Bonding for Federal Construction Projects

The most common types of bonds required for federal construction projects are performance bonds, payment bonds, bid bonds, and supply bonds.

Performance bonds

One of the biggest concerns with federal construction projects is that the contractor could become insolvent and default on a contract or that the quality of work will be substandard, requiring it to be redone by another contractor. Performance bonds guarantee satisfactory project completion in accordance with contractual requirements and guarantees that funds will be available to compensate the project owner in the event that the contractor fails to live up to that performance guarantee.

Payment bonds

Payment bonds usually are required in conjunction with a performance bond to guarantee payment of laborers, subcontractors, and suppliers in accordance with contractual obligations.

Bid bonds

Bid bonds may be required from contractors bidding on a federal construction project as a way to ensure that the winning bidder will go ahead and accept the contract. Such bonds will compensate the federal project owner for the cost of having to go through the bid solicitation and evaluation process again to select another contractor, should the awarded contractor decide not to proceed with the contract. It is standard to provide a 20% bid bond as security on bids for federal government contracts.

Supply bonds

A supply bond sometimes is required as a guarantee that money paid to a contractor for the purpose of purchasing supplies actually is used for that purpose. It also ensures that the contractor doesn’t cut corners and substitute inferior materials for those specified in the contract.

There are three parties to every federal construction bond: the “obligee” (the project owner) requiring the bond, the “principal” (the contractor) purchasing the bond, and the “surety” (the company guaranteeing the bond). Any violation by the principal of the terms of the legally binding surety bond agreement that causes a financial loss by the obligee can result in a claim against the principal’s construction bond. The legal obligation to pay claims belongs solely to the principal.

The surety will investigate each claim received, decide whether it is valid, and approve it for payment if it is. Because the surety has guaranteed the payment of claims, the surety normally pays any valid claim initially and is then reimbursed by the principal. This ensures prompt compensation of the injured party and gives the principal some time to gather the funds to cover the claim.

Repaying the surety for claims paid on the principal’s behalf is not optional, as the surety is indemnified against any legal liability for claims. The principal’s legal obligation to pay claims simply shifts to repaying the surety. Failure to do so can result in the surety taking legal action against the principal.

Purchasing a construction bond requires payment of a one-time premium that is a small percentage of the required bond amount. The obligee establishes the required bond amount (also known as the bond’s “penal sum”), which is the maximum amount that will be paid on a single claim. The surety sets the premium rate for each bond based largely on an underwriting assessment of the principal’s creditworthiness.

The best indicators of risk involve the principal’s financial capacity, prior work portfolio, and credit score. The surety will use these metrics to assess the risk and determine the bond capacity (limits) of the subject contractor.