Performance Security for Integrated Project Delivery

Jonathan Dunn and John J. Petro have an interesting article in the Fall 2012 edition of the Construction Lawyer.  In case you don't have a photographic memory, or if you never got around to reading this,  it's well worth reading (again).  

We reproduce an excerpt here, discussing letters of credit, bonding, and default insurance in the context of integrated project delivery (IPD).  

A.  Integrated Project Delivery 

In response to perceived “fragmentation” and poor productivity in the construction industry, a few owners have embraced “lean” concepts and collaborative agreements for construction known as “integrated project delivery,” or “IPD.”  The main concept behind IPD is “to align the commercial interests of the major project participants and govern the delivery process as a collective enterprise.”  The goal of the IPD agreement is to eliminate traditional focus on risk transfer, and instead emphasize the relational aspects of the team charged with delivering the project.   

The IPD agreement is a relational contract … [that is] signed by the architect, the construction manager/general contractor (CM/GC) and owner … describ[ing] how they [are] to relate throughout the life of the project. … The [IPD agreement] seeks to create a system of shared risk, with the goal of reducing overall project risk, rather than just shifting it.  In part, this goal is supported by investing significant efforts in up-front collaboration, with the owner funding early involvement of the project team … The CM/GC is compensated on a cost-plus fee basis with either a guaranteed maximum price (GMP) or an estimated maximum price (EMP).  An EMP operates as a pain and gain sharing threshold, but limits the potential losses to the IPD team at their collective profit, keeping with the owner the risk of more significant cost overruns.   [Instead of] separate contingency amounts for design issues and construction issues[, t]he [IPD agreement] combines these contingencies into one IPD team contingency.  The core group of team members sets criteria and decides how the project contingency will be shared, which IPD advocates contend enhances productivity, and reduces project duration, cost and injuries.  IPD can be pursued through collaborative agreements, design assist agreements, or single purpose entities.    

Beyond the core group and signatories to the IPD agreement, risks for certain procurements in delivery of construction services, materials and equipment may be contracted out on a full risk basis. ....  In practice, it appears many projects attempting to use IPD theories are applying collaboration and shared risk and reward agreements only to some teams (e.g., the constructor/designer in design-build), but not the entire core construction team.  Additionally, insuring the IPD project may be a challenge that requires modifications to some endorsements or manuscript policies.   

B.             Surety Bonds & IPD 

At its core, the concept of surety bonds to secure the risk of non-performance seems in contradiction to IPD theory, which jointly obligates the IPD contracting parties to collaborate and share risk and reward toward a common performance criteria.  Indeed, a common condition of a surety’s obligation is the obligee’s performance.  How can the obligee’s performance be measured and determined if the principal and obligee are jointly charged with the obligation to collaborate together to jointly achieve the performance?
For these reasons, sureties have struggled with questions about underwriting bonds for contractors in IPD projects.  Common questions and concerns include:

• Who covers the design risks?

• Given these untraditional roles and relationships, does the principal have sufficient experience to justify surety credit (i.e., capability)?

•  
The scope of the obligation seems fuzzy, or not clearly defined.  Is the surety expected to cover the ambiguities or vagueness?

• What warranties is the surety expected to guarantee, especially where design and construction obligations are shared?

Thus, core group contractors may have difficulty obtaining surety bonds for an IPD project where it is their first endeavor unless they can show experience with the owner and designer, plus the surety is likely to limit its exposure, exclude design and warranty responsibility, and manuscript the bond language to add conditions on its obligation.  For non-core group participants with defined scopes and risk, obtaining surety bonds would seem quite routine and appropriate.  

C.              Letters of Credit & IPD 

Like surety bonds, the concept of hedging against contractual non-performance with a letter of credit for an IPD core contracting party seems like a contradiction in theory.  However, to the extent a surety bond or letter of credit can be prepared to cover the primary risk of insolvency protection, either would seem appropriate and reasonable given the likely damages to the other project participants if one of the core contractees had to abandon an IPD agreement due to its financial woes.  Generally, neither letters of credit nor bonds, as explained above, are considered part of the bankruptcy estate.
Between the two, standby letters of credit are likely to result in faster cash relief given the principle of independence, which would assist the core group as it searches for a replacement of its defaulted member, but surety bonds might afford greater eventual relief if insolvency were truly principal’s basis for default because letters of credit are typically for amounts equal to a small percentage of the contract price estimate, while surety bond amounts are typically 100% of the contract price.  With respect to non-core group IPD contractors and suppliers, traditional approaches to surety bonds and letters of credit are appropriate.   

D.             Subcontractor Default Insurance 

With respect to the construction aspects of IPD projects, default insurance in conjunction with other policies, may be a viable option.  Some considerations for default insurance in IPD projects include: 

Larger projects may justify large deductibles and co-pays;

• Endorsements may allow coverage for CM/GC, owner and designer;

• May cover design/build subcontractors so long as design obligations are “incidental;”

• Insurers may be able to accommodate risk/reward sharing of IPD agreement; and

• Damages (after deductible and co-pay) are not limited to the amount of the subcontractor’s agreement if larger limits are provided.

In short, there may be some advantages to default insurance on very large projects where time is critical to the overall delivery goals. 

Observations:

To me, performance guarantees for a contractor and architect in IPD does not seem that novel or unusual.

1.  The Contractor:  The contractor's bonding company simply guarantees that the contractor will do what it is supposed to do in accordance with the three party agreement, i.e. BUILD THE BUILDING.  The obligation is limited by the penal amount of the bond, so the fact that there may not be definitive price should not be a problem.   Similarly, the fact that IPD is a relational agreement that employs Lean principles, and more collaboration than usual would not seem to present a problem for the surety.   As professor Carl J. Circo's article in that same issue makes clear:  all construction contracts are relational in nature.  The collaborative model of IPD is geared to reduce risk, including the risk of the surety.  So I don't see why sureties would shy away from this once they get used to what it is.

In a traditional design-bid-build delivery model, the contractor--and hence the surety--has unlimited risk on the cost side to finish the project when things go wrong.  If there are cost overruns, the contractor or its surety must complete the project without payment, and they can then litigate with the owner later over responsibility when the project is finished.  If I'm a surety, that makes me nervous.  In an IPD model, the owner bears the risk of cost overruns once the contingency pool, including some or all contractor profit, is used up.  In other words, if I'm the surety, I like that.  I have less risk.

I don't see how the contractor's surety is more nervous about "who has the design risk."  The architect of record has the design risk, just as always.  On a traditional design-bid-build project, the plans can be "for shit" too.  The IPD model makes it less likely that this will be the case.  If I'm a surety I don't think this presents more risk;  I think it presents less risk.

2.  The Architect:  Architect's typically are not required to post performance bonds.  I think that's a non-issue.

3.  Insurance:  There is a real problem with traditional insurance products and IPD.  The industry must move away from liability based coverage and learn to price the risk of projects not hitting their estimated targets, not completing on time, or manifesting latent defects over a suitable tail period WITHOUT FAULT.   Until such insurance products become available, IPD will struggle.