Construction projects take a long time to finish, and some contractors don't stay the course. A performance bond in construction is a form of insurance, compensating the client if the contractor fails to complete the project. A payment bond insures against the risk of the contractor not paying their subcontractors, who could then sue the project's owner.
TL;DR (Too Long; Didn't Read)
Many clients wanting large projects built require construction companies to pay for a performance bond before accepting them as the contractor. If the builder defaults, the bond company can hire a replacement or reimburse the client. If the contractor ran out of money, the bond company may provide enough funds to keep them going.
Performance Bond Basics
Performance bonds are one variety of surety bonds committing one party to carry out an obligation. Another example would be an estate trustee. They may have to take out a surety bond to guarantee that they manage the estate's money responsibly.
Like other surety bonds, a performance bond in construction is an agreement between three parties. The principal is the contractor completing the project, the guarantor is the surety company and the obligee is the client who wants the construction project built.
A bid bond reimburses the obligee if they accept a bid on a project but the contractor then backs out of the deal. Performance bonds guarantee the surety company will either see the project finished or reimburse the obligee if the contractor defaults. A payment bond similarly ensures the contractors pays their subcontractors and suppliers.
Why Obligees Want Sureties
From the contractor's perspective, being asked to take out a performance or payment bond may seem unfair. They're honest, and they're ready to work on the project to the end, so what could possibly go wrong?
From the client's viewpoint, there's a risk in signing a contractor, particularly if it's a startup or a company with which they've never dealt before.
- Contractors could go bankrupt before they even begin the project.
- Contractors could go bankrupt after the project starts.
- Contractors may run into unanticipated problems and fall behind their deadlines.
- An unethical contractor can simply pocket the client's money instead of paying subcontractors and suppliers. Rather than suing the contractor, the cheated parties usually find it easier to go after the client by filing a mechanic's lien on the property.
The federal Miller Act requires surety bonds on any public project worth more than $150,000. Most states have similar laws on the books for government projects.
Resolving the Problem
If the principal covered by the bond does default, the surety company has several options, though the terms of the payment bond clause may eliminate some of them.
- If the issue is cash flow, the guarantor can finance the principal's completion of the project. This is the cheapest, quickest solution because the principal already knows the project and has their equipment on site. However, it only works if the contractor is in a position to resume the job, and the obligee is OK with them returning to work.
- Provide the obligee with an acceptable replacement contractor. The replacement then signs a contract with the client to do the job. This can take a lot of time, and it's often impractical with government projects since the law may require the government to send out for competitive bids.
- Take over the project themselves. In this case, the surety company contracts with a replacement firm or firms, which is often simpler than having the obligee sign up the new contractor. However, the guarantor has to be careful not to wind up paying more for completion than the bond penalty would have cost them.
- Pay the obligee the penalty amount for which the bond calls. The obligee is then on their own as far as completing the project. This is the quickest solution for the guarantor, but it's usually the most expensive.
- Some bond contracts allow the guarantor to stand back and let the obligee complete the project and then pay the obligee for the work. This comes with a risk, as the guarantor then has no control over the scope of the work or the size of the bill.
If the surety company completes the project, they're entitled to whatever unpaid sums remain. For example, if the project is worth $2.5 million and the principal received $1.2 million before defaulting, the surety firm is entitled to the $1.3 million that remains.
Purchasing a Bond
If a construction company has to take out surety bonds to land a contract, it can talk to any of the many bond companies that offer performance and payment bonds. The contractor can also work through a bond broker to find an affordable bond deal.
If the contractor has good credit and looks unlikely to default, a performance bond usually costs 1% of the contract price. On a project worth less than $1 million, that could rise as high as 2%.
For example, if the contractor wins a bid on a $2 million project, the cost of the bond would be $20,000, or 1% of the price. That fee typically covers the payment bond cost as well.
Limits on Payment
Surety bond companies write bonds for principals when they're confident the risk of default is low. The payment or performance bond clause in the contract is often written to minimize the guarantor's risk. The obligee should review the terms to confirm that they're acceptable, and they have to abide by them to collect.
- Does the performance bond clause cover losses from delays? Some courts have ruled that if the bond doesn't specifically cover those losses, the guarantor is off the hook.
- Did the obligee give the principal a notice of default? Usually, the obligee has to notify both the principal and the guarantor to collect on the bond. The surety contract may spell out notification requirements, but in general, it's safer for the obligee to notify too much than too little.
- Is the contractor already in default, or is it that the client has seen the writing on the wall? Even if the default is inevitable, the surety has no obligation to pay anything until the default actually happens. They could, in fact, be in legal trouble if they intervene pre-default.
- Does the contractor dispute the default? This is tricky for the guarantor because they have obligations to both the contractor and the contractor's client, and it's hard to satisfy both.
- Does the performance bond cover the obligee's legal fees if a dispute goes to court? If it's not specifically covered in the contract, the obligee may be out of luck.
Defenses Against the Obligee
If the obligee declares the principal is in default, the principal and the guarantor may choose to fight back. Aside from the terms of the performance bond clause, there are several defenses available against a default declaration or against the guarantor paying out.
- There is no default, or the default is insignificant and immaterial.
- The obligee wrongfully terminated the contractor. Even if the contractor was in default, they can claim wrongful termination if the obligee didn't follow the law or the contract terms in ending things.
- The obligee didn't provide notice of default.
- The obligee paid the principal early. Suppose the obligee paid the contractor $100,000 ahead of schedule and then the contractor defaulted. The guarantor may be able to void the bond, as the contract balance is supposed to go to them.
- The client and the construction firm renegotiated the contract without consulting the guarantor, and the changes materially affected the guarantor's obligation and potential payout.
- Lance Surety: Performance and Payment Bonds
- ConstructionWorkZone: Performance Bonds – a Terrifying Thought?
- National Association of Surety Bond Producers: What Are Surety Bonds?
- Fullerton & Knowles: Performance Bonds
- UpCounsel: Contractor Refuses to Pay Subcontractor: Everything to Know
- National Society of Professional Engineers: A Basic Guide to Surety Bonds
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com