. The bid bond claim under an indemnity bid bond will be the difference in the first and second place bidder not to exceed the bid bond penalty. The bid bond penalty is also called the Penal Sum. It represents the maximum liability for the surety bond company on the bid bond. Here is an example of a bid bond claim.
- Contractor 1 Bids $1,000,000
- Contractor 2 Bids $1,025,000
- Bid Bond is 5%
The maximum penalty of the bid bond is $50,000 or 5% of the $1,000,000 bid. However, the difference between the two bids is only $25,000. In this case, the bid bond claim amount is $25,000 to compensate the Obligee for going to the second bidder. Here is a second bid bond claim example.
- Contractor 1 Bids $1,000,000
- Contractor 2 Bids $1,075,000
- Bid Bond is 5%
The maximum penalty of the bid bond is still $50,000. This time, the difference between the two bids is $75,000. However, because the maximum bid bond penalty is $50,000, the bid bond claim will be $50,000.
Suppose instead that we have a forfeiture bid bond instead of an indemnity bid bond. Here is the same example.
- Contractor 1 Bids $1,000,000
- Contractor 2 Bids $1,025,000
- Bid Bond is 5%
With a forfeiture bid bond, the bond claim is the maximum amount of $50,000 even though the amount of actual damages to the Obligee was only $25,000. Therefore, these types of bid bonds are higher risk for the Principal and surety bond company. Some jurisdictions do not allow forfeiture bonds because they represent a penalty instead of indemnity.
Contractor Defenses to Bid Bond Claims Caused By Mistakes
There are several possible defenses available to contractors for bid bond claims, but this often depends on whether the Obligee is a public or a private owner. Federal contracts are by far the most lenient. Federal Contracts require that the contracting offer review bids for mistake and notify the bidder if they are found. If a unilateral mistake is made by the contractor and the Obligee allows it, there are two options to take. These options are Reformation and Rescission.
Reformation – This means that the Principal can change their bid to accommodate the mistake. Reformation is very uncommon.
Rescission – This is when the Principal withdraws the bid altogether. In bid bond claims, rescission of the bid is much more likely to be allowed.
On Federal contracts, it is possible to Reform the bid in some situations. More can be read about this process here. By contrast, private contracts are often more difficult to defend. After all, a bid is an offer, and courts are often reluctant to let contractors out of “bad bids” as this would be against public policy.
Additionally, the contractor’s mistake usually must meet the following general conditions:
• The mistake was promptly realized and communicated to the Obligee. Typically, the earlier a Principal communicates to the Obligee, the more successful they will be.
• The mistake was clerical or mathematical and was not an error in judgement. Examples of a clerical error would be a mistake in adding subcontractor bids together. However, underestimating labor cost, material costs, site conditions, ect are considered judgement errors and will not be excusable.
• The mistake did not arise out of gross negligence on the part of the Principal.
• The Obligee knew or should have known that a mistake was made. This one is very tricky. Courts rulings have varied widely about bids spreads and how much Obligees should understand.
• The mistake is so material that enforcing it would be not be just. Again, this applies to a mistake, not a bad judgement.
• The Obligee must not suffer undue hardship for the mistake.
Other Contractor Actions for Bid Bond Claims
My experience has shown that communication with the Obligee is key. Regardless of whether you made a clerical mistake or a mistake in judgement, do not try to hide it. Experienced Owners and General Contractors have experience dealing with these situations. Many know that it is better to find a replacement contractor upfront than to try and drag somebody through a bad bid. Of course, not all obligees will agree with this, but it often ends up costing them more.
If all else fails, contact a good construction attorney. Just the threat of litigation may be enough to allow a Principal out of a bid and to move on to the second-place bidder.
Contractor Defenses to Bid Bond Claims Caused by Refusal
If your surety bond company is refusing to write performance and payment bonds after writing a bid bond, the best step is usually to try and get out of the contract. If that is not possible, a contractor can try to get another surety bond company to step up and write these surety bonds. This is referred to as Jumping a Bid Bond. Most surety bond companies do not like to do this. However, the Principal should be ready to explain to the potential new surety bond company why the project makes sense. This includes detail plan for performing the project and how it will be successful and profitable. If there was a large bid spread involved, make sure you review the numbers multiple times. Have firm prices from subcontractors and material supplier to show the new surety bond underwriter. All of these things will increase your chances of getting the new surety bond company to write your performance and payment bonds and avoid a bid bond claim.
Surety Bond Company Defenses
– The biggest defense the surety bond company has is the penal sum on the bid bond. As mentioned earlier, that is the maximum amount of the surety bond company’s liability and can be used as an absolute defense.
– This defense is available to the surety bond company and the Principal. Most contracts and bid forms specify a time for the Obligee to award the contract. 60 day to 120 days are standard. If the Obligee does not award the contract within the given amount of time, the surety bond company and principal are under no obligation to sign a contract and issue performance and payment bonds.
– The surety bond company and Principal should carefully review the bid spec and procedures. If the Obligee did not perform all their obligations, a Principal may be able to get out of the bid.
– Many standard bid bond forms require that the Obligee award the contract to the second lowest bidder in a claim situation. If the Obligees instead awards the contract to the third, fourth or another bidder, it may be a valid bid bond defense.
Know Your Indemnity
As with all surety bonds, bid bonds are written on the Principle of Indemnity. If a surety bond company pays out on a bid bond claim, they will seek reimbursement from the Principal and any indemnitors as we mentioned earlier. Contractors and indemnitors need to familiarize themselves with the General Indemnity Agreement so that they know their responsibilities. Normally, these include things like cooperating with the surety bond company and opening up your books to the bond company.
Once again, bid bond claims tend to be very rare. If they do happen, work with surety bond broker and construction attorney who are familiar with the process. The best action is often to notify the Obligees as soon as possible and try to negotiate a resolution. You can learn all about bid bonds here and please contact us anytime if we can help.