Question 3 of 6: Insurance — bid bonds, performance bonds and retainage

Question 3: Insurance — bid bonds, performance bonds and retainage (20 marks)

Question text not reproduced: the examination questions are © Engineers and Geoscientists BC. Open the official past paper (linked at the top of this page) to read the question, then follow the worked solution below.

A surety bond is not insurance, although the question groups it under that heading and the same companies write both. Insurance is a two-party contract in which the insurer prices an expected loss and absorbs it. A bond is a three-party instrument: the principal (the contractor) promises something to the obligee (the owner), and the surety guarantees that promise. The surety underwrites the contractor rather than the hazard, prices the bond as a credit facility at roughly half to one percent of the bonded amount, and retains a right of indemnity against the contractor and its principals for everything it pays out. A bond therefore transfers the owner’s exposure to a solvent third party without relieving the contractor of a dollar of ultimate liability, and a contractor consumes bonding capacity every time one is issued.

The bid bond (CCDC 220 in Canadian practice) attaches to the tender, not to the work. It guarantees that if the bid is accepted within its stated irrevocable period, the bidder will execute the contract at the tendered price and furnish whatever performance and payment security the tender documents call for. Its penal sum is customarily ten percent of the bid. If the low bidder walks away — typically because it discovers an arithmetic or scope error after opening — the surety pays the owner’s actual damages, which are measured as the difference between that bid and the next acceptable one, capped at the penal sum. Its life is short: it expires the moment the contract is signed and the construction bonds are delivered, or when the tender period lapses. Its purpose is to make a tender genuinely irrevocable and to screen the field, because a bidder who cannot obtain a bid bond has already failed a surety’s credit review and should not have been in the competition.

The performance bond (CCDC 221) attaches to the contract itself and guarantees completion of the work in accordance with its terms. Its penal sum in Canada is normally fifty percent of the contract price, and one hundred percent on many public projects, and it stays in force for the whole construction period and usually through the warranty period. The trigger is different in kind: the owner must first properly declare the contractor in default and terminate its right to continue, at which point the surety may choose to finance the existing contractor, arrange a completion contractor by tender, complete the work itself, or simply pay the owner’s loss up to the penal sum. The quantum is different too — the bid bond covers a re-tender differential measured in a few percent, while the performance bond covers the cost of completing a partly built project, which can approach the full contract price. In practice the performance bond is nearly always issued together with a labour and material payment bond (CCDC 222), which protects subcontractors and suppliers who have no privity with the owner and whose unpaid claims would otherwise return to the owner as builders’ liens.

Retainage, or holdback, is a quite different security device: instead of buying a third-party guarantee, the owner simply keeps part of the contractor’s own money. In Canada the mechanism is statutory as well as contractual. Every province’s lien legislation requires a lien holdback — ten percent of the value of the work in British Columbia under the Builders Lien Act, held for 55 days after certification of completion, and ten percent for a comparable period under the Ontario Construction Act and the Alberta Prompt Payment and Construction Lien Act. Contracts frequently add a contractual retainage on top of the statutory one, and CCDC 2 GC 5.5 and GC 5.6 govern its release at substantial performance and its progressive release.

For the owner the cash-flow effect is favourable and the risk effect is strong. Ten percent of every monthly draw stays in the owner’s account, so the owner earns the carry on a growing balance that peaks at ten percent of the contract value near substantial completion. That fund is the owner’s only self-help remedy for deficiencies, incomplete commissioning and unfinished punch-list work, and it is the statutory answer to lien claims by unpaid subtrades. Its risk value is that it can be applied immediately, without declaring default, without notifying a surety and without litigation — which is precisely what a performance bond cannot offer. The offsetting costs are real but secondary: in several provinces the holdback must be maintained in a separate trust or holdback account and cannot simply be commingled; releasing it late exposes the owner to interest and to prompt-payment adjudication; and because contractors price the financing cost of being held out of their money, an aggressive retainage percentage is recovered in the bid.

For the contractor the same clause is usually the single largest negative item in the project cash-flow curve. The contractor pays labour weekly, materials in thirty days and subtrades on receipt of the owner’s payment, but recovers only ninety percent of each progress claim, so it is financing ten percent of all work in place for the entire job and for the lien period after it. On a general contractor’s typical net margin of two to five percent, the retained amount exceeds the whole profit on the job long before completion, which means the contractor is lending the owner more than it will ever earn. The consequences are a larger operating line and the interest that goes with it, reduced bonding capacity because sureties underwrite working capital and the holdback is a slow-moving receivable, pressure to front-load the schedule of values so that early draws recover overhead sooner, and a strong incentive to close out deficiencies quickly. The burden also cascades: the general contractor holds back from its subtrades, who hold back from theirs, so the smallest and least-capitalised firms in the chain carry the greatest proportional strain. Sensible mitigations, all common in Canadian practice, are progressive release of holdback on early-finishing trades and on completed phases, reduction of the retainage percentage once the work is fifty percent complete, substitution of a letter of credit or a retention bond for the cash, and the annual or phased release now permitted by the prompt-payment regimes in Ontario, Alberta and Saskatchewan.