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F I S C A L I M P A C T R E P O R T

SPONSOR Rawson

ORIGINAL DATE

LAST UPDATED

2/14/2006

HB

SHORT TITLE Securities Requirement of Letter of Credit

SB 22

ANALYST McSherry

ESTIMATED ADDITIONAL OPERATING BUDGET IMPACT (dollars in thousands)

FY06

FY07

FY08 3 Year

Total Cost

Recurring

or Non-Rec

Fund

Affected

Total

($550.0) ($550.0) ($1.100.0) Recurring

Public

Schools

Facility

Fund

(Parenthesis ( ) Indicate Expenditure Decreases)

SOURCES OF INFORMATION

LFC Files

Responses Received From

Public Education Department (PED)

Regulation and Licensing Department (RLD)

New Mexico Department of Transportation (NMDOT)

General Services Department (GSD)

Energy Minerals and Natural Resources (EMNR)

Public Schools Facility Authority

SUMMARY

Synopsis of Bill

Senate Bill 22, “

Securities Requirement of Letter of Credit

” proposes to amend the Procurement

Code, NMSA 1978, Section 13-1-148, to allow a letter of credit or other security in lieu of bonds

for contractors and subcontractors for public works contracts.

The bill proposes that subcontractor bonds be executed by a surety company authorized to do

business in New Mexico, and approved in federal circular 570 as published by the U.S. Treasury

Department, or from a company approved by the state board of finance or the local governing

authority.

FISCAL IMPLICATIONS

According to EMNRD, an irrevocable letter of credit can be issued at lower cost than a perform-

Senate Bill 22 – Page

2

ance bond and, because of the savings, the proposed provision could lower construction costs on

public works projects. The Department cites typical fee for performance and payment bonds at 3

percent, and asserts that this cost is passed along to the owner as a construction cost. This sav-

ings could be passed along to the agency.

Additionally, EMNRD reports that, depending on the availability of the irrevocable letter of

credit, the pool of construction contractors available to public agencies may increase, allowing

more competitive bidding on public works projects.

PSFA asserts that the current subcontractor bonding provisions have limited competition and in-

creased the cost of construction for public works contracts, including schools, significantly:

Of the 32 new contracts that have been awarded with funding from the PSCOC since the

effective date of subcontractor bonding requirement, 17 have involved additional bonding

of subcontractors at a total cost of $550.0 thousand (see attached). In fact, the cost of

subcontractor bonds has exceeded the cost of the 100% payment and performance bonds

already being provided by the general contractors. In other words, the bonding cost more

than doubled with no benefit to the owner (schools or other public entity).

Estimated additional operational cost is estimated based upon the PSFA savings of $550 on bond

costs.

SIGNIFICANT ISSUES

The bill could require the State Board of Finance or local governing authorities to institute stan-

dards for bonding companies.

According to the PSFA:

Bonding of Subcontractors providing work of $50,000 or greater became effective in

June 2005 (13-1-148.1). The current statute does not specify who the subcontractor sup-

plies the bonds to or the form, so the majority of public owners have placed the onus on

the general contractor to specify the form and sufficiency of the subcontractor bonds.

This bill would require the owner (central purchasing authority) to specify and determine

the validity of bonds or other securities. The subcontractor bonds are in addition to the

bonds required of the general contractor and provide no additional benefit to the owner in

case of default.

The provisions of 13-4-18, also known as the “Little Miller Act”, require all construction

contracts awarded in excess of $25,000 to include a performance bond and a payment

bond each equal to 100% of the awarded bid amount. The bonds are primarily intended

to protect subcontractors and material suppliers by providing a remedy for recovery of

monies due for performing work or providing materials on a state or local construction

project. The owner and taxpayers are also protected as a mechanism to guarantee deliv-

ery of the contracted work should the awarded contractor fail to perform. This bill will

allow the owner to allow other forms or securities to be accepted by the owner.

NMDOT cites the following concerns:

1.

Upon the default of a contractor or subcontractor supplying a letter of credit in lieu of

a Performance Bond, the agency would be entitled to make claim against the funds on

deposit with the institution issuing the letter of credit, but would not be in a position

Senate Bill 22 – Page

3

to demand from a surety that it supply a completion contractor or that it otherwise

complete the project itself. The agency gets a pot of money, not a completed project.

Under such circumstances the agency cannot tap into the large body of surety law that

benefits the project owner in order to obtain a completed project.

2.

Due in part to 9/11, there is less bonding capacity now than before, and even when

surety bonds are obtainable, premiums may be exorbitant. Sureties are now more

careful about what kinds of projects and which contractors they will supply bonding

to. Sureties are more likely today to supply bonds on only simple straightforward

projects. This militates in favor of adding letters of credit as an option.

3.

An irrevocable letter of credit in lieu of a Payment Bond may be problematic. Cur-

rently, an unpaid worker or small business on a public works project can make claim

against a Payment Bond under the Little Miller Act by contacting the surety, which is

required to honor valid and properly documented claims. Sureties have the experi-

ence to investigate and deal with such claims—this is what they do. A banking insti-

tution issuing a letter of credit, however, may not have such experience. There is no

mechanism in SB 22 for how banks are to review claims made by unpaid subcontrac-

tors, suppliers, or material men. The procedures set forth in the Little Miller Act,

NMSA 1978, Section 13-4-19 only apply to claims against Payment Bonds.

EMNRD asserts that a letter of credit is only as secure as the credit of the issuing company, and

that state agencies may need to consider that issue. The Department points out that the bill does

not specify qualifications for the issuer of the letter of credit; whereas, under other state laws,

only letters of credit from banks authorized to do business in the United States qualify.

DFA reports that:

A letter of credit, which a is a letter from a bank stating that it has established a credit in

the company’s favor, is deemed to be just as secure as a bond to professionals in the field.

The letter replaces the credit worthiness of the contractor with the credit worthiness of the

bank issuing the letter. Therefore, as long as the bank is a reputable, financially sound

bank, there shouldn't be an issue. The bill sponsor may want to consider including cer-

tain financial requirements (i.e. a certain level of debt rating) for the issuing bank in the

bill.

According to GSD, a few contacts noted that a letter of credit could be more expensive than the

bond and that these costs, would be passed along to the state.

GSD further asserts that:

•

Performance and payment bonds assure that the project will be completed in a timely manner

and guarantees against defects. With bonds, a bonding company is responsible to verify the

claim and make reimbursements as well as complete any unfinished work.

•

A letter of credit is only a monetary assurance. With a letter of credit, it is the agency’s re-

sponsibility to:

o

Verify the claims and reimburse laborers or material suppliers if the awarded con-

tractor failed to pay; and

o

Get another contractor

to finish if the awarded contractor did not complete the project.

Senate Bill 22 – Page

4

PERFORMANCE IMPLICATIONS

Public School Facilities Authority (PSFA) reports that one of their goals is speed of delivery, and

to control costs and quality of public school construction. PSFA further reports that the subcon-

tractor bonding requirement has increased the cost of construction of public schools. The De-

partment contends that subcontractor bonding has reduced the pool of available subcontractors

and made it more difficult to obtain qualified bids, especially in remote, rural areas of the state.

PSFA asserts that bonding capacity has no correlation with quality of construction, and can favor

contractor profitability over ability to deliver quality.

ADMINISTRATIVE IMPLICATIONS

According to PSFA, the extent to which subcontractors can obtain bonding is unknown and this

provision could limit the number of subcontractors that are able to perform work on projects and

be problematic on small rural projects.

GSD asserts that additional administrative time would be required to process documentation nec-

essary to prove to the issuing bank the validity of a claim. The Department cites that this time

would not be required in the case of a bond; rules would have to be promulgated stating the re-

quired terms and conditions of the letter of credit.

TECHNICAL ISSUES

EMNRD asserts that many state agencies would have to be updated on the terms required in the

irrevocable letter of credit to ensure that the State is adequately protected in the event that the

irrevocable letter of credit needs to be invoked.

According to DFA, the first part of this bill, section 13-1-1-148.1, is unclear regarding to whom

the bond would be provided to. The Department contends that since the section deals with sub-

contractors, will the bond be provided to the state or to the general contractor.

PSFA asserts that numerous sections of the procurement code and related sections would be af-

fected by this bill and require language changes including the “Subcontractors Fair Practices

Act” and “Competitive Sealed Proposals for Construction.”

PSFA further asserts that the Subcontractors Fair Practices Act requires each subcontractor sub-

mitting a bid to a contractor to submit a payment and performance bond if requested by the con-

tractor. This section also allows the expense to be the responsibility of the subcontractor if the

contractor in his written request for subcontract bids states the amount and requirements of the

bonds.

OTHER SUBSTANTIVE ISSUES

PSCOA suggests that public owners may need to consult an attorney to review letters of credit

for an opinion regarding whether they would actually compensate the owner in case of a default.

The process for calling on the letter of credit may, in some cases, be even more cumbersome

than trying to collect on a bond.

Senate Bill 22 – Page

5

ALTERNATIVES

NMDOT suggests the following as alternatives to the proposed bill:

1.

Give agencies the option to accept irrevocable letters of credit in lieu Performance

Bonds, but not give bidders that option. Agencies could be required to make a writ-

ten determination when such an alternative security mechanism is warranted, and

would advertise that alternative in the Invitation For Bids. In the absence of such a

determination, bidders would have to furnish Performance Bonds.

2.

Permit contractors to furnish irrevocable letters of credit in lieu of Performance

Bonds, but continue to require them to furnish Payment Bonds. Unpaid workers or

small subcontractors may not have the ability to make claim against an irrevocable

letter of credit, and financial institutions may not know how to handle or evaluate

such claims. A Payment Bond may offer better protection to small businesses or in-

dividuals victimized by a defaulting contractor.

PSCOA suggests:

1.

Re-qualification of contractors by public owners; and

2.

Requiring general contractors to pre-qualify their subcontractors in order to provide

better safeguards and lead to higher-quality projects

WHAT WILL BE THE CONSEQUENCES OF NOT ENACTING THIS BILL

The current language in the Procurement Code and Little Miller Act which mandates perform-

ance and payment bonds on public works projects will continue unchanged

.

EM/yr