What is Contract Bond?
Contract bonds are essential in the construction industry, requiring contractors in the public and private sectors to obtain bonding for their services. Contract bonds are a type of surety bond that provides a guarantee from a surety company that the terms of an agreement will be fulfilled. If a bond is forfeited, the surety company will provide compensation to the obligee.
Contract bonds are designed to provide a level of security for all parties involved in a project. The parties to the underlying contract for which the bond is issued are known as the principal and obligee. The obligor, the surety company who issues the bond, will provide the principal (the contractor) with the funds required to complete the project if they are unable to do so themselves. In most cases, a court will be involved in providing approval or appointing a receiver to oversee the project if the principal is unable to fulfill the contract. The funds disbursed to the obligee by the detour through the obligee will be reimbursed by the principal to the surety company. Therefore , the principal may face additional liabilities resulting from supplemental costs incurred by the Surety Company. A contract bond is similar to a performance bond, with the exception of having a broader application. The most common type of contract bond is the one submitted in order to obtain a construction contract. However, contract bonds can also be used to enforce other types of contractual agreements. The following are the types of contract bonds frequently encountered in the construction industry. The purpose of a contract bond is to provide security for everyone involved in a construction project. Contract bonds are most commonly required in the public sector but they may also be required on various private contracts. Although the purpose of contract bonds is primarily the same as performance bonds, they are used in a wider context.
A Guide to Performance Bonds
Contract bonds are an essential part of the construction contract process, but many may not understand the difference between a contract bond and a performance bond, or the reasons why they are necessary. In addition to performance bonds, there are also contract bonds and payment bonds.
A contract bond assures that the contract provisions will be adhered to and the work will be completed per the terms and conditions if the contractor defaults. There are three types of contract bonds: bid bonds, performance bonds, and payment bonds. A bid bond is a guarantee that a contractor will enter into a contract, at a specified price, if their bid is accepted. If the contractor does not, the bonding company will pay the entity requesting the bond for the cost of a new bid up to the amount of the bond, usually three percent of the contract bid. So, if you are a contractor and have a $1 million bid bond and do not enter into a contract with the project owner, you will need to pay the bonding company $30,000.
Duplicating the bid proposal prepared by the contractor also costs money. If the bond amount is large and the contractor is unable to enter into the contract for some reason, the bonding company will compensate the contractor for duplicating the bid, up to the amount of the bond. After a contractor wins a project, the bonding company then issues a performance bond.
A performance bond guarantees that the contractor will complete the project in accordance with the contract. In essence, the bonding company is saying we believe this contractor is capable of completing the work as specified and we will, therefore, bond them for the contract amount. A bonding company will not issue a performance bond for a contractor who has a history of defaulting on projects. The bonding company is then liable for completing the remaining work if the contractor defaults. Therefore, bonding companies are diligent in investigating contractors prior to issuing a bond. Performance bonds are often considered insurance against loss of product or financial loss, as well as assuring completion of the project. Without performance bonds, many contractors would not be able to compete for work on capital improvement projects.
The Difference Between Contract and Performance Bonds
Before delving into understanding Performance Bonds, it is important to differentiate between the various types of bonds that might be involved in the procurement of a construction project. Contract Bonds provide an excellent framework for a holistic understanding of Performance Bonds.
Contract Bonds refer to a surety bond issued on behalf of a contractor in connection with the performance of a contract. Performance Bonds are just one type of Contract Bond.
In sum – all Performance Bonds are Contract Bonds but not all Contract Bonds are Performance Bonds. Contract Bonds include Bid Bonds, which are intended to provide assurance that a contractor who bids on a construction project will enter into the contract and perform if awarded the work. The parties to the contract are the owner of the project and the contractor who receives the award. In contrast, Performance Bonds provide assurance, after the award is made, that the awarded contractor will perform the work. The benefit of a Performance Bond runs to the obligee, who is a third-party to the underlying contract.
How Contract Bonds Secure Project Owners
Contract bonds provide a solid financial safeguard for project owners on large construction projects. Essentially this protection comes in two ways. First, they protect the owner from contractor default. They also ensure contractors abide by all the terms of the contract, rather than cutting corners in the process of doing the job.
Because contract bonds provide the owner with a financial safety net in case the contractor defaults, it’s important for project owners to require them on every public project and for every subcontract over a specified amount. This amount can vary by state, but typically the requirement is $25,000 or more. Failure to get contract bonds in place, or accepting low rated or no bonds at all, makes you vulnerable if a contractor or subcontractor fails to complete their job. Whether or not payment bonds are available on the project, the contract bond will pay for the damage to your interests caused by the default. But if you don’t have the contract bond and the materialman, laborer or subcontractor that is owed money chooses the surety over you, then you have no recourse. You likely will have a bond claim you need to present to the surety company within the short timeframe specified in the bond form.
Although contract bonds are a protection for a project owner, they most often tend to benefit laborers and materialmen. The owner is able to pass off a lot of the credit risk associated with a project to a third party surety company that has rated its performance and financial strength. These contract bonds give many contractors and subcontractors reassurance that the federal government, state government or other private owner will not ignore or delay payment. The surety company assumes the responsibility of supplying materials and laborers or paying the subcontractor directly. The surety company also assumes the risks of the contractor that could lead to default or bankruptcy, such as financial or credit problems, inability to pay creditors, substance abuse, or lack of expertise to perform the work or meet the schedule.
Surety companies do their homework on the contractors they provide bonds for, vetting them by looking at their credit reports, bank statements, financial statements, resumes, invoices, and anything else that might indicate whether they should be issued a bond. They look for contractors who have been in business for a couple years and are reliable, getting the little things done on small jobs and with a customer base that vouches for their timeliness and quality of work. Sureties will also want to know how the contractor will handle change orders, which they must budget for and still stick to the fixed sum of the contract price. These and other factors make it virtually impossible to secure a bond without proof of financial stability and past performance.
While many contractors and subcontractors may feel like they have the upper hand when bidding for work, the bottom line is that they will have difficulty securing a bond unless they are good risks.
The Importance of Performance Bonds for Contractors
Performance bonds, while not mandatory in every construction project, have become the industry standard. When a contractor signs a contract to complete a construction project, they take on a serious obligation to complete the work according to contract specifications and on-time. If they fail to do so, the client or owner cannot recover any lost profits or costs unless it was stipulated clearly in advance that the contractor is assuming these costs and risks. It was common, in decades past, for owners to have the general contractor pay subcontractors so that they, the owners, could avoid liability for the subcontractors’ negligence and defects. However, as an increasing number of cases have found, the contractors themselves are the best parties to bear the risk of negligent subcontractors or laborers since they are much better able to plan and account for such contingencies, and to absorb liability through increased rates charged to clients and subcontractors.
The main problem associated with failed projects is simply the lack of ready cash to keep the project going when there are critical delays in progress. Government agencies are still able to assert eminent domain and commandeer funds, but this is not true in private contracts . The missed deadlines and promises of the contractor to finish the project thus means nothing to the private owner who is left to find volunteers, friends, or other contractors who will pick up the slack and finish the job, all for little or no money. Performance bonds therefore protect the owners of the project by assuring them that if the initial contractor cannot fulfill their obligations, a third-party will step in without any delay to pay to either find a replacement contractor, or, if need be, to complete the job themselves.
For a contractor, performance bonds are important because they are the financial assurance that they will be able to fulfill their end of the bargain and are expected to be able to pay to finish the job if necessary. Often, a client will not hire anyone who has not paid for a good performance bond because this will represent that the contractor does not have enough confidence in their own abilities to assure that they will be able to fulfill the project if things go wrong. Performance bonds are expected especially of a contractor who cannot afford to sink their own money into the project.
Selecting the Appropriate Bond for Your Venture
Selecting the right type of bond for a construction project is not only essential to ensuring compliance with contractual and statutory requirements; it can also be the difference between a project’s success or failure. While some projects may not need any bonds, others require contract bonds, performance bonds, or both. It is important to differentiate between the various types of bonds, know when they are required, and understand their specific purposes.
Contract and performance bonds are distinguished by the fact that contract bonds, such as bid bonds or maintenance bonds, do not guarantee satisfaction of the principal’s contractual obligation, while performance bonds do. Consequently, contract bonds are generally required prior to award of the contract and performance bonds are typically required after award of a contract. Additionally, performance bond obligations are generally backed by significantly more capital than contract bonds, which further distinguishes them in terms of obligation.
A performance bond guarantees a project principal’s performance of its contractual obligations under a construction contract and is typically required in connection with a public construction contract. Performance bonds are security to protect the owner from a loss resulting from the principal’s failure to meet its obligations, and must be provided by an authorized corporate surety. A contract’s specifications will generally set forth a minimum amount of required performance bond security. Although they are more expensive than other types of bonds and may be difficult to obtain, public owners frequently require performance bonds of all contractors.
Unlike performance bonds, bid bonds do not guarantee satisfactory completion of a contract. Rather, the purpose of a bid bond is to provide security to the owner of a project and to discourage frivolous bidding. Bid bonds are frequently required prior to the bidding process. The amount of the bid bond (typically 10% of the bid) is normally the difference between the award price of the contract and the second lowest bidder’s price. The bid bond is typically forfeited to the owner if the successful bidder, after having been awarded a contract, wrongfully refuses or fails to execute the contract. Again, bid bonds must be provided by an authorized corporate surety.
When deciding whether to issue a contract bond or performance bond, a surety company will consider several factors. These factors include analyzing the value of the contract, the owner’s reputation, the owner’s financial background, available security (i.e., cash, home equity loans, certificates of deposit), and the particular industry and market conditions.
Myths Surrounding Construction Bonds
One of the most common misconceptions about contract and performance bonds is that they are purchased by the contractor to serve as insurance against the risk that they will fail to perform. Nothing could be further from the truth. While it is true that a contract bond assures the public that the bonded contractor will fulfill its contract and do so in accordance with the terms provided, this type of bond is not an insurance policy protecting the contractor. On the contrary, the contractor’s own surety company – once it has been put on notice of a possible default – will protect and defend (and sometimes even ignore) default claims in accordance with its own best interest. The surety company is an advocate for the owner, not the contractor. In fact, a contractor frequently is precluded from suing its surety to compel it to settle or defend a bond claim brought by the owner because of the surety’s own conflict of interest.
A common misunderstanding that follows next is that since a performance bond is not a "performance bond" unless it is issued to secure privately funded construction work, there is no such animal as a "performance bond" for public work. This is un true. There is such a thing as a "performance bond" for public work. In fact, all contract bonds (and performance bonds) are public bonds, because they are until claimed upon, all deemed to be the property of the public.
The Role of Bonds in Project Outcomes
Bonds play an integral role in the success of a project by providing assurances to all parties involved that the project will be carried out according to the agreement terms. Contract bonds and performance bonds are primarily used to reduce the risk of failure, ensuring that the project is completed with the expected level of reliability and accountability.
By obtaining a contract bond, the contractor can provide a guarantee to the project owner or developer that the project will be fulfilled to the standards specified in the contract, generally within a specified timeframe. Should the contractor deviate from the terms , the contract bond provides a means for the project owner to recover financial damages up to the bond amount. The bond provides added peace of mind for the project owner that the contractor will have the ability to deliver on the agreement, or the project owner will be compensated for non-performance.
Taking it a step further, a performance bond specifically provides assurances to the project owner that the contractor will not only fulfill the terms of the agreement, but also meet the performance expectations of the project. Both contract bonds and performance bonds are meant to establish credibility, reliability and trust among all parties while fear of losing the bond may increase the contractor’s motivation to fulfill the agreement while also reducing disputes and litigation between the project owner and contractor.