The Three C’s of Surety Bond Underwriting and the Increasing Importance of Character
Before issuing a bond, a surety will evaluate a company using the three C’s: (1) capital, (2) capacity, and (3) character. And while suretyship is not a field that changes often, a small shift towards relying more on character in that evaluation has been making itself more visible in recent years.
Suretyship encompasses many traditional practices and is not always amenable to emerging trends. However, even the smallest change that occurs within the field can have a major impact. In evaluating a potential principal, sureties have gone back to focusing more on a potential principal’s character. As explained below, while construction companies seeking bonds have always focused on having sufficient capital and capacity, they now also must focus on having good character.
Just like how homeowners need homeowner’s insurance in the case of a flood or earthquake, builders and developers need bonds when taking on projects in case they develop issues with things like design, subcontractors, or supplies. However, while insurance and bonds may seem similar, they are actually very different. Bonds are more analogous to a form of credit that involves three parties where the bonding company (the surety) guarantees to the owner of the project (the obligee) that the contractor (the principal) will perform all its obligations under the contract. Subsequently, if the principal does not perform its duties, the surety must step in to ensure completion of the project and will then look to the principal for all the losses it incurs in doing so.
Due to the risks associated with underwriting a bond, a surety will meticulously evaluate a potential principal before deciding to issue a bond. In doing so, as is industry practice, the surety will focus on the three “C’s”: capital, capacity, and character.
A surety must ensure that a principal has the financial wherewithal to be able to complete a project and fulfill its obligations under a contract. As such, a surety will evaluate a principal’s cash on hand, its assets, and its current lines of credit. This is not, however, limited to a present-day analysis. It will also include an analysis of the principal’s future capital, because the surety will need to learn how much cash the principal may require from the surety in case someone makes a claim against a bond or if the principal may not have sufficient funds to complete the project.
When a surety looks at a principal’s capacity, it looks at the ability of the principal to complete the project under the contract. In addition to examining financial ability, the surety looks at a principal’s technical ability and ability to close out the bonded contracts.
A principal is technically able to perform the work if it employs or can secure the necessary manpower to timely perform it.1 Additionally, the surety must be assured that those people have the necessary expertise to do the work correctly. This includes on-site laborers, as well as administrative staff, such as accountants and project managers.
A principal’s ability to close out the bonded contracts is even more important. To assess this, the surety will look to a principal’s past projects to see what projects were ultimately completed. In addition, the surety will attempt to learn how the principal performed on a project that was known to have difficult issues.
While character has always been an important “C”, sureties are placing more and more weight on a principal’s character, because it is the key to a successful relationship between the principal and the surety.
In evaluating character, a surety company will assess whether a company is trustworthy enough to fulfill its obligations under the contract. A surety will look to the principal’s reputation in the market, including successes with prior projects and operational integrity, such as promptly paying its suppliers.
A surety will also look to whether the principal is good at communication, whether it is trustworthy, and whether it is honest in conducting business. The relationship between a surety and a principal is generally not a short one, especially if it involves multiple bonds for multiple projects, which is not uncommon. The surety and the principal must communicate regularly regarding any and all disputes that may arise, including those with supplies, laborers, or contractors.2 While the surety and the principal need not agree all the time, the surety must believe that the principal is doing everything it can to fulfill its obligations under the contract and that the principal will provide ready access to its books, records, and other necessary information.3 As such, communication, trustworthiness, and honesty are extremely important characteristics for a principal to have.
Character is evaluated not only in the potential principal, but also in the individual indemnitors who are the personal guarantors for the surety bond. Specifically, if the surety incurs losses on the principal’s behalf and the principal has insufficient funds to indemnify the surety for the losses, the individual indemnitors are responsible for the rest. As such, it is important for the surety to assess the same characteristics for the indemnitors.
Without good character in a potential principal and indemnitors, a surety will be extremely hesitant to issue a bond. Even if the principal has enough capital and the necessary capacity to complete a project, it means nothing if the surety cannot trust the principal to make a good-faith effort to complete the project and fulfill its obligations under the contract.
1 George J. Bachrach, et al., Bond Default Manual 265 (4th ed. 2015).
2 Id. at 268.
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