What to Know About Bond Liability Before Selling Your Company

Selling a construction business can be a bittersweet experience for contractors. Many companies started with a single owner, a few key people or family members. Cashing out is a reward for a lot of hard work and for substantial risks taken. However, some selling contractors learn the hard way that not all liability can be easily transferred. Specifically, the liability on contract surety bonds can be challenging and hard to eliminate. Below are some steps that can help mitigate these risks. 

Existing Contracts

Most selling contractors have many projects that are in various stages of completion. If these projects are bonded, this can create liability that continues long after the sale of the company is complete. Many contractors agree to personally indemnify the surety bond company in exchange for bonds. This indemnification is not easily transferred to another party. 

Even the best succession attorneys make this mistake. Contractually transferred liability in a sales agreement will not relieve a contractor of their indemnification obligations to the surety bond company. 

Here is an example: Contractor A has a contract with Owner 1, and Contractor A provides a performance bond and payment bond on the project. Contractor A then sells to Contractor B before the project is completed. Contractor B contractually agrees to assume Contractor A’s project liability. During construction, Owner 1 makes a claim against Contractor A’s surety bond. Contractor A believes it is Contractor B’s responsibility because they purchased the liability. 

Unfortunately, in this example, Owner 1 is holding valid contract bonds on the project. Contractor A’s surety will have to pay legitimate claims. The surety does not have a contractual relationship with Contractor B and will seek to be reimbursed from Contractor A. Contractor A may have a valid argument to be contractually reimbursed by Contractor B, but what if Contractor B does not have the funds? At best, this could end up taking time and effort to recover. At worst, it could end up in costly litigation or loss for Contractor A.

Solutions

Obviously, the situation above is not ideal for a selling contractor. However, this exact scenario plays out all the time. There are two scenarios that produce far better outcomes for all parties involved. These include new contracts or replacing bonds. 

New Contracts

The best outcome for selling contractors with outstanding surety liability is to end existing contracts and sign new ones under the new company. In this scenario, the new construction company signs brand-new contracts with project owners, and the new contractor’s surety bond company provides new contract bonds for each project. The existing surety bond company will refund any unearned portion of the contract bonds that were in place. 

The benefit to this strategy is that it accomplishes what each party wants. The selling contractor’s liability is limited to projects they oversaw while in control, and the purchasing contractor takes responsibility from the point of sale. The project owner is neutral as they still have a valid contract and bonds in place to get their project completed and protection to make sure bills are paid. 

The biggest challenge with this strategy is often with the project owners themselves. Owners may be reluctant
to terminate any existing contracts or sign new contracts. However, this process may be easier if the new contractor is an existing, strong construction company. Communication is key. Project owners should understand that they are better working with the new company that is actively interested in the success of the project. 

Replacing Bonds

When project owners will not end existing contracts, the next best thing is to replace the surety bonds. Replacing the bonds involves the new construction company providing surety bonds to replace the selling contractor’s bonds. The difference is that the existing contracts remain in place. The new contractor must get the old surety bonds back in exchange for the new bonds. 

This process can still create some confusion for project owners, but they do not have to close any existing contracts or sign new ones. As long as they have their required bonds, this is usually not a problem. Normally, the existing surety bond company will refund all premiums for the old bonds, but this is not required. The new bond company will certainly require premiums to be collected, and this could result in paying for two bonds for the same project. Finally, contractors should be aware that they will need a letter from the project owner stating that there are no problems on the project and that all payments are up to date. 

Remove Indemnity

Another mistake I have seen contractors make when selling their businesses is not requesting indemnity from a bond company. This becomes less of a concern with an asset sale but is a must for any stock sale. A letter should be sent to all bond companies the contractor has used in the past requesting that any indemnitors beside the sold construction company be removed. This can be a challenging task. Contractors may have used many different bond companies over the years and may have had a number of indemnitors. 

Unfortunately, I have seen this mistake come back to haunt selling contractors. These contractors thought they sold off their liability only to find the buyer in a bond claim in the future. The selling contractor may have had no involvement with the project, but when these claims happen, the bond company will go back through their file and look for all indemnitors and assets. A contractor could easily find themselves on the hook many years down the road. 

A best practice would be to send a certified letter to all surety bond companies the contractor has used. It should contain the date of sale and specifically state that all previous indemnitors request to be removed from future indemnity. It is important to note that this will not relieve any of the indemnitors from liability that was incurred for bonds written. Unfortunately, this liability can extend many years in the future. This is common for maintenance and warranty provisions. 

Selling a construction business is a great reward for sellers and an opportunity for buyers. However, too many contractors assume they can easily pass off their surety bond liability and are often surprised that they cannot. By taking a few extra steps upfront, contractors limit their long-term risks. Business transition attorneys and advisors serve a valuable role but should not be used exclusively by contractors. Always make sure to get the advice of a good construction attorney and surety bond advisor in the process.