Issues Involving Surety for Public Transportation Projects (2012)

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20 project is so large that few bidders can be fully bonded, or because of its effect on competition, you can consider other ways of reducing your agency’s risk. You may (through prequalifying only strong bidders, or requiring a high standard of responsibility) be able to reduce your risk in a way that allows more competition than would result from a full performance bond requirement. Design-Build Projects. For design-build projects and large transit capital projects (those over $200M) it would be advisable to talk to prospective sureties before the solici- tation is issued to see if the Design-Build contractors will have problems securing bonds because of the size of the project. There are two problems to be aware of: (1) the lack of bonding capacity in the industry at the current time, and (2) the fact that surety practice has historically been based on the conventional Design-Bid-Build method, where design and construction are performed by separate companies and where sureties have detailed designs com- pleted for which they can assess the performance risks. On a Design-Build project, the lack of detailed designs desired by sureties to evaluate project risk may make it difficult to obtain performance bonds for the full value of the contract. When this is the case, the grantee will want to involve their FTA regional office and request a waiver from the standard bonding requirements. It should also be noted that consultation with FTA would be advisable in any design-build project to create a reasonable bonding strategy. In any case, if a 100% bond were required by your agency, it would apply only to the value of the con- struction work within the design-build contract.74 Insofar as state-imposed bonding requirements are greater than those imposed by FTA, either in terms of a lower threshold contract price or higher bond coverage, the state requirements will apply to the same extent they would otherwise apply, notwithstanding FTA in- volvement in the project. Nevertheless, FTA discour- ages “unnecessary bonding” because of the resulting increase to the overall contract cost and the restriction in competition, particularly by disadvantaged busi- nesses.75 H. Costs to the Transit Owner of Requiring Surety Bonds Sureties are compensated for the risks they assume by charging a premium for each bond they issue to a principal. The percentage is applied against the con- tract value, and will vary from surety to surety and from state to state. Importantly, because the surety looks at its underwriting process similar to the way a bank would approach a loan, the premium is also a di- rect function of the risk of loss that the surety could bear. As a result, the size of the project contract, the type of bond, the construction period, and the credit- worthiness of the bond principal (as well as the fees or commission of the broker) will also affect the cost of the bond. Generally speaking, bond premiums range from 0.5 to 2 percent of the contract price. The commission is a predetermined percentage of the base premium estab- 74 FED. TRANSIT ADMIN., supra note 71 § 8. 75 FED. TRANSIT ADMIN., supra note 71 § 8.2.1. lished in the underlying agreement between the surety and agent. Surety bond premiums are not regulated, so their price is completely market driven. Because the cost of the bond premium will be passed through to the owner in the contractor's price for the work, some owners think that they can reduce their cost exposure by finding ways to reduce the require- ment for 100 percent bonds to some lesser percentage. This thinking is based on the belief that the amount of the bond premium is a percentage of the penal sum of the bond, and not the contract price. As discussed more fully in Section VIII, surety underwriters at the na- tional level describe that each bond issued represents a 100 percent loss scenario, such that a “reduced bonding level" has no measureable utility—since the bond is underwritten to assume default at 100 percent of the contract value. The surety is underwriting to the full value of the contract, and assesses the premium against the full value of the contract, regardless of the actual penal sum. Consequently, while there are other benefits to an owner in asking for a reduced bond amount, such as greater competition, reducing the “pass-through” surety costs is not one of them. IV. ALTERNATIVE FORMS OF PERFORMANCE SECURITY As noted in Section III, most owners desire some form of independent contract security for their projects. While surety bonds are one of the most common vehi- cles for construction projects, other forms of security are used. This section reviews the three most common al- ternatives to surety bonds—LOCs, parent company guarantees, and contractor default insurance. A. Letters of Credit Contrasted with Surety Bonds In the construction context, an LOC is an irrevocable guarantee by a bank, on behalf of a contractor, that the bank will meet an owner’s demand for payment. The owner may call on the LOC on demand and generally without proof of any default by the contractor— documentation merely indicating a default is typically sufficient. Once the owner calls on the LOC, the LOC becomes a cash payment to the owner and an interest- bearing loan to the contractor. Unlike surety bonds, banks require that LOCs be se- cured by collateral, and liquid assets are the preferred form. LOCs therefore reduce a contractor’s available line of credit and constitute a contingent liability on the contractor’s financial statement. Additionally, the re- quirement that the LOC be secured by the contractor’s liquid assets has the effect of limiting the extent of cov- erage. Although an LOC can conceivably be written for any percentage of the underlying contract amount, the typical range is from 5 to 10 percent of the total con- tract price. A bank generally charges a contractor 1 percent of the face value of the LOC for each year of duration as a fee for providing the credit. The contrac- tor traditionally includes the cost of the LOC in the bid price.

21 Because an LOC is secured by collateral, the bank issuing it has no need for an investigation of the con- tractor’s experience and capabilities. The bank only needs to know the extent of the contractor’s liquid as- sets and to have the contractor agree to turn over those assets to the bank upon default. In contrast to the surety, who has performed (or should have performed) a thorough examination of the contractor in the under- writing process and has determined that the contractor is qualified to properly perform the contract before issu- ing a bond, the bank issuing an LOC provides an owner with no prequalification vetting of contractors. The bank only represents that the contractor has sufficient creditworthiness to allow the bank to extend, on behalf of the contractor, a fixed amount of credit for a fixed amount of time. Whereas a surety bond will remain in force for the duration of the underlying contract, along with an addi- tional warranty or maintenance period, an LOC is good only for a fixed duration. The typical LOC has a 1-year duration, but some LOCs may, for a fee, contain an automatic renewal provision. An owner’s demand on the LOC must be made during the LOC’s specified dura- tion, regardless of when the contractor’s liability is in- curred. There is no differentiation in the claims or costs that an LOC may be used to satisfy—the owner simply makes a demand on the LOC, and the bank pays the demand (up to the LOC’s face value). The bank does not usually make any determination as to the validity of the claim. Instead, the bank only requires that the owner provide the appropriate, specified documentation on or before the expiration date of the LOC. While a performance bond surety will work to assure completion of the underlying contract in one manner or another, and a payment bond surety will investigate the subcon- tractors and suppliers’ payment claims, a bank honor- ing an LOC fully discharges its duty to the owner by handing over a sum of money. The owner is then left to arrange for completion of the contract and to determine the validity of payment claims itself. While public works projects are generally immune from liens, sub- contractors and suppliers may place liens on the owner’s property on private construction projects if the LOC is insufficient to satisfy their payment claims. Overall, as a source of payment protection for a con- struction contract, LOCs generally provide greater benefits than a surety bond. Alternatively, as a source of performance protection for a contract, surety bonds are considered to be more reliable. The principal benefit that an LOC provides to an owner is that the funds from the LOC are available on demand, almost immedi- ately, and do not (generally) require proof of the con- tractor’s default or a lengthy claim investigation. How- ever, an LOC typically only covers a small percentage of the total contract amount, and does not reflect any pre- qualification of the covered contractor. In addition, the owner may be able to draw upon an LOC for payment, but then is left responsible to complete the remaining work in the event of a contractor’s default. An LOC will also not assist the owner in resolving any subcontractor or supplier payment claims. Although an LOC’s utility increases as the percentage of the contract covered in- creases, encumbering the additional collateral neces- sary to secure the increased credit can have a negative impact on the contractor’s cash flow—the contractor cannot spend money used to secure the LOC—and therefore impairs the contractor’s ability to perform the contract. Thus, an LOC often may not be a practical substitute for a surety bond for construction projects. In Table 2, the Surety Information Office has out- lined the key distinctions between surety bonds and LOCs in terms of prequalification, borrowing capacity, duration, obtaining process, cost, coverage, and claims.

22 Table 2. Surety Bonds vs. Bank Letters of Credit76 Surety Bonds Bank Letters of Credit Definitions A three-party agreement among the surety, the obligee (the project owner), and the principal (the contractor). A performance bond protects the owner from nonperformance and financial expo- sures should the contractor default. A payment bond, also known as a labor and material bond, protects certain subcon- tractors, laborers, and material suppliers against nonpayment by the contractor. A bank LOC is a cash guarantee to the owner, who can call on the LOC on de- mand. The LOC converts to a payment to the owner and an interest-bearing loan for the contractor. The performance of the contract has no bearing on the bank’s obligation to pay on the LOC. Prequalification A surety company and producer assess the contractor’s business operations, finan- cial resources, experience, organization, existing workload and its profitability, and management capability to verify the con- tractor is capable of performing the con- tract. The purpose is to avoid default. The banker examines the quality and liquidity of the collateral in case there is a demand on the LOC. If the banker is sat- isfied that the contractor can reimburse the bank if demand is made upon the LOC, there is no further prequalification. Borrowing Capacity Performance and payment bonds are usually issued on an unsecured basis and are usually provided on the construction company’s financial strength, experience, and corporate and personal indemnity. The issuance of bonds does not diminish the contractor’s borrowing capacity and may be viewed as a credit enhancement. Specific liquid assets are pledged to se- cure bank LOCs. Bank LOCs diminish the contractor’s line of credit and appear on the contractor’s financial statement as a contingent liability. The contractor’s cash flow in funding initial stages of construc- tion and retention amounts throughout a contract term can be adversely affected. Duration Surety bonds remain in force for the du- ration of the contract plus a maintenance period, subject to the terms and conditions of the bond, the contract documents, and underlying statutes. An LOC is usually date specific, gener- ally for one year. LOCs may contain “ev- ergreen” clauses for automatic renewal, with related fees. How to Obtain The contractor obtains the bond through a surety bond producer. A list of surety bond producers is available through the National Association of Surety Bond Pro- ducers at www.nasbp.org. The contractor obtains the LOC through a banking or lending institution. 76 Chart prepared by the Surety Information Office, www.sio.org/html/SBvsLOC.html (last accessed June 30, 2010), reprinted with permission.

23 Table 2 continued Surety Bonds Bank Letters of Credit Cost Generally 0.5% to 2% of contract price. The bond is project-specific, covering the duration of the contract. Included in contractor’s bid price. Cost is generally 1% of the contract amount covered by an LOC—e.g., if the LOC covers 10% of contract, Cost = 1% x (10% x Contract Amount) x years of con- tract. Included in contractor’s bid price. Coverage Performance bond—100% of the contract amount for project completion. Payment bond—100% of contract amount protects certain subcontractors, laborers, and materials suppliers and pro- tects owner against liens. At least 10% coverage for maintenance of defects the first year after completion. The LOC may be obtained for any per- centage of the contract, but 5% to 10% is typical. No protection/guarantee that subcon- tractors, laborers, and materials suppliers will be paid in the event of contractor de- fault. They may file liens on the project. Claims If the owner declares the contractor in default, the surety investigates. If the contractor defaults, the surety’s options are to: • Finance the original contractor or pro- vide support; • Take over responsibility for comple- tion (up to penal sum of bond); • Tender a new contractor; or • Pay the penal sum of the bond. With payment bonds, the surety pays the rightful claims of certain subcontrac- tors, laborers, and suppliers up to the penal sum of the bond. The bank will pay on an LOC upon demand of the holder if made prior to the expiration date. There is no completion clause in an LOC. The task of administering comple- tion of the contract is left to the owner. The owner must determine the validity of claims by subcontractors, laborers, and materials suppliers. If there is not enough money from the LOC to pay all of the claims, then the owner has to decide which claims will be paid and which will be rejected. B. State Legislation Permitting Letters of Credit as an Alternative to Surety Bonds Public agencies considering LOCs in lieu of surety bonds are well-advised to consider the manner in which either instrument will be better suited to support the project’s goals. Some states (11 of them) expressly al- low contractors to provide an LOC as an alternative to posting a statutory performance or payment bond on public works projects. The statutes allowing for such a substitution, however, generally restrict the extent to which an LOC is an available option: • Florida: Allows an LOC as a substitute for a surety bond, but the required value of the LOC is subject to the determination of the appropriate state, county, city, or other political subdivision.77 • Illinois: For public works projects under $100,000 that do not involve use of motor tax funds, federal-aid funds, or other funds received from the state, political subdivisions—but not the state—may accept LOCs in lieu of surety bonds.78 • Indiana: For public works projects under $250,000, other than those involving highways, roads, streets, alleys, bridges, and appurtenant structures situated on streets, alleys, and dedicated highway rights-of-way (ROWs), a political subdivision—but not the state—may accept LOCs from an Indiana financial institution ap- proved by the department of financial institutions in 77 FLA. STAT. § 255.05(7). 78 30 ILL. COMP. STAT. 550/1.

24 lieu of performance bonds.79 Upon determining, after notice and public hearing, that an otherwise responsive and responsible bidder on a capital improvement project is unable to provide a payment or performance bond, and the cost or coverage of such bond is not in the best interest of the project, the Indiana stadium and conven- tion building authority may substitute an LOC for a payment or performance bond.80 • Maine: Allows for an LOC as an alternative to surety bonds, at the discretion of the state or other con- tracting authority, if the LOC is equal to the full amount of the contract, is in a form satisfactory to the state or other contracting authority, and is issued by a federally insured financial institution that meets cer- tain statutory requirements regarding financial stabil- ity.81 • Minnesota: Allows for an LOC as an alternative to performance bonds on public works projects under $50,000 at the public body’s discretion and as long as the LOC is in the same amount as the bond.82 • Montana: Allows for an LOC as an alternative to surety bonds at the government’s discretion if the LOC is at least equal to the contract sum and is issued by a federally insured bank or savings and loan association or by a credit union insured by the national credit union share insurance fund.83 • Oklahoma: Allows for an LOC, containing terms the Department of Central Services proscribes, issued by a federally insured financial institution and in an amount no less than the total contract amount, to sub- stitute for surety bonds.84 • Pennsylvania: Local governments—but not the Commonwealth85—may accept an LOC equal to the full amount of the contract in lieu of surety bonds.86 • South Carolina: Letters of credit in an amount ap- propriate to cover the cost to the governmental body of preventing infrastructure service interruptions for a period up to 12 months may be required, at the gov- ernment’s discretion, to secure timely, faithful, and un- interrupted provision of operations and maintenance services associated with public works projects.87 • Tennessee: Allows for an LOC, issued by a federally insured bank or savings and loan association that maintains its principal office or a branch office in Ten- nessee, as an alternative to surety bonds, subject to terms approved by the contracting official. All letters of credit shall be accompanied by an authorization of the 79 IND. CODE § 36-1-12-14(h). 80 IND. CODE § 36-1-12-13.1(e); IND. CODE § 36-1-12-14(i). 81 ME. REV. STAT. ANN. tit. 14, § 871(3-A). 82 MINN. STAT. § 574.261(1a). 83 MONT. CODE ANN. § 18-2-201(2)(b). 84 OKLA. STAT. tit. 61, § 1(A)(2). 85 62 PA. CONS. STAT. § 903. 86 8 PA. CONS. STAT. § 193.1. 87 S.C. CODE ANN. § 11-35-3037. contractor to deliver retained funds to the bank issuing the letter.88 • Virginia: Allows for an LOC as an alternative to bonds only upon approval of the Attorney General (or the attorney for the political subdivision, in the case of political subdivisions), only if it is equal in amount to the bonds it is substituting, and only upon a determina- tion that it affords protection to the public body equiva- lent to a corporate surety bond.89 In addition, several other states more generally au- thorize “other security” or “alternative security” in lieu of surety bonds on public works projects. Such “other security” or “alternative security” is subject to the ca- veat that it must be acceptable to the state or other governmental entity overseeing the project. Although LOCs are not specifically mentioned, they are conceiva- bly a potential substitute for surety bonds so long as they are acceptable to the government contracting en- tity with the discretion to decide such matters. C. Recent Projects Using Letters of Credit Though a transportation project, it is useful to high- light one major project in Texas that used LOCs in lieu of surety bonds. The North Tarrant Expressway project is a major capacity enhancement on the IH-820 (Seg- ment 1) and SH-183 (Segment 2W) corridors in the Dal- las-Fort Worth Metropolitan Area. Construction work includes two managed lanes and one general-purpose lane in each direction on Segment 1 and three managed lanes in each direction on Segment 2W. The concession agreement provides for a 52-year use agreement, in- cluding construction per the Comprehensive Develop- ment Agreement signed by the consortium and the Texas DOT (TxDOT). The DB contract includes typical protections such as 50 percent parent guarantee and liquidated damages scheduled to cover fixed obligations for up to 12 months in the event of developer delay. However, TxDOT also determined that requesting LOCs from the developer, and each tier, in lieu of a per- formance and payment bond, was consistent with the intent of the Texas statutory framework. As such, the North Tarrant Express Contract provides an elaborate framework for the use of LOCs and a Collateral Agent to manage the draws, if any.90 Using LOCs as an alternative to bonding is consid- ered more of a European model, but the method comes with risks. As discussed above, if a contractor were to default, the owner potentially has the liquidity to fund completion of the work, but has no ready third-party expertise on how best to complete the project. 88 TENN. CODE ANN. § 12-4-201(c)(4). 89 VA. CODE ANN. § 2.2-4338(B). 90 See June 23, 2009, Comprehensive Development Agree- ment for a Concession North Tarrant Express Facility Between Texas Department of Transportation and NTE Mobility Part- ners, LLC, see http://www.txdot.gov/project_information/ projects/fort_worth/north_tarrant_express/cda.htm.

25 D. Cost Considerations for Owners—LOCs Versus Surety Bonds The factors affecting the price of obtaining LOCs are not as variable or subjective as the pricing for bond premiums and are typically set by respective bank rates and policies. The general pricing structure is 1 percent of the LOC amount, the LOC amount typically being 10 percent of the contract value. On a $500 million pro- ject, the LOC is likely to be set at $50 million value, with the cost of the LOC being approximately $500,000. Just as the underwriting process is dependent on a multitude of factors involving the principal’s credit, capacity, and character, the costs of obtaining a bond— the bond premium set by the surety—is also determined by a number of issues. As noted earlier, average bond premiums range from 0.5 percent to 2 percent of the contract value, including those on large transit projects. On the same hypothetical $500 million project, the bond premium could be $2.5 million at the lower end of the pricing structure. Such issues affecting bond premiums will be the contract value, the bond amount, the con- tract type, the state, the surety company’s filed rate, the principal’s credit and financial standing, past job history, current work on hand,91 and administrative or other processing costs incurred by the surety, in addi- tion to any fees charged by a surety agent or broker.92 Perhaps the biggest variable, and the biggest avenue for cost savings and negotiation with the surety on bond premiums, is the size of the principal seeking the bond. Relating to the “work on hand” issue referred to above, the “national account clients” as termed by sureties, is a small group of contractors representing the biggest and best surety clients with the most substantial portfolio of projects. These highly qualified contractors are able to obtain lower bond rates as compared to midsized con- tractors with credit issues, financial deficiencies, or less of a national presence. Another factor that may affect bond premiums and thus the cost to the owner relates to whether sales tax is included in the contract price. If the contract value includes sales tax, then the owner is arguably paying for a surety bond amount that includes sales tax. If the contract value excludes sales tax, then the bond amount would also exclude sales tax. FTA, for example, is will- ing to consider requests by transit owners to propose a bond amount that is lesser than the value of the con- tract. Whether the owner is willing to accept an electronic bond is purportedly another factor affecting the cost of obtaining a surety bond. The National Association of 91 Referred to as “national accounts” by sureties, this group of contractors represents the biggest and best surety clients, those highly qualified contractors who are able to obtain lower bond rates compared to a contractor with credit issues, finan- cial deficiencies, or a lack of presence. 92 Commissions are typically paid to licensed agents and agencies when issuing performance bonds. A commission is a predetermined percentage of the premium as per an agency agreement between surety and agent. Surety Bond Producers (NASBP) and the Surety & Fi- delity Association of America (SFAA) Committee for Joint Automation have advised that the electronic exe- cution and filing of surety bonds “reduces processing costs and increases efficiency for everyone involved in the bonding process: government agencies and other obligees, contractors and other bond principals, surety bond producers, and surety companies.”93 According to the NASBP/SFAA Joint Automation Committee, state DOTs have been the leaders in adopt- ing electronic bonding in conjunction with their use of electronic bidding systems that fully automate the bid submission process for construction projects. At least 31 DOTs have implemented electronic bidding/bonding technology and the Pennsylvania DOT (PennDOT) has implemented an electronic solution for the final bonds.94 Electronic bidding systems allow the contractor to enter its bid data, such as name of contractor, contractor li- cense number, project number, and line item prices di- rectly into the DOT’s system Web site, and the bond authentication systems work in the same vein. Bond data that are entered in the bond authentication system include the name of the surety, obligee, description of project, bond amount, execution date, description of bond form used, etc. Even though owners do not receive an actual paper bond or image of a bond, the under- standing is that the surety is bound to the terms of the bond with such a transmission because the bond au- thentication number verifies the bond’s existence.95 On bid bonds for example, one of the data elements that the contractor enters into the bidding system is the bid bond authentication number. With the authentication number, the bidding system is able to access the bid bond data. E. Parent/Corporate Guarantees Another potential alternative to a surety bond is a parent or corporate guarantee. In the construction con- text, a “parent company guarantee” (PCG) generally refers to an agreement by a contractor’s parent com- pany or holding company to be held jointly responsible for completion of the contractor’s construction contract. Despite the name “parent company guarantee,” the guarantor does not have to be the parent company of the contractor. For example, in cases of multitiered or- ganizations containing several layers of parent– subsidiary relationships, the direct parent of a contrac- tor may have little more, or sometimes fewer, assets than the contractor. In dealing with such an organiza- tional structure, one may find that the ultimate parent company or an affiliate will have the appropriate level 93 NASBP/SFAA Joint Automation Committee, ABC's Con- struction Executive Surety Bonding Section (Nov. 2006), http://www.sio.org/pdf/ABC2006.pdf. 94 See id. 95 The delivery of an electronic bond that is digitally signed by the contractor and surety in a secure manner is also used by a number of agencies.

26 of assets to guarantee the contract, as well as the will- ingness to do so. A PCG is only as valuable as the assets of the company offering it, and a PCG from a company with little or no assets is worthless. PCGs are commonly used outside of the United States because foreign performance bonds tend to only cover 10 percent of the total contract amount. In the United States, however, where performance bonds tend to cover 100 percent of the total contract amount, there is less need for a PCG. Nevertheless, a PCG can be use- ful in situations where the contractor is a company formed specifically for a particular construction project and therefore may not have substantial assets of its own. A common example of such a situation occurs when two or more contractors form a JV to undertake a major construction project. If the JV is structured as an independent company, it may lack any substantial as- sets and the contractors that formed the JV would likely be insulated from any liability. In this case, a PCG from the contractors who formed the JV would bind those contractors and hold them liable for per- formance of the project. Not only would the PCG allow the project owner to recover damages from the contrac- tors in the event of a default, it also gives the contrac- tors a greater incentive to ensure that the JV properly performs the contract in the first place and thereby avoids a default because the contractors now have “skin in the game.” Without the PCG, the contractors that formed the JV only risk the assets that they transferred to the JV, which may be little or nothing. This aspect of a PCG, however, can be somewhat duplicated in a surety bond when the surety requires personal guaran- tees from the contractor’s principals. The PCG also benefits a project owner in that it gen- erally does not cost much or anything. A surety bond may cost 2 percent (or more) of the contract price and thereby increase the bid price accordingly. Although 2 percent may not seem significant, on a $100 million contract, the bond cost will add $2 million to the overall price. In contrast, a contractor can often obtain a PCG from its parent or affiliate company for little or no cost—perhaps a small administrative fee. Additionally, unlike a surety bond, which usually caps liability at the amount of the penal sum of the bond, a PCG generally has no cap on liability other than what already exists in the construction contract. In theory, a PCG provides a project owner with “deeper pockets” to reach into if the contractor defaults and becomes insolvent. Nevertheless, it is worth noting that it would not be rare for a parent company to be- come insolvent along with its subsidiary contractor. In that case, the parent’s pockets would be just as empty as the contractor’s, and the PCG would be rendered worthless. A PCG is only as strong as its guarantor. Perhaps because of the potential insolvency of parent companies, the Miller Act does not provide for PCGs as an alternative to surety bonds for either performance bonds or payment bonds. Likewise, they are not widely offered as alternatives to surety bonds under state bonding requirements. F. Determining the Strength and Sufficiency of a PCG Because a PCG is only as sound as the party that provides it, determining the soundness of a parent com- pany is critical in negotiating for this alternative form of security. For a public agency considering whether to accept a parent guarantee, the evaluation of the finan- cial strength of a parent company is often no different from evaluating the contractor or JV’s financial capa- bilities. The purpose is to determine whether the parent companies have the financial resources to fulfill con- tractual requirements. The Defense Contract Management Agency conducts analyses of a contractor’s financial capabilities and has formal guidelines and procedures to be used in evaluat- ing certified financial statements.96 Those guidelines suggest that in any financial capability assessment, it is important to recognize signs of undercapitalization, a condition “best reflected by a firm’s inability to meet its debt at maturity.”97 The guidelines indicate that when this condition exists, the financial statements usually show “(a) Short Working Capital, (b) Heavy Debt in Relation to Working Capital, and (c) Rapid Capital Turnover.”98 Additionally, the kinds of financial information that should be reflected on the certified financial statements include assets such as cash, marketable securities, ac- counts receivables, notes receivables, inventory, un- completed contracts, prepaid expenses, tax refunds, fixed assets, stocks and bonds, investment in subsidiary companies, prepaid expenses and deferred charges, amounts due from stockholders, mortgages and real estate contracts, and miscellaneous assets. The net worth of a company represents the “margin of safety” or protection to a company’s creditors. As a result, changes to a company’s net worth that take place year to year are concerning and a proverbial “red light.” The Defense Contract Management Agency guidelines indicate that the balance sheet portion of a financial statement is only indicative of the company’s position as of that date. In other words, it is only through a profit and loss statement and a net worth reconcilement that changes in a company’s net worth can be adequately explained. Some “yellow flags” to look for as possible problem areas with a company’s financial statement are indicated below: • Accounts are not classified according to generally accepted accounting principles. • Financial statements are on a hybrid cash and ac- crual basis (showing accounts receivables, but not cash payable). 96 See Defense Contract Management Agency, Guide to Analysis of Financial Capabilities for Pre-Award and Post- Award Reviews, http://guidebook.dcma.mil/27/GUIDE%20TO %20ANALYSIS%20OF%20FINANCIAL%20CAPABILITIES. htm. 97 See id. at § V, C.4. 98 See id.

27 • Recording accounts or notes receivables from the officers of the company when the officers do not intend to repay the advances as loans. • Footnotes are missing from financial statements. • Investments in discontinued operations may not be written off. • Ratio of gross profit to sales appears unusual when it is compared to previous years.99 Additionally, in ascertaining basic due diligence infor- mation about a potential parent company, dozens of reputable business Web sites dedicated to storing public and financial information on domestic and international companies are listed in the Guide.100 G. Recent Examples of PCGs used in Transit Projects Like LOCs, parent company guarantees are a typical vehicle used to backstop the performance of a contract- ing party. Two prime examples in the rail sector are discussed at length in the Section IX case studies. Phase 1 of the Dulles Corridor Metrorail Project re- quired guarantees from the parents of both members of the limited liability company (LLC) that was serving as the design-builder. Houston METRO also required PCGs on the 4-Lines Project, with the guarantees being required for all of the major project contracts— including the DB contract. H. Subcontractor Default Insurance In addition to using LOCs and PCGs in lieu of surety bonds, a third form of alternate security has recently emerged on the market and is commonly known as “contractor default insurance” or “subcontractor default insurance” (SDI). SDI is an alternative product to sub- contractor performance bonds that provides coverage for the general contractor against a “catastrophic” sub- contractor default. In other words, SDI is a general con- tractor’s insurance policy that removes the subcontrac- tor’s surety altogether from the default equation. Public transit owners should have a working under- standing of how SDI is used, because 1) large contrac- tors on major projects are using SDI with more fre- quency; 2) though not intended for owners, SDI insurance policies are sometimes purchased directly by owners as a component to owner-controlled insurance programs; and 3) in the event of a default at the general contractor level, an owner may step in to complete the contractor’s scope, which may involve managing an SDI policy. SDI emerged approximately 15 years ago as a result of perceived deficiencies with subcontractor perform- ance bonds. The default of a major subcontractor can impact the overall project schedule, expose the general contractor to liquidated damages or other delay-related damages, and affect the work of other subcontractors. Faced with an imminent default by a subcontractor, a 99 See id. § VI, G. 100 See id. at 24. general contractor will typically make demand upon the subcontractor’s performance bond. Ideally, the surety should be ready, willing, and able to step in and remedy the default. But serious criticisms have emerged from those making bond claims that the response time for the surety to act is too protracted given the urgency of the project schedule.101 Also, as discussed in Sections III and V, the performance bond surety has the ultimate choice on how best to remedy the subcontractor default. The surety’s decision to remedy the default may be based upon reasons that are advantageous to the surety for business or legal reasons, but may not be in the best interests of the project.102 Addressing these perceived shortcomings of surety bonds, Zurich created an SDI policy known as Sub- guard®. It works as a two-party agreement between the contractor and insurance company, with the contractor procuring the policy as the named insured. The general contractor is responsible for prequalifying the individ- ual subcontractors and suppliers into the program. Coverage commences upon a formal declaration of de- fault, but the general contractor is not required to ter- minate the subcontract. The direct costs of default that are typically covered under the policy include costs in- curred in fulfilling the defaulted subcontractor’s con- tractual obligations, correcting nonconforming work, and attorney’s fees and consultant fees to remedy the default. Indirect costs that are covered include delay damages, acceleration costs, and extended overhead. In terms of pricing, there are three categories of costs a general contractor will have in procuring this insurance, some of which may or may not be shared with the project owner: 1) the premium paid to the in- surer; 2) the cost to manage the subcontractor prequali- fication and claims process; and 3) a loss-sensitive pre- mium “to build up a reserve for anticipated future claims.”103 The premium itself is typically 0.35 percent of the subcontract or purchase order enrollment value. Contractors can recognize a savings only if the SDI is priced to the owner at, or slightly less than, a surety bond, which is usually 1 to 3 percent of the subcontract value, and losses are contained.104 While Subguard is touted as being a “faster and more reliable” alternative to surety bonds, the mechan- ics of how the policy operates are three-tiered. When a loss is suffered, the first level of protection is self- insurance in the form of a deductible. The program re- quires substantial deductibles that normally range from $350,000 to $2 million per loss (subcontractor de- 101 See Dennis C. Bausman, Subcontractor Default Insur- ance: Its Use, Costs, Advantages, Disadvantages and Impact on Project Participants, Foundation of the American Subcontrac- tors Association, Inc. & National Association of Surety Bond Producers 9 (Sept. 2009), http://asaonline.com/eweb/ upload/Subcontractor%20Default%20Insurance%20Its%20 Use%20Costs%20Advantages%20Disadvantages.pdf. 102 See id. at 9. 103 See id. at 12. 104 See id.

28 fault).105 Once the deductible is reached, the next level of protection is the “co-pay layer.” This means that for losses between $1 million and $5 million, the costs are shared by the contractor and the insurance company on a percentage basis, with the contractor typically paying 20 percent.106 Beyond that level, the insurance company is 100 percent responsible for losses, and policies can have limits up to $50 million. From the owner’s perspective, to the extent Sub- guard helps ensure that the project is completed on time and under budget, having a contractor procure the policy can be advantageous. Additionally, to the extent a large loss is occasioned, the higher per-loss limits are considered beneficial to contractors and owners. More- over, because small, local, or minority subcontractors are unable to obtain surety bonding due to the rigorous prequalification process, some argue that an SDI policy “broadens the pool” of subcontractors that may not have bonding capacity.107 There are some potential disadvantages for own- ers.108 If the general contractor itself is not bonded, and the general contractor defaults with no surety to step in and remedy the default, the owner will have to assume the payment and performance risks of the contractor— including the responsibility to manage the SDI pro- gram. Because it steps into the shoes of the general contractor, the owner would be directly responsible for paying that first-dollar coverage under the policy for a catastrophic subcontractor default, on top of a contrac- tor default. Other disadvantages are that contractors may charge the owner a higher premium cost for the policy than is actually being incurred by the contractor. It should be noted that despite its widespread use, there are some critics of SDI generally and Subguard specifically. The American Subcontractors Association strongly opposes the contractor screening process in Subguard, as some subcontractors are reluctant to dis- close confidential financial information to the contrac- tor. In addition, the SFAA opposes SDIs on the basis that sureties are more qualified in the underwriting process to verify a subcontractor’s financial stability. Table 3 highlights the primary differences between subcontractor surety bonds and Subguard. 105 See id. at 11. 106 See id. 107 See id. at 16. 108 See id. at 33.

29 Table 3. Subcontractor Surety Bonds vs. Subcontractor Default Insurance Policies Subcontractor Surety Bonds Subguard® Definitions A three-party agreement among the surety, the obligee (the contractor), and the principal (the subcontractor). A performance bond protects the con- tractor from nonperformance and financial exposures should the subcontractor default. A payment bond, also known as a labor and material bond, protects certain lower- tier subcontractors, laborers, and material suppliers against nonpayment by the sub- contractor. A two-party agreement between the in- sured (usually the contractor) and the insurer. Reimbursement is for the contractor only for the performance default. There are no provisions to ensure that sub-subcontractors or suppliers get paid. Prequalification A surety company and producer assess the subcontractor’s business operations, financial resources, experience, organiza- tion, existing workload and its profitability, and management capability to verify the contractor is capable of performing the con- tract. The purpose is to avoid default. The general contractor assumes the prequalification process and is given lati- tude to determine who is enrolled. The enrollment can be project-specific, or by select subcontractors regardless of project affiliation. Duration Surety bonds remain in force for the du- ration of the contract plus a maintenance period, subject to the terms and conditions of the bond, the contract documents, and underlying statutes. SDI policy usually covers nonconform- ing work, including latent defects for up to 10 years. How to Obtain The contractor obtains the bond through a surety bond producer. A list of surety bond producers is available through the National Association of Surety Bond Pro- ducers at www.nasbp.org. The contractor obtains the SDI policy through Zurich Insurance.