An Overview of Contract Bonds
Contract bonds are a specialized type of surety bond that provide a guarantee between three parties: the owner of a project, the contractor who is performing the work, and the surety company. Sureties can be individuals or corporations, and they typically only issue contract bonds to those they have qualified to perform the work in question. For example, since the work subject to a bond has already been bid and agreed to by the parties, the surety generally has a mechanism to review the contractor’s previous work and performance, as well as their financial records.
A contract bond is not the same as insurance. While "surety" and "insurance" are sometimes colloquially used interchangeably, insurance policies operate on an entirely different mechanism. Insurance is there to protect the purchaser from unforeseen and unknown future obligations , meaning that the insurance company doesn’t know what risks it is underwriting. A surety bond, however, does not guarantee performance by the contractor; it guarantees the owner that, if the contractor fails to fulfill his obligations, another party will step in and do the work it was obligated to do.
There are many different types of contract bonds. For the purposes of this article, we will address the performance and payment bonds; we will have separate articles on other types of bonds later. The performance bond guarantees that the contractor will meet the obligations of its contract. The payment bond guarantees that the contractor will pay its subcontractors and suppliers. These two involuntary guarantees are the most common, but there are also instructive examples in the other types of contract bonds that the construction industry may encounter, such as maintenance bonds, supply bonds, subcontractor bonds, and may others.
Categories of Contract Bonds
A contract bond is a "B onds A,bility C ontractors are required to have for a project" that the federal government, a state government or some other public or private entity has put out for bidding. For the public sector, an owner requiring that the contractor obtain a bid bond, performance bond and payment bond (collectively known as contract bonds) is authorized by the Miller Act, for federally owned or financed projects, or by various state "Little Miller Acts," for state or locally financed construction projects. The Contractor will list the required contract bonds as a requirement of its contract bid. All three contract bonds are usually awarded by an insurance company, although certain surety companies are authorized to back the contract bonds required for the public sector under the Miller Act.
Bid Bonds
A bid bond is a form of insurance that the contractor provides an owner with prior to and as part of its bid for the contract for the project (the sealed envelope submitted by a contractor in response to a public or private invitation to bid on a construction project). Typical bid bonds will provide that, if the contractor is awarded the contract to do the work, within a certain number of days after the award, the contractor guarantees that it will enter into the contract and obtain the required performance and payment bonds, and it will be liable for a specified "penalty" of the bid amount to the owner in the event the contractor fails to meet its obligations. In the event the owner subsequently determines to accept the bid of a specific contractor, that contractor must be prepared to provide the owner with the performance and payment bonds within a specified number of days after the owner issues a "Notice of Award". If the Contractor fails to furnish the required contract bonds, the owner can make a claim upon the bid bond. The bid bond generally lists the amount of the award and the surety or bonding company liable to the owner. The owner may use the bid amount to have someone else perform the work at the contractor’s expense.
Bonding Company Fall-Down
Occasionally, a bonding company will fall-itsexposure to bid liability. If a bonding company becomes insolvent or goes out of business, the owner will be left with no recourse against it for bid bond liability. In that event, the owner is free to pursue its exposure under the bid bond against the other contracting parties.
Performance Bonds
Performance bonds protect an owner in the event the contractor fails to perform in accordance with the contract. The performance bond guarantees that the contractor will complete the work called for in the contract with the owner and that it will do so in full accord with the contract documents. If the contractor fails to perform in accordance with the contract, the performance bond will protect the owner from the loss suffered by the failure of the contractor to comply with its contract commitments. Typical performance bonds provide: (1) that "if [the contractor] having entered into a written contract … for the construction of [the project] … and in partial consideration thereof agree[s] to accept as security for performance of this Agreement, and performance under the Agreement, the Surety … SURETY, its successors and assigns, will make good on or reimburse to OWNER any loss or damage … resulting from the failure of … [CONTRACTOR] to perform in accordance with the Agreement."
If the contractor should fail to perform in accordance with the contract documents, the owner must notify the bonding company and the contractor of its intention to make a claim under the performance bond. The notice must identify the specific grounds for the claim. The bonding company must then either (i) make payments for labor and materials in accordance with the contract documents, or (ii) perform the contract through a substitute contractor or by hiring labor and purchasing materials itself thereunder, and may take any step necessary to complete performance. The performance bond typically will provide that it is upon the bond company to determine how it will proceed.
In the event the cost to the bonding company to remedy the situation exceeds the amount of the bond, the bonding company is liable to the owner for the amount of the excess over the bond amount. If the cost to the bonding company to remedy the situation is less than the face of the bond, the bonding company is entitled to return of the overage.
A surety is liable for all damages the owner suffers, including the cost of completion of the contract within the contract time, damages for delay and consequential damages. However, the owner is not entitled to recover (i) punitive damages and unreasonable liquidated damages, (ii) attorney’s fees or costs, and (iii) other indirect, consequential and special damages.
Payment Bonds
A payment bond guarantees that the contractor will make all payments for labor performed and materials furnished in connection with the performance of the contract by the contractor or any subcontractor or other person performing work or rendering service on the project for the owner. A payment bond will usually list the specific persons who are entitled to make a claim against the payment bond. The list of persons entitled to claim against a payment bond often includes (1) the owner of the project, (2) all subcontractors and suppliers to the project, (3) employees of the subcontractors and suppliers to the project, and (4) any other party entitled to make a claim against the contractor and its surety under the specific facts of the case.
A payment bond obligates the bonding company to make payment for claims covered by it up to the amount of the bond. Under most circumstances, the bonding company is liable to the owner for 100 percent of each claim, including claims covered by other bonds.
The Process of Contract Bonds
The mechanics of contract bonds are fairly straight forward. The contract bond process involves three parties: the principal, the obligee, and the surety. The party that obtains the bond is known as the principal, and the party to whom the bond is furnished is known is the obligee. The surety is, of course, the company that issues the bond. These relationships can be viewed in the following manner:
The "duty" of the surety under the bond is to pay the obligee upon its demand. The duty of the principal is to satisfy the demands of the obligee without calling upon the surety to make a payment. In effect, the principal is "guaranteeing" performance of an underlying obligation, and the surety is "guaranteeing" compliance with that guarantee.
For example, assume a contractor, XYZ Construction, applies for an AIA A312 Payment Bond to guarantee payment to suppliers and subcontractors on a project and that an AIA A312 Performance Bond to guarantee completion of the project. Assume that ABC Development is the obligee under the bonds and that A&B Surety Company is the surety. In this example, XYZ Constructions is the principal, ABC Development is the obligee, and A&B Surety Company is the surety. If the principal completed the project in accordance with its contract obligations and satisfied its subcontractors and suppliers, the surety would not be called upon. The principal would have satisfied its guarantees. If, however, a supplier filed a lawsuit against the principal and sought a money judgment for non-payment, the surety’s obligation could be triggered. In other words, the obligee, ABC Development, could make a demand against the surety, A&B Surety Company, and demand payment of the supplier’s judgment. Assuming that A&B Surety Company chose not to defend XYZ Construction, then the surety would be liable to the obligee for the judgment.
The surety is not, however, without recourse. The surety will have the right to look to the principal for reimbursement for any amounts that were paid. If A&B Surety Company in the above example believes that XYZ Construction did not pay the supplier and did not have a good reason for its non-payment, then the surety could look to the principal for all amounts paid to satisfy the judgment. In many cases, the surety will have a right to sue the principal for the amount paid to satisfy the judgment. In some cases, the surety may simply withhold the amount from future payments to the principal. Designers relied on surety and payment bonds because the owners’ rights were also protected.
Advantages of Contract Bonds
Contract bonds offer an array of advantages that both project owners and contractors should understand as they negotiate project terms. Primarily, contract bonds serve as a form of financial protection and risk management for both parties:
• Financial Protection: The principal’s surety company guarantees the principal’s contract with the bond, up to the bond’s limit. If the principal defaults on its contract obligations, the surety company pays the project owner. Essentially, the surety company financially backs the contractor’s promise to fulfill its contractual duties.
• Risk Management: Many project owners require contract bonds in order to manage financial risk. A surety company provides a guarantee that a contractor will satisfy its contractual obligations, and is generally more likely to vet prospective contractors thoroughly than a project owner might be able to. In this sense, requiring a contract bond can facilitate risk management because it gives project owners an assurance that the contractors with whom they choose to engage are both financially capable and able to deliver the promised quality of work.
In addition to financial protection and risk mitigation, both project owners and contractors, particularly smaller contractors, also enjoy several other, more specific benefits of contract bonds:
• Access to a Larger Market: In many cases, small- and mid-sized contractors do not have enough financial backing, assets or creditworthiness to be able to successfully negotiate and complete a contract. Contract bonds are one avenue that can allow smaller contractors to expand their operations. Because a contract bond is essentially a promise from the surety to honor another company’s promise to perform a specific obligation, smaller contractors are able to achieve a larger market share by putting up a bond for someone else’s contract. It’s important to note, however, that sureties will generally only offer a contract bond to a contractor with the resources to back up the promise. On the contractor’s end, this type of arrangement can work, provided there is a reputable contract with reasonable terms detailing the relationship between the companies.
• Affordable Coverage: Contract bonds are a relatively affordable form of business protection. However, it is important to understand that they are only available as a minimum requirement until the bond limit is reached.
How to Get a Contract Bond
To obtain a bond, a surety will usually require the applicant to complete an application for a bond, along with a personal financial statement of the individual principal(s) and/or financial statement of the business seeking the bond. A resume of the principal(s) (owner(s), officers, directors, etc.) is also typically required. For businesses that are owned by a closely-held relationship, such as husband and wife, partners or other familial relationships, a personal financial statement of each of the owners is typically also required. Some sureties may also request that an applicant provide three years of federal tax returns. In some cases, a surety may want to meet the applicant in person to get a sense of the business. The surety will then review the information in order to evaluate the bond applicant’s creditworthiness , experience and financial capability to perform the contract.
The application and personal financial statements generally contain or are accompanied by a myriad of questions and information. These questions and information usually include:
The information above is not only used by the surety to evaluate the bond applicant’s past experience, but also to assess the applicant’s character, reputation, financial standing, and also the applicant’s current ability to post a "completion bond" (if such is required). While these types of questions may seem to be somewhat intrusive, the surety’s inquiry of the bond applicant’s business history, finances and personal background are commonplace and of critical importance to the bonding process. Most surety underwriters will analyze an applicant’s financial information through a process known as "GAAP" analysis. In order to fairly evaluate financial statements, underwriters will apply Generally Accepted Accounting Principles (GAAP) in an attempt to quantify, adjust or add and subtract various items.
Common Issues with Contract Bonds
There are several common issues contractors run into when they first start using contract bonds. One of the easiest ways to avoid these issues is to be aware of what’s to come and plan accordingly.
I don’t have credit—can I still get a contract bond? If you are currently in business for yourself and are looking to obtain a contract bond, then yes, you might be able to get a contract bond without personal credit. However, this option is only available for certain types of contracts due to the nature of the work. For example, if you are doing a project under a $150,000 general government contract where you aren’t required to have an 80% bond, chances are that no one will require a personal indemnity. However, for all government contracts over $150,000, as well as private contracts, you very well may be required to have personal indemnity in place. The best way to figure out the specific requirements for the bond you’re applying for is to ask your surety agent, who should be more than happy to help you understand the requirements of each bond.
I have bad personal credit—does that mean I can’t get a contract bond? Having bad personal credit could result in an issue when applying for contract bonds. If a bond requires personal indemnity, then most likely your personal credit will be reviewed. For most sureties, this means running a consumer credit report with FICO scores. While some sureties will issue bonds despite poor personal credit, keep in mind that they may require collateral or a higher premium — either of which will cost you more money on the bond being issued. It’s important to remember that sureties are in the business of lending and they want their money back, so the less money out of their pocket the better. If you have significantly poor personal credit, then it’s likely that you will have a difficult time getting a bond without placing some collateral with a surety. Alternatively, if you only have bad credit because you’ve had some bad medical issues in the past (e.g. hospital visit that your provider didn’t cover, so hospitals are now listed on your credit report) then you can usually get a written letter from your primary care provider explaining the situation, which the surety might then accept to override the bad credit.
Contract Bond Frequently Asked Questions
These can be a tricky thing to wrap your head around. But, we’ve answered some frequently asked questions below to demystify it for you.
Why Do I Need a Contract Bond?
Contractors are required to have bonds to protect project owners. If your contract requires any kind of bond, it’s simply to protect your business partners.
How Much Does a Contract Bond Cost?
It’s dependent on project’s value. You’ll also need to pay some kind of premium for the underwriting process.
How Long Does It Take to Get a Contract Bond?
The amount of time can vary for a few different reasons. Different organizations will set different time tables for approval, and additional conditions might also affect your timeline. Generally, you shouldn’t expect a lengthy process for a small bond , but a complex one can take a couple of weeks.
What is a Contract Bond?
It’s a promise made in writing followed with the promise of a payment in the event that something goes wrong.
What Happens When a Contractor Fails to Fulfill a Contract Bond?
Depending on the situation, the bond could end up being subject to arbitration or litigation, especially if there are problems with the project itself. The third-party who issued the bond may also investigate.
How Are Contract Bonds Structured?
Contracts are generally structured with three different components as it sits between the three separate parties involved in the deal.
Are Contract Bonds for Government Projects Only?
No, a project doesn’t have to be government to require a contract bond. They can come up with all sorts of projects on all different levels.
