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What Are Performance Bonds?
Performance bonds are surety bonds commonly used in the construction industry to protect project owners against the risk of default by contractors who cannot complete a job under contractual requirements. A performance bond transfers that risk from the project owner to a “surety,” typically an insurance company or division of an insurance company.
Surety bonding dates back over 4,000 years to the ancient Babylonians and has developed over the millennia to its current form. Since 1893, law has mandated performance bonds for federally funded projects. Under the Miller Act of 1932, performance bonds and payment bonds are required for all federal construction contracts valued in excess of $100,000. At the state level, similar legislation, commonly referred to as “Little Miller Acts,” requires both performance and payment bonds for state-funded public works projects. Today, performance bonds, once exclusively used in taxpayer-funded construction, are increasingly required by private construction project owners.
Why Are Performance Bonds Now Being Required in Private Construction?
More business failures occur in the construction industry than in any other industry in the United States. Construction contractors face many challenges. Cash flow is often a problem, as are complex projects with a lot of moving parts to manage and demanding schedules. To make matters worse, there are few barriers to getting into the construction marketplace as a general contractor. Many states don’t even require general contractors to be licensed!
Contractors can default on construction projects because they bid them too low and don’t have the cash flow necessary to pay their bills. There may be performance issues due to poor management and planning that cause costly delays. Often these performance issues arise because a contractor overestimates capacity and becomes overextended due to unrealistic assumptions about the number of projects that they can handle at one time. The unfortunate truth is even the best-managed, most reliable contracting businesses can find themselves in trouble because of unforeseen challenges such as unexpected supply chain problems or sudden changes in the economic environment.
Whether a contractor voluntarily declares default or is found by the project owner to be in default, the financial impact on the project owner and investors can be devastating. Private project owners can avoid such consequences by choosing to require contractors to furnish a performance bond as a condition for being awarded a contract. Prime contractors can also manage their own risk by requiring their subcontractors to purchase performance bonds.
How Do Performance Bonds Work?
A performance bond is a legally binding contract among three parties, known in surety bond lingo as the obligee, the principal, and the surety. The obligee, the party requiring the bond, is the project owner, the principal is the contractor required to purchase the bond, and the surety is the company guaranteeing the bond. Only the project owner has the right to file a claim against a performance bond.
As the obligee, the project owner establishes the required bond amount based on the project’s value. Formally referred to as the bond’s penal sum, this is the maximum amount the project owner will receive if the contractor defaults on the project. However, what happens in the event of a contractor default is not quite as simple as issuing a check. The surety has a legal obligation to remedy the situation, but there are several options for doing that. The terms of the performance bond govern the process and the options available.
What Happens When a Bonded Contractor Defaults?
First, the terms of many performance bonds require a formal declaration of default, either by the project owner or voluntarily by the contractor. The surety then initiates an impartial investigation. That’s a rather straightforward matter when the contractor declares default, but when the declaration of default is made by the project owner, it’s possible the surety will find the contractor is not in default or has some legal recourse for avoiding default. If the surety does not find the contractor in default, there is no valid basis for a claim by the project owner.
Takeover
If there is an actual default, the surety typically has options other than paying the full penal sum. One option, referred to as takeover, puts the surety in charge of the project in place of the original contractor. The surety typically hires another contractor to complete the project. This option is often the best solution when the original contractor has finished much of the work; working with the surety, the completion contractor simply picks up where the original contractor left off.
Tender
Tender may be another option. In a tender, the surety does not actually take control of the project but instead tenders a new contractor for approval by the project owner, which may involve re-bidding the contract based on what still needs to be done on the project. A tender may require the surety to either pay the project owner for damages resulting from the default of the original contractor or make additional payments to the new contractor beyond what is still owed on the balance of the original contract.
Contractor Assistance
Contractor assistance is yet another option the surety may have in the case of a default. This involves providing assistance (technical or financial) that will enable the defaulting contractor to complete the project. This option is most appropriate when the surety has a prior relationship with the contractor and is confident the assistance provided will lead to an acceptable outcome. It’s a good idea for a contractor in danger of not completing a job to let the surety know, because there may be a solution that will prevent default.
Obligee Completion
The other option a surety has for resolving a default is obligee completion. This is a reasonable option when the project owner is willing to find a new contractor without the help of the surety and doing so would not carry additional risk for the surety. This may still require additional payments to the project owner, up to the performance bond’s penal sum, as compensation for losses incurred because of the original contractor’s default.
Indemnification of the Surety
The terms of a performance bond indemnify the surety against legal responsibility for the losses incurred by the project owner due to the contractor’s default. Whatever measures the surety takes to resolve a claim, the indemnitor must reimburse any resulting costs borne by the surety. This could be the contractor or a third-party indemnitor, such as a partner in the contracting firm or someone else with a financial interest in it, like the spouse of an owner. This distinguishes a surety bond from insurance. Unlike an insurer, a surety has no expectation of monetary loss when resolving a claim.
The indemnity provision in the surety bond agreement gives the surety the right to recover from the indemnitor what they have paid to the project owner on the contractor’s behalf and other costs incurred in resolving a claim. If necessary, the surety can take legal action against the contractor or other indemnitor to recover those funds.
What Does a Performance Bond Cost?
The cost of a construction performance bond is a small percentage of the bond’s penal sum. That’s the simple part of the explanation. The more complicated part is how the surety determines what that percentage, the premium rate, will be. And that’s largely a matter of assessing the risk to the surety.
The risk is that the contractor purchasing a performance bond will not complete the project according to the terms of the contract with the project owner and will be found in default, resulting in a claim by the project owner. Although the surety is indemnified against monetary loss, the claim–if the surety finds it to be legitimate–must be paid. The surety could conceivably have to cover the claim initially, up to the bond’s penal sum, and then collect reimbursement from the contractor or other indemnitor. Collecting reimbursement can be a long and arduous process involving civil lawsuits.
For a surety to take that risk, the contractor must undergo a thorough vetting process to prequalify the contractor in terms of industry experience, professional reputation, financial stability, and the resources necessary to complete the project successfully. A contractor with a solid, well-managed construction business, demonstrable financial strength, and a history of handling credit responsibly presents a relatively low risk to the surety. The surety’s underwriters will take a close look at the contractor’s CPA-prepared financial statements, personal and business credit history, the terms of the construction contract, and other evidence to determine whether the contractor has the wherewithal to complete the project.
If the surety finds a contractor to be qualified, a premium rate will be assigned. The more creditworthy the contractor, the lower the premium rate.
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