How Surety Bonds Work in Case of Business Default

Millions of small businesses operate around the world every day, bringing products and services to the masses across several different industries. Resources abound for both current and potential business owners, including special lending programs, education courses on business management, and nearly any kind of outsourcing a business may need to operate smoothly. However, even with these tools in place, thousands of businesses shut their doors every year.

According to the Census Bureau’s most recent data on business failure rates, survival is not guaranteed. Manufacturing and service companies have a survival rate of 48.4% and 47.6% respectively, while transportation and construction businesses have a less than 40% chance of making it.

Several factors influence the success or failure of a business, but surety bonds are in place to help offset the financial loss customers may experience in the process. With a surety bond, customers or project owners are given some peace of mind that should a business default on the product or service they promised, a surety agency will cover a claim amount for damages. Surety bonds represent a cost to the business, but they are a crucial aspect of remaining on the successful side of the line for the long-term. Here’s how surety bonds work in the event a business defaults.

Types of Default

Small businesses can default for several different reasons, but the most common include:

  • Economic downturn – in industries like construction, a slowdown in the economy can mean trouble for business owners or contractors.
  • Financial issues – if cash flow is a problem within a business, delivering on promises made to customers or project owners may be a difficult task. This may lead to abandoning customers altogether, which leads to a surety bond claim. Unfortunately, bond claims then lead to higher bond prices, creating a cycle that some business owners cannot easily undo.
  • Performance issues – in certain industries, performance may be a problem that results in default. If the business is unable to complete a project within the timeline and budget agreed upon with the customers, it often means a claim against a surety bond.
  • Overextension – many business owners are driven to grow, but that drive can lead to overextension quickly. If a business is not able to keep its promises to customers or project owners because too much work was taken on, a surety bond claim may be the result.

Default Solutions for Businesses

When a business defaults for any of the reasons listed above, the surety agency they work with is likely to step in to help solve the problem. However, the route the agency takes to remedy the default depends largely on the reason for the default. There are some cases where the surety agency investigates a claim against a bond and finds that it is not credible. In these situations, the business owner is not penalized with a higher bond price or a claim against their bond, and work continues as normal. When a claim is legitimate, however, the surety agency will take one of the following steps:

  • Takeover – a takeover happens when a surety agency steps in to complete a project for the original contractor. A completion contractor may be hired to finish the job, especially when the project is near the end.
  • Tender – if the surety agency decides a tender is the right solution, they will not take over the project and assume control, but instead, they tender a new contractor to do so. In these cases, the project owner and the surety agency work together to agree upon the new contractor.
  • Contractor assistance – with this default solution, a surety agency may opt to provide assistance to the original contractor, offering additional personnel or financial help. This option is typically used when the surety agency has a strong relationship with the original contractor.
  • Obligee completion – in some cases of default, the surety agency can let the project owner finish the job on their own, typically by finding a new contractor to do so. Often a payment is made to the project owner to go down this path.

Surety agencies want to know that businesses are able to complete the jobs they take on for customers before approving a new bond application. However, things can happen that are beyond the business owner’s control. This is why various types of surety bonds exist. When default occurs, several options exist for a surety agency to help a business manage the situation, but it depends on why the default took place and how severe it is. Business owners should also note that a surety bond claim has the potential to increase their cost of a bond in the future. For these reasons, keeping claims to a minimum is key to ongoing success.

 

Eric Weisbrot

Eric Weisbrot is the Chief Marketing Officer of JW Surety Bonds. With years of experience in the surety industry under several different roles within the company, he is also a contributing author to the surety bond blog.

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