Chapter 1 — Introduction

State transportation departments rely on private industry construction contractors to build, rehabilitate, and replace their infrastructure assets. The FHWA is interested in ensuring that State transportation departments select contractors that can complete projects cost-effectively. One potential method to help select qualified contractors is to use a performance-based contractor prequalification process. FHWA commissioned this study to evaluate the wisdom of expanding the use of this process. This report presents the results of this study, which examined relevant literature, evaluated the benefits and costs of performance bonds and performance-based contractor prequalification, and recommended a model performance-based prequalification approach. Data regarding performance bonds and performance-based contractor prequalification was gathered through a thorough literature review; outreach to the State transportation departments, contractors and sureties; and case studies of five State transportation departments. This report investigates both methods of performance bonds and performance-based contractor prequalification and presents a performance-based contractor prequalification program that can be adapted to State transportation departments across the Nation.

The purpose of this study was to investigate the cost and benefit of performance bonding versus replacing performance bonding, to various degrees, with performance-based contractor prequalification. This final report includes recommendations on the cost effectiveness of performance bonds; guidance for State transportation departments that wish to develop and transition to a performance-based contractor prequalification system; and recommendations for how such systems can best be implemented. The specific objectives are as follows:

1. Document the benefits and costs of the current system of performance bonding in highway construction.
   
   
2. Quantify the benefits of replacing currently required performance bonds on some highway construction projects with a rigorous performance-based contractor prequalification system.
   
   
3. Provide State transportation departments with guidance on the development and implementation of the prequalification system.
   
   

The report includes the following:

• Chapter 1 — Introduction: This chapter includes a discussion of the motivation for this investigation, a performance bond background, and an overview of the industry outreach efforts. It provides the necessary background for the remainder of the report.
  
  
• Chapter 2 — Literature Review: This chapter presents an overall summary of the literature review, as well as the detailed review for each of the four focus areas of the literature review.
  
  
• Chapter 3 — Overview of Industry Outreach Efforts: In order to inform the research, outreach efforts were conducted with State transportation departments, contractors, and the SFAA. These efforts were conducted through surveys, interviews, and case studies. This chapter discusses all of these efforts.
  
  
• Chapter 4 — Benefit-Cost Analysis of Performance Bonds: The costs and benefits of performance bonds are identified and analyzed in this chapter. Additionally, this chapter further clarifies the definition of a performance bond, the roles of the surety, and determines a default rate for the industry.
  
  
• Chapter 5 — Performance Bond Paradox: This chapter discusses State transportation department views on performance bonds and compares those to the experience with default rates. This chapter also contains a recommendation for raising the minimum project size that requires a performance bond.
  
  
• Chapter 6 — Performance Bonds versus Performance-Based Contractor Prequalification: Building upon the benefit-cost analyses of the previous two chapters, a comparison of performance bonds and performance-based contractor prequalification is presented in this chapter. Additionally, an argument is made for increasing the minimum project size that requires a performance bond.
  
  
• Chapter 7 — Proposed Performance-Based Contractor Prequalification Program: This chapter presents a performance-based contractor prequalification program. The program includes a quantitative method for modifying the contractor bidding capacity, based on the results of performance ratings.
  
  
• Chapter 8 — Conclusions: This chapter presents the overall findings and conclusions of the entire research project.
  
  

We note that this research project was funded and administered by FHWA. While FHWA has a stewardship role in funding and administering Federal-aid highway program, the primary responsibilities for administering highway construction programs lies with the individual State transportation departments and local public agencies. The Federal-aid highway program is a federally funded/state-administered program. State transportation departments are responsible for virtually all aspects of highway planning, design, construction, maintenance and operations. Congress defined this relationship with implementation of the statutory provisions in Title 23 United States Code Section 145(a) — "Protection of State Sovereignty."

In light of this guiding principle, FHWA’s regulatory requirements for performance bonds in Title 23 Code of Federal Regulations Section 635.110 are relatively brief. These provisions ensure that State licensing, prequalification, insurance or bonding requirements be administered in a manner that does not restrict competition. Furthermore, in section 635.107 the participation by disadvantaged business enterprises (DBE), the State transportation department shall schedule contract lettings in a balanced program providing contracts of such size and character as to assure an opportunity for all sizes of contracting organizations to compete.

Unlike the Federal Miller Act that applies to direct Federal contracting, FHWA’s bonding policy does not specify the amount of a performance bond or when or how bonds must be used. This is a matter of state and local policy. So while this research provides important information for public agencies to consider in implementing their surety requirements, FHWA will not require the states to implement the research recommendations, but will consider the recommendations to be good practices that should be considered.

PERFORMANCE BONDS

A performance bond is a promise from a surety that monetary compensation or contract completion services will be provided to the owner if the contractor fails to complete all the services required under the construction contract, which thereby insulates the State transportation department from potential damages due to contractor default. Sureties’ performance bonds hold State transportation departments harmless in the event that a contractor (1) fails to complete a bridge or highway construction contract and then (2) is unable to provide a remedy for the failure, which typically arises from the contractor’s deteriorated financial condition. State transportation departments generally use one of three approaches for performance bonding: they bond the entire contract value, bond a portion of the contract value, or do not require performance bonds.

The Miller Act of 1935 made performance bonds a requirement for Federal construction work, and thus required any states that accepted federal funds for construction work to create their own legal requirements for performance bonds. Each individual State created its own specific Miller Act, known as “Little Miller Acts,” which define the requirements for performance bonds, including the percent of the contract value to be bonded and the minimum contract value that requires a bond. The amount of bond required varies across the nation, from 25 percent to 100 percent of the contract value. The vast majority of the States require a performance bond for 100 percent of the value of the contract. The minimum contract size that requires a performance bond also varies from State to State, and ranges from $0 to $300,000.

The performance bond underwriting process conducted by the surety is a process of prequalification, similar to the prequalification processes of State transportation departments. During the underwriting process, a given contractor is evaluated on three sets of criteria:

Character: The contractor’s reputation among subcontractors, suppliers, owners, and lenders, as shown by (a) administrative evidence, such as letters of reference; (b) the presence of certain systems and procedures, such as quality management systems and alternative dispute resolution methods; and (c) past performance, measured in terms of outcomes of past contracts.

Capacity: The contractor’s management practices, personnel, and equipment, as shown by (a) administrative evidence, such as resumes of key employees; (b) the presence of the systems and procedures that make up good management practices; and (c) past performance, measured in terms of outcomes of past contracts and whether or not they were completed without default, claims, etc.

Capital: The contractor’s funding capacity as shown by (a) administrative evidence of the net assets and net income reported in its financial statements and those of its owners, along with the assessments of other creditors; (b) the presence of certain operations’ systems and procedures, such as sound treasury management business practices; and (c) past performance, as reflected in the contractor’s credit score.¹

A contractor with a marginal track record for quality and timely completion, but the same level of financial assets as another contractor with a record of exemplary performance, will be able to furnish performance bonds, and hence will have the same opportunity to bid.⁽¹⁾ This method, if used alone, turns prequalification into merely an inventory of contractor assets and past experiences, without regard to the quality of the given contractor’s performance. A contractor with sufficient financial assets and marginal experience and/or performance would be found fully qualified. When a surety concludes that a particular contractor presents too high a financial risk, the surety will decline the opportunity to underwrite a bond for the contractor. The contractor is then forced to seek out another surety whose underwriting process or appetite for risk is more accommodating.

PERFORMANCE BONDS ARE NOT INSURANCE

A performance bond is like credit in that the surety provides a bond with the expectation of no loss. That is, the surety provides a bond only to those contractors that it has determined are capable and qualified to perform the obligation that is bonded. In addition, the contractor ultimately remains liable for a default. If the contractor defaults and the surety incurs a loss in remedying the default, the surety may seek reimbursement from the contractor. Insurance is fundamentally different in that losses are expected and the losses are ultimately borne by the insurer, who does not seek to recoup its loss from the insured entity. Car insurance companies, for example, do not prequalify the insured’s ability to prevent its car from being stolen; rather, the insurer can lower the premium on cars through the use of anti-theft devices. When a car is stolen, insurance pays out the value of the car, regardless of whether its owner has sufficient wealth or income to replace the car. The insurance premium reflects the insurer’s expectation that it will incur losses on a portion of the policies written.

This difference explains why insurance policies and surety bonds are priced differently. A significant portion of the insurance policy premium is a loss-paying component that, when coupled with the premium from all insurance policies, is used to pay claims. Because a surety does not expect a loss when writing a bond, the loss-paying component in the surety bond premium is relatively small. The premium is largely an underwriting fee for the surety’s prequalification review. While risk under an insurance policy is addressed largely by the amount of premium charged, risk under a surety bond is addressed by imposing additional credit requirements on the contractor or, ultimately, by not writing the bond.

Guaranteeing the Lesser of Contract Completion or Compensation

When a contractor fails to complete a construction contract or damages have been assessed against the contractor and it is determined that the contractor cannot pay those damages, the surety is required to make good on the damages (i.e., to either complete the contract or pay the owner the bonded amount).

The surety has the right to exercise options other than simply paying the amount of the bond. The surety is entitled to all the rights and equities of the owner, the contractor, or both, or to those of any others that benefit from the surety’s performance, in order to deal with claims from subcontractors and suppliers and resume construction under the contract. Given the choice of paying out assessed damages or completing the contract, the surety will choose the lower-cost option. The surety industry estimates that in almost all of the confirmed claims, its member sureties step in and actively manage at least a portion of the contract until its completion.

No Additional Guarantee of Construction Quality

Performance bonds underwrite financial risks, but are not a guarantee of all of the terms of a contract. Additionally, the terms that are specifically related to contract performance are only relevant to performance bonds when there is a risk of default. If, for example, a contractor has performed marginal-quality work that the State transportation department is forced to approve because it is under pressure to eliminate the congestion caused by the project’s work zones, then the State transportation department has no recourse to the surety, because a performance bond only applies in cases of default (i.e., where a serious breach has occurred and a contract is consequently terminated). A performance bond is not a guarantee of a certain level of performance; that is, a surety bond provides no guarantee against a contractor’s marginal quality of work, so long as the contractor’s failures are not large enough to trigger a default.

The worsening of a contractor’s financial position is generally the controlling factor in most instances when a contractor fails to complete a contract. In these instances, indicators that a contractor may not be able to complete the contract can be identified by the contractor’s financial position. These links result in sureties that focus their attention on both the financial capacity of the contractor and on monitoring and assessing the contractor’s general ability to complete its work.

Role of the Surety

Because sureties need to monitor and assess contractors by the completion of contracts and because they need to manage the completion of contracts to lower the costs of claims, sureties generally take responsibility for the following: (1) the assessment of financial risk before a contract is let; (2) the ongoing monitoring of the financial health and performance of the contractor while the contract is being completed; (3) the handling and adjustment of claims; and (4) the completion of a contract to mitigate the harm to the owner. However, little evidence, if any, was found of a surety proactively working with a contractor to avoid default before the State transportation department reports a contractor’s poor performance to the surety.

PERFORMANCE-BASED CONTRACTOR PREQUALIFICATION

Performance-based contractor prequalification developed to address the State transportation department need to evaluate the ability of a contractor to complete a specific project, over and beyond the contractor’s financial ability. Some of the different aspects evaluated through a performance-based contractor prequalification system are: prior performance, claims history, past project experience, timely completion of past projects, quality of material and workmanship, technical ability, quality assurance plans, safety plans, environmental plans, and traffic control plans. Alternative project delivery methods shift more responsibility onto the contractor for the quality of a project, and performance-based prequalification can evaluate a contractor’s ability to manage and produce quality work.

National Cooperative Highway Research Program (NCHRP Web Document 38) categorizes the reasons State transportation departments have implemented a performance-based contractor prequalification program as one of two types.⁽¹⁾ The first represents frustrations felt by both owners and construction contractors. These frustrations include the following:⁽¹⁾

• Public owners generally treat low-quality construction work no differently than high-quality construction work.
  
  
• Public owners indirectly reward poor workmanship because they do not penalize poor workmanship, which gives a bidding edge to those contractors who consistently perform poorly.
  
  
• Administrative prequalification merely establishes a benchmark for financial capacity and not for technical capability.
  
  
• Reliance on performance bonding does not insulate the State transportation department from marginally competent contractors who have a strong financial foundation.
  
  

Many of these frustrations spring from the State transportation department’s requirements to ensure “free and open competition” and to avoid unnecessary delays to much-needed transportation projects that result from bid protests. Most State transportation departments are required by law to procure construction projects in a manner that promotes “free and open competition.”⁽⁴⁾ This requirement has been interpreted to mean that the State transportation department cannot generally restrict the ability of any given contractor to bid on public works.⁽⁵⁾ If a contractor believes that a given procurement process unfairly restricts its ability to compete and win, the common remedy for that contractor is to protest the contract award.⁽⁶⁾ A protest requires the State transportation department to suspend the award of the contract, and hence the start of construction, until the protest is resolved, which thereby delays the prosecution of the work.

Because prequalification inherently entails a reduction in the level of competition, these programs have to be well designed and avoid arbitrariness. A State’s governing laws and regulations, as well as Federal requirements from the Miller Act (requiring performance bonds for Federal construction contracts), often constrain the State transportation department’s ability to implement performance-based prequalification. For instance, the Delaware Code provides that State’s transportation department with the authority to prequalify construction contractors and cites 10 specific reasons why a contractor can be found unqualified to bid.⁽⁷⁾ Two of these reasons, “inadequate experience to undertake the project” and “documented failure to perform on prior public or private construction contracts,” can be addressed through performance-based prequalification.⁽⁷⁾ However, neither of these reasons can apply to a marginally qualified contractor who had not been directly penalized for poor workmanship, as expressed by NCHRP Web Document 38.⁽¹⁾

NCHRP Web Document 38 also details a second, timelier reason to implement performance-based contractor prequalification. This relates to the movement to alternative project delivery methods and a greater reliance on contractor quality control (QC). In 1995, for the first time, 23 CFR 637B allowed the use of contractor QC testing by the State transportation department as part of the project acceptance decision.^(6,8) The report describes this motivation in the following terms: ⁽¹⁾

• Changes in regulations regarding use of contractor quality testing in quality assurance decisions and continuing reduction in State transportation department personnel will increase the need for “quality driven” contractors in public transportation construction projects. This change, coupled with more departments adopting performance-based and performance-related specifications, places more need on contractors to know and use quality management in their field operations management. With more contractors providing the quality control function, the State transportation department’s role would change to a quality assurance role. As one part of the quality assurance process, there is a need for comprehensive methods to evaluate a contractor’s eligibility to engage in work from a quality perspective.
  
  

The same sentiments were expressed in a Transportation Research Board paper focused on contractor-led QC:⁽⁹⁾

• As State highway agencies move further in this direction [the direction of contractor-led quality control], it is incumbent on them to first plan carefully during the procurement phase to ensure that they choose qualified teams. They must then draft contracts and specifications that put sufficient checks and balances in place so that these project delivery methods return quality equal to or better than that obtained by the traditional methods.
  
  

NCHRP Report 561 delved more deeply into the use of qualifications and past performance, including the use of both administrative and performance-based prequalification:⁽⁴⁾

• Best-value procurement methods allow various elements to be considered in selecting a contractor on the basis of performance. Objective elements include contractor experience with similar projects, completion within schedule, compliance with material and workmanship requirements, timeliness and accuracy of submittals, and record of safety. Subjective elements include effective management of subcontractors, proactive measures to mitigate impacts to adjacent properties and businesses, training and employee development programs, corporate commitment to achieving customer satisfaction, and client relationss... It is also recognized that, because of constrained staffing and budgets, it is not possible for State agencies to “inspect” quality into the work. Therefore, a procurement process is needed that considers value-related elements in awarding contracts.
  
  

Performance-based contractor prequalification is a vehicle for rewarding good performance and it satisfies a need to ensure that a better-qualified contractor with a record of good performance is entrusted with the increased autonomy in the quality management process required by contractor-led QC. Thus, the State transportation department properly discharges its responsibility to the traveling public to deliver a quality project with public money. To accomplish this purpose, the program needs to have all of the necessary components to collect contractor performance data, analyze that data in a meaningful manner, and use the performance output in the prequalification decisionmaking system.