What is a performance bond? Over the years I’ve felt like a complete chump more than once at the hands of a software developer or computer programmer.
When I talk to other business people, the rule of thumb seems to be, “When an IT company gives you a price and completion schedule, you need to double both as it’s going to cost at least twice as much and take twice as long as they tell you.”
My experience has been that a factor of three to four times is more like it. In some instances unscrupulous IT people (programmers, software developers and designers) have caused small businesses I’ve known to fold by failing to deliver on their promises.
The other consistent comment I hear from business people who have suffered at the hands of software developers who don’t come through is a silent shrug and a maybe a muttered, “What can you do?”
“Nobody’s madder than me about the website not working as well as it should, which means it’s going to get fixed,” Obama said during an appearance at the White House Rose Garden. But he didn’t specify exactly what went wrong or who was to blame for the problems, which include long waits to log onto the federally administered website and maddeningly long wait times once online.
People have complained about problems logging in at HealthCare.gov. Insurance companies have stated the information they’re getting is inaccurate or duplicated by confused applicants.
Our economy is based on the success of small business. According to the 2010 census there were 26.2 million establishments in the U.S. Of these, 12 million had less than 10 employees. Almost 41.5% of all employees work for a small establishment.
These establishments appear to be the most vulnerable to abuse in cost and time in the delivery of very necessary IT.
Years ago, when I went through two years of intensive training with my first insurance company, I spent a great deal of time working in the bond department. While watching President Obama struggle trying to explain how an IT SNAFU can occur, it was interesting to watch the various developers point fingers at one another. Anyone in business today could easily identify with hardware people blaming software people and vice-versa.
Having spent over forty three years in the insurance industry I immediately questioned, “Why aren’t the bond companies stepping to the plate?”
In all probability the government didn’t require a performance bond. Had they, things might have turned out much better. But our federal government has gone away from requiring bonds on IT work. They’re required by law to have performance bonds on any construction job over $100,000.
During college I was a materials engineer assistant for the highway department in my state. I spent my days testing aggregate samples and taking cement cores out of highways to make sure the specifications had been met. It was extremely interesting to me to get involved in contract performance bonds at my first insurance company job, for the people who I had worked with where the rubber hits I-94.
A performance bond, often called a surety bond, is an three-sided agreement under which one party, often called the surety, guarantees to another party, often called the obligee, the contracted (specified) performance of an obligation by a third party, known as the principal.
It’s much like a dialogue out of a movie.
The weepy heroine stares into the hero’s eyes. “I hardly know the guy,” she says of the character who has offered to help her, who the hero knows. “Why should I trust him?”
The hero draws himself up to his full height. “You trust me, don’t ya, dollface?”
“Of course.” She lays her head on his shoulder.
“Then I’m telling ya . . . you can trust him. Don’t worry. Should something crazy happen, and he doesn’t live up to his promises, I’ll step in and finish the job.”
Bonds are really that simple. It would seem a slam dunk for beleaguered businessmen to demand that software developers and computer programmers provide a bond, but it is a rare occurrence.
In some regards the underwriting of a bond resembles the same discipline a bank uses to grant a loan, although the surety does not make a loan. In fact, it may require the posting of a financial guarantee to the full amount of the bond.
The bond also appears to be like insurance, but it is not insurance, in that the surety will go after the assets of the principal should the principle default on the bond. A default occurs when the principle fails to meet, or is unwilling to meet, the contract terms. The surety will step in and pay the bond penalty or complete the project.
Often the bond company is put in the position of “big brother” to make sure disputes within the contract terms are settled equitably, short of a default.
The bond world is what makes the construction industry work as well as it does. There are four major kinds of contract surety bonds:
Bid bonds guarantee that the contractor will enter into a contract at the bid level and will provide the necessary bonds required by the bid specifications should the bid be accepted.
Performance bonds serve as protections for the obligee from financial loss should the contractor fail to meet the terms and conditions of the contract.
Payment Bonds make sure the contractor pays workers, suppliers, and sub-contractors.
Maintenance Bonds usually last two to three years after the Performance bond is completed and covers normal maintenance on the work that was completed.
Imagine the chaos if contractors weren’t required to carry bonds. The road contractors I worked with were a unique group of individuals. When I worked as an engineer’s assistant, I participated in many jobs being done by one of the largest road contractors in North Dakota. Years later I rented an office for my insurance agency in the basement of his office. His company built at least a third of the federal and state highway system in North Dakota in the 1960s through the 1980s. Imagine my surprise to find out that he made most of his major decisions based on astrology.
Of course, his bond companies did not use astrology. He consulted his astrological charts, while his bond company looked at his financial statement, work-in-progress reports, and a number of other tangible sources to affirm his judgment.
Part of my job while working in the bond department was to check contract bids to look for adverse patterns from our contractors. We reviewed all available bids, public and private, to make sure our bonded contractors were bidding prudently. If any of their winning bids were more than 10% low, we would seek to find out why. Sometimes the contractors had a geographic advantage, but even then it wasn’t good for a contractor to leave too much money on the table.
If a contractor was “buying work”, we would become suspicious of their intentions and would become much less likely to provide a bond for them.
Since many road contracts ran in the millions and the bond penalty could be as much as 20% of the contract value, or more, we wanted to be absolutely sure our contractor had the Capital, Character, and Capacity to complete the contract.
The Capital part of our diligence is probably the easiest to understand. The contractor could fail if they didn’t have the cash flow needed to make the contract work. Often the contract paid according to a completion amount, which required the contractor to front a certain amount of payroll and materials during part of the construction. Normally the contractor wanted to work on the principle’s money, but if suppliers were demanding, or cost overruns occurred, things could go bad.
Further, if things went wrong you wanted to make sure that when you, the surety, stepped in to finish the job, your contractor had the “net quick” cash necessary to reimburse your expense. The trick was to make sure your contractor actually had the money he said he did.
That’s where the Character part came in. The surety had to look at the contractor’s work history to determine what he’d done in the past. If he had been able to flow similar jobs and he was doing a good amount of work at what appeared to be profitable contracts, he would have the cash, based on his history. Moreover the surety would look to how the contractor treated his workers, sub-contractors and suppliers for indications of problems.
The other important part was Capacity. If the contractor was a building contractor, you would look at the total contract amount compared to the largest job he had done in the past. Then you would look at the total amount of contracts he had in progress. You didn’t want him to take on buildings more than 15% to 20% larger than anything he had done in the past. You also didn’t want his total volume of work, the total of all jobs, to grow too quickly. Most importantly, the surety needed to know if the contractor possessed the needed skill and expertise for that particular contract. If a road contractor was suddenly bidding on a building a school, it was unlikely he would get a bond.
A good bond underwriter was a very good communicator and often would have crucial face-to-face meetings with the contractors they bonded to discuss their plans for the year.
I had a great deal of respect for that road contractor in North Dakota, before and after I found out about his astrological decision-making process. I’ve learned that most business decisions are not as important as diligent monitoring and the willingness to adjust to achieve success. Watching him affirmed that notion.
So why aren’t performance bonds for software developers and computer programmers much more commonplace? The frustration and failure caused by IT cowboys is evident. It is clear from how the surety industry stands behind the construction industry that a system that serves as a clearinghouse is beneficial to all involved in major construction.
Wouldn’t it be nice to have a third party involved, with skin the game, when your IT contractor starts the normal “Scope Creep” dance in which they claim everything in the world wasn’t included in the original contract? Wouldn’t it be nice to have a third party review the contract specifications for your next IT project and declare the programmer capable of fulfilling his promises?
It’s possible, but it seems our government believes more in becoming bigger than it does in IT performance bonds, which hurts the industry.
The Department of the Treasury compiles a list of all certified sureties who wish to provide bonds for the federal government. Each company is listed with the amount of bond they’re approved to write. The T List is a ready reference for the surety industry.
A large percentage of contract bonds run to our government: state, federal, and local political subdivisions. I believe our government sets the tone for the bond industry in the United States.
In 2012, NASCIO issued a paper titled “Leaving Performance Bonds at the Door for Improved Procurement”. NASCIO is the National Association of State Chief Information Officers. Its primary members are senior officials from state government who have statewide responsibility for information technology leadership.
Their paper indicated a clear bias against the use of surety bonds for IT contracts.
- Sureties have raised the overall bonding costs by requiring the bonds be fully collateralized with a bank letter of credit.
- Requiring performance bonds has reduced competition because smaller companies don’t have the capital required to obtain bonding.
- Bond pricing has increased drastically due to early 2000s financial shake out.
- Failure to qualify for bonds adversely impacts small business.
- The intent of a bond is to pay for the expense (the state) incurs when the contractor fails to perform for procurement of a new solution.
- There are many alternatives to a bond through legal remedies.
The above statements slide into a conclusion that bonds are a waste of time and taxpayers’ dollars.
When I went through my bond training I was taught that if a bond underwriter does his job correctly there should never be a loss. Theoretically a bond underwriter can assess the potential for success for a project much better than someone outside the industry. As a fallback, the bond underwriter has a pulse of the contractor’s financial condition so if a default occurs the surety can attach assets to cover their loss.
- Sureties did raise the overall bonding costs by requiring the bonds be fully collateralized with a bank letter of credit. This was a logical response to uncertain financial times. Personally, I saw my business’ LOC go from over $600,000 at the start of the financial downturn to about $150,000 at its worst point. I can’t imagine why a state official would see anything nefarious about a logical response to what was occurring. The increased cost was a direct reflection of increased risk. Although only about 10% of all bond companies place IT related performance bonds, that still leaves a huge list of companies who are competing. I’m not a fan of state officials deciding they’re better at being a bonding company than actual sureties.
- When smaller companies don’t have the capital required to obtain bonding that should tell state officials something about that small IT companies capacity to complete the project. I’m a huge fan of small business, but it is illogical to think every small company is the Little Engine Who Could.
- While I agree the intent of a bond is to pay for the expense the state incurs when the contractor fails to perform for procurement of a new solution, the bond serves the much broader purpose of qualifying the contractors who can actually accomplish the job.
- Yes, there are many alternatives to a bond through legal remedies, but does the state have the time to be diligent enough about the financial condition of the contractor? It is a basic legal theory that you can’t suck blood from a frozen turnip. The state might prevail with a legal remedy only to find the contractor judgment-proof.
While I can certainly follow the paper’s logical conclusions, it would seem to ignore that the bond industry has served a noble purpose for state and federal government since at least the late 1800’s . . . and is not to be so summarily dismissed without adequate cause.
I’m a firm believer that government should only do what private industry can’t do. For individual governments to set up what amounts to a private surety seems counter-intuitive . . . and a false economy of savings.
It is disappointing to me that government, who should be taking a leadership role to bolster an industry that could be an amazing help to business, would take such a damaging stand.
Please understand that I’m the founder of the North Dakota Insurance Reserve Fund (NDIRF), which I created in 1985 when the private property and casualty industry was unable to respond adequately to the needs of North Dakota political subdivisions and state agencies. It is a self-insurance pool providing general, professional, and auto liability and inland marine coverage. Because of my actions creating NDIRF, the ND School of Medicine kept its doors open, several zoos were able to reopen, the statewide leafy spurge eradication campaign was able to continue, senior citizen buses were able to run, etc. . . . and over the years . . . the taxpayers of North Dakota saved millions of dollars.
But – had the private industry been able to solve the problems presented, I would have vehemently opposed the creation of NDIRF.
The surety industry needs to do a better job of marketing its services as a provider of bonds for the IT industry. It is our understanding that there is a ready market for at least those contractors who work with off-the-shelf type of software, service contract bonds for IT consulting, and help desk type of work.
From a personal standpoint, had I used that facility over the last few years I would be several hundred thousand dollars better off.
That’s not to say that users should forget about requiring . Software developers, Programmers and other Information Technology businesses have been insured by Technology Errors or Omissions insurers for Professional Liability for decades.
Tech E&O insurance has been written by numerous insurers both domestic (Berkley Tech, Chubb, Travelers, CNA, etc.) and offshore (London – Beazley, Hiscox, etc.) for quite some time. Most forms have their own unique product name, but in the end they are marketed as a Tech E&O policy. Within the scope of this almost exclusively Claims-Made, Defense-Within-Limit coverage are a number of fundamental grants that address things like failure of your goods products or services to perform.
Nearly all of these policies exclude what is covered under a General Liability contract: Personal Injury, Bodily Injury, Property Damage, Advertising Injury. What’s left to insure is financial injury – loss or damage sustained by a third party when none of the aforementioned have been triggered, resulting from your work or product.
Coverage concepts generally include:
- Failure of Your Work or Your Product to perform, including representations and warranties you make about the fitness or quality of said Work or Product.
- Loss or damage to Intangible Property (i.e. loss or damage to “data”).
So in theory, if an insured, a Software Programmer, represents or warrants that the website they are programming will handle 30,000 users at a time, but it actually crashes at 1,000 users – you may have a Tech E&O claim.
For a related article on Insurance Exchanges.
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Health Insurance (Includes Video)
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