July 19, 2002

Inquiries

General Policies Bureau

Construction Industry Section

Phone: 03-5253-8111 (ext. 24714 and 24725)

 

The Ministry of Land, Infrastructure, Transport and Tourism has conducted 6 meetings of this study group, which is comprised of outside experts, since December 2001 and at which the group has studied the possibility of introducing a new bond system for public works in Japan, the design of the system, and issues that need to be addressed. The results are summarized in this report.

 

●Report of the Work Study Group Concerning a New Warranty System

 

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Tender bonds are considered to be effective, as they hedge the contractor's risk by adding marketability to the process of contractor selection, which leads to sorting out and reorganization of the market, and exclude arbitrariness from selection of contractors for public works.

Furthermore, from the standpoint of protecting subcontracting companies from bankruptcy of the master contractor, requests have been made for consideration of subcontract bonds.

With regard to these demands, the study group studied the possibility of introducing a new bond system for public works in Japan, the design of the system, and issues that need to be addressed.

 

 

Tender bonds were considered between 1993 and 1994 as part of reform of the tendering system for introduction of general competitive tendering.

At that time, tender bonds were mainly considered from the standpoint of eliminating the arbitrariness of contractors and facilitating the inspection of contractors following introduction of general competitive tendering.

It was also evident that introduction posed problems, and this was considered to be an issue that required further study.

 

 

(1) The current state of tender and payment bonds

Tender bonds are obligatory for tender participants as a measure against the risk of the ordering organization (new tendering fees, etc.) when it does not obtain a contract even though a participant in a tendering for public works submits a winning tender. There are almost no cases of a tender bond being issued in which no completion bond is issued, and tender bonds are actually used as completion bonds.

In regard to payment bonds, the institution underwriting the bond pays the subcontractor in the case of bankruptcy of the master contractor. In the United States, a lien is accepted as a bond in the case of failure to pay for private work but not for public works, which utilizes the payment bond system to ensure that no situations arise in which a contractor and payment business demand payment from the master contractor when the master contractor goes bankrupt.

 

(2) The current state of bond companies and brokers

There are around 1,000 bond companies in the United States. In order to underwrite a bond, these companies require that the public works for the respective bond are registered with the federal or state government. However, in the United States, the number of bankruptcies of construction businesses due to the effects of the economic downturn and terrorism is also rising, the profitability of bond companies is in a slump, and the rigorousness of warranty standards and reduction in the warranty range are becoming apparent.

In the United States, regular construction businesses do not deal directly with bond companies, but instead deal with them through brokers. Brokers compare the ratios of the warranty costs of the bond companies and applies to the company with the best conditions to underwrite the bond. The brokers function as a market intermediary whose existence is also a buffer to avoid unnecessary pressure on bond companies.

 

(3) Credit inquiry

Credit inquiries for underwriting of bonds are strictly observed when the first bond is issued, and inspections at the time of tendering are relatively easy as long as they do not exceed the defined credit limit.

Credit administration for all construction business operators underwriting bonds is conducted centrally at the main office of the bond company, and their expertise related to risk management and risk dispersion for construction businesses is sound.

 

 

When inviting offers for public works, companies with strong management foundations compete and the risk of problems following order and securing accurate work execution are important issues; a system that requires warranties at the time of tendering participation is very effective as a measure to avoid risk for the ordering organization.

In addition, construction investments are decreasing at great speed, and as the impression of excessive supply in the entire construction industry is becoming stronger, promotion of selection and reorganization in the construction industry requires that orders for public works, which amount to around 1/2 of the market volume, follow market principles, and a bond system using market selection at the time of the tendering has great merits.

On the other hand, introduction of tender bonds would not lead to a higher level of transparency and competitiveness in tendering and contracting systems, although coupled with reform of the tendering and contracting system, it would have a certain effect on various improprieties related to public works.

In regard to subcontract bonds, it is necessary to study them with regard to protection of subcontracting companies from the risk of bankruptcy of the master contractor; however, unlike the United States, where the master contractor and subcontractor relationship is made clear in a contract, it is not uncommon for construction work in Japan to be conducted without clear contracts, and there is a great gap between business practices. It is unrealistic to expect subcontractor protection only from subcontract bonds.

 

 

(1) Character of the warranty at the time of tendering

There have been no cases in Japan where the winning tenderer refused to conclude a contract, and as it makes little sense to have a contract warranty for winning tenderers, it appears appropriate to request pre-approval of a completion bond (or a conditional contract) at the time of tendering participation.

 

(2) Investigation when underwriting a bond

Regarding warranty or completion bonds at the time of tendering participation, there should be an inspection of the construction business that wishes to underwrite the order for construction work in order to judge whether it has the credit to do so. It is difficult to rely on a tender bond for examination of the necessary technical capabilities when selecting a contractor for public works.

 

(3) Relation to selection of a contractor by the ordering organization

Selection of a contractor for public works is to be ultimately conducted as the responsibility of the ordering organization, and pre-approval of a completion bond should be one of the tendering participation requirements.

 

(4) Bond underwriting institutions

Institutions pre-approving a completion bond must have a clear understanding of the construction business' management situation and must be an institution that can define the credit range in accordance with the management situation.

Institutions that can potentially underwrite bonds include insurance companies and financial institutes, such as urban or regional banks.

 

(5) Construction work subject to completion bonds

1. Considering there are more than 85,000 public work contractors, the amount of office work would be enormous if institutions had to judge the management situation in time for each tendering in order to establish an organization's credit.

2. For mid- and small-scale work, the damage caused to the ordering organization if the contractor goes bankrupt is limited.

Based on this, large-scale construction work subject to general competitive tendering should be subject to completion bonds.

 

(6) Relation to the warranty system in accordance with the Accounting Act

Pre-approval of a completion bond should be obtained to ensure that a completion warranty can actually be obtained at the time of tendering participation and should have the status of a variant of the currently conducted completion warranty.

 

(7) Warranty fee for pre-approval of a completion bond (processing fee)

Pre-approval of a completion bond in Japan should be subject to a fee, as an examination is conducted at the time of tendering participation.

 

(8) Relation to management inspection

Even if the pre-approval of completion bonds is introduced, data is required as material the ordering organization bases judgment on for selection of a contractor, and as pre-approval of a completion bond must be limited to large-scale construction work, management inspections must be continued. Insurance companies also indicate that management inspections have a very important role.

 

(9) Subcontract bonds

Establishment of a system to easily conduct assessments, at least based on documents, of subcontract volume and proper master contractor and subcontractor relations with regard to rigorous conclusion of contracts is indispensable.

 

 

Insurance companies state:

1. There is a tendency for the reinsurance range of construction businesses in Japan to be narrowed by foreign reinsurance companies, and it is extremely difficult to secure new capacity for pre-approving completion bonds.

2. In the current state, there is doubt concerning the profitability of setup of a new system and securing the inspection personnel indispensable for handling the increased numbers of inspections and burden for credit administration.

It has been identified that, for these reasons, underwriting bonds through introduction of a new bond system at the current time is difficult.

It is difficult to make financial institutions, such as city banks and advance payment warranty businesses, the main underwriting institutions, and it is also difficult to establish new underwriting institutions in addition to the preexisting ones.

With regard to this, in the current situation, introduction of a system of pre-approved completion bonds is difficult due to the problem of the underwriting institutions.

 

 

While immediate introduction of a new bond system is difficult with regard to underwriting companies, the merits of introduction of a new bond system are great, and study of the following issues should proceed to make introduction possible quickly with respect to changes in the economic environment.

 

(1) Issues concerning design of a system that can be realized

1. Measures to increase the underwriting ability (capacity) of underwriting institutions

It has been acknowledged that one large issue for insurance companies as underwriting institutions is securing capacity, and therefore, measures to secure capacity are required first for realization of the system.

2. Relation between pre-approved completion bonds and establishment of credit range by underwriting companies

It is necessary to further intensify study concerning establishment of credit range from the standpoint of the winning tender and contract for all construction businesses that obtain pre-approval with reference to the model of the United States.

 

(2) Relation to other systems

1. Bond warranty ratio

The ratio of completion warranties is to be raised for construction work ordered by the Ministry of Land, Infrastructure, Transport and Tourism and subject to general competitive tendering, the expectation of risk hedging by contracting organizations, and suspension of orders from businesses with deteriorating management. When introducing pre-approval of completion bonds, it should be studied if the percentage should be set at 30% judging from the relation with the credit range of the underwriting institutions.

2. Relation to the advance payment system

It should be studied if there is enough room to also jointly revise the partial payment system with the introduction of pre-approval of completion bonds in regard to the demand that contractors for large-scale construction work have sufficient fundraising power, the payment ratio, and the payment methods in the advance payment system.

 

(3) Other

Regulations are necessary to determine whether proof of pre-approval of a completion bond should be submitted with the application for verification of tendering participation qualification in the case of general competitive tendering or whether it is enough for it to be submitted at the time of tendering.

 

(4) Issues for the system and utilization of subcontract bonds

1. In the United States, liens are accepted for subcontractor companies for private construction works and payment bonds have become systematized by law in order to prevent demand of subcontract money directly from the ordering organization by subcontractor companies for public works, which are excluded from the application of liens. Is it possible to introduce payment bonds as long as the prerequisite for this kind of system are different?

2. In Japan, it is not unusual for cases to occur where, judging from the documents, the contract between the master contractor and subcontractor is not correct, and there are cases where there are changes in planning of the construction work made before the contract has been changed. These examples differ greatly from the common contracting practices in the United States. Is it possible to make payments to subcontractors even if no contract is established?

3. In the United States, payment of debt to subcontractors is easily settled by lawsuit; however, in Japan, where court decisions take a long time, who is there to assess subcontract payment debts and under what standards can this be done?

 

(5) Study of measures for the protection of subcontractors

Regarding the protection of subcontractors in the case of bankruptcy of the master contractor, it is necessary to consider direct payment of subcontractors by the ordering organization.

It is also necessary to study how to make partial payments more concrete in order to reduce the damage to subcontractors through bankruptcy of the master contractor.

 

 

In order to realize a new bond system, it is indispensable to meet the requirements of having the market accept it first with regard to the problem of reinsurance. The reinsurance market is shrinking worldwide as an effect of the economic slump in the United States and terrorism, and this study group judged that it is difficult to introduce the system at present.

In the future, based on the results of the studies of this group, we expect that broad discussion and study by concerned persons will develop targeted at its realization.