- Posted by Danielle Rodabaugh
- On August 14, 2012
No matter how much experience contractors have in the construction industry, they likely have some unanswered questions about contract bonds. Unfortunately, when it comes to contractor bonding, the quality of available information is limited. As such, the following primer will explore what contract surety bonds are, why they are required, and how they work.
First and foremost, surety bonds are legally binding contracts, which is why they are known as “contract bonds.” A basic explanation defines surety bonds as three-party contracts that guarantee certain tasks and/or obligations are fulfilled. The specific task varies depending on the type of bond and its purpose. Because bonds are issued on a multitude of private and public projects, thousands of individual surety bond contracts exist. No matter the exact title of the contract, each bond functions in the same basic way. The three different parties to the bond contract include:
- The principal, which is the contractor or contracting firm that purchases a bond to guarantee work quality and/or professional performance;
- The oblige, which is the project owner, typically a government agency, that requires the bond to protect against financial loss; and
- The surety, which is the insurance company that underwrites the bond and acts as an intermediary between the principal and obligee.
- The reasons that project owners require contract bonds vary. For example, the federal Miller Act requires contractors to provide payment and performance bonds for federally funded construction projects that are estimated to cost in excess of $100,000 before they can be cleared for work. Government agencies at state, county and city levels enforce their own contract bond requirements as well. Private project owners may also require the contractor provide bonds on a private project. No matter why a bond is required, most construction projects require three different contract bond types.
Bid bonds lock in bid amounts. When a contractor purchases a bid bond, it agrees to contract with the owner if its bid is selected. This assures the project owner that a contractor provides a serious bid. Bid bonds also verify that bidders have the financial capacity to take on the jobs on which they are bidding and prevents the contractor from increasing its bid after being awarded the contract.
Performance bonds ensure projects will be completed. When contractors fail to complete projects according to the contractual terms, performance bonds keep project owners from taking on financial loss. After it accepts a bid, the project owner might require the winning contractor to provide a performance bond before awarding the contract. Whether a performance bond is required, of course, depends on the specific project. Project owners can file claims on performance bonds when contractors abandon projects or complete them inadequately. If the claim is found to be valid, the surety that backed the bond is contractually bound to resolve the problem. In most situations, the surety will opt to find a new contractor to repair or finish the job; otherwise it will pay retribution to the project owner.
Payment bonds require contractors to pay their subcontractors and material suppliers. When contractors fail to compensate their suppliers, subcontractors and other miscellaneous workers, payment bonds ensure that they are paid appropriately. Payment bonds are often issued along with performance bonds; sometimes performance guarantees and payment guarantees are written into the same surety contract.
For construction bonds, surety contracts generally prevent against financial loss that may result from a contractor’s inability to perform the construction contract. If the event occurs that is covered by the bond (i.e. the contractor is unable to complete the project), the project owner (or, in the case of a payment bond, a subcontractor) can make a claim on the bond as a way to gain retribution. If the claim is valid, the surety must resolve the situation or pay reparation up to the bond amount.
When underwriting traditional insurance policies, insurers assume a certain amount of loss will have to be incurred. This is not the case with surety contracts. When writing bonds, insurance companies (sureties) intend to avoid all claims. They do so in two key ways. First, obtaining a bond is an extremely stringent and thorough application process; to put it simply, surety providers will not bond risky clients. Second, most surety contracts include an indemnification clause that requires the principal to fully repay the surety if claims are paid out. As such, indemnification clauses hold contractors financially accountable for potential performance problems (depending on the terms of the bond, sometimes the owner of the construction companies may be personally liable for the claimed amount).
Depending on the nature of the project, a number of other construction bond types (such as maintenance bonds, site improvement bonds, subdivision bonds, or supply bonds) may also be required. As with other types of contracts, contract bonds are unique depending on the exact legal language. A contractors should contact its lawyer if, at any time, they do not understand the contractual obligations included in their bonds.
Although contract bonds and the bonding process can be tricky to navigate for both contractors and their lawyers, government agencies and other project owners have viewed them as valuable loss-prevention tools for decades (a viewpoint that is likely to hold steady in the future).
Danielle Rodabaugh is the chief editor at SuretyBonds.com, a surety provider that works with construction professionals across the nation. Danielle writes to help construction professionals and their lawyers better understand the intricacies of contractor bonding. You can follow Danielle on Google+.