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Construction Bonds

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Construction bonds are financial guarantees that back up contractors’ promises to fulfill their contractual obligations: to build the job for the bid price; to pay for the labor and materials they use; and to complete the project to all terms and specifications set forth in the project contract. In this article, we’ll explain how construction bonds work and why they are vital to successful partnerships in the construction industry.

Why Construction Bonds Are Needed

Because public and commercial construction projects require large investments, the failure of builders to meet their obligations could be disastrous for the project owner. This risk of default is why bonds have become such important tools in the construction industry.

If the builders won’t start the job for the amount of the winning bid, or if they leave suppliers unpaid, if they default on the contract agreement, or if they simply fail to complete the job as specified, the project owner could be left with all the bills, amid the ruins of a failed project.

To be certain that the builder will fulfill these obligations in construction contracts, government entities and commercial project owners will often require various types of construction bonds.

Construction Bonds to Manage Risk

Project owners can mitigate the risk of a failure to meet specific obligations by requiring construction bonds for each type of commitment made by the builder.

Should the contractor fail to meet any of these obligations, the project owner can access the construction bond funds to be reimbursed for the losses, or for the cost of hiring another builder to correct or complete the work.

Protection Against Financial Losses

In this way, a construction bond is something like an insurance policy. However, rather than protecting against physical risks, such as fire and flood, the construction bond protects the project owner against financial consequences arising from the contractor’s failure to meet the obligations.

Transferring the Risk of Failure

The requirement to post a construction bond also transfers the risk of failure from the project investors (or the taxpayers) to the contractor. If the bond funds are needed to compensate the project owner for a financial loss, the money lost must be repaid by the contractor.

There are three parties to a construction bond arrangement, all of which are parties to the contract:

  1. The principal – the contractor who puts up the construction bond to guarantee performance;
  2. The obligee – the project owner who seeks the financial security provided by the bond; and
  3. The surety company – the specialized insurer that uses its capital to underwrite the construction bond amount.

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Construction Bonds for Public and Commercial Projects

Construction bonds became a standard feature of public projects with the passage of the Heard and Miller Acts by the U.S. Congress. These laws required construction companies on government projects valued at more than $150,000 to post bonds guaranteeing that they would perform to all of the terms and specifications of the contract, and that they would duly pay their suppliers, subcontractors and workers.

How Construction Bonds Work to Protect Taxpayers

As noted above, the requirement for construction bonds shifted this risk from the taxpayers to the contractors, and the result was so effective that state governments soon passed their own “Little Miller” laws for public projects. In due course, bonds became a standard feature of private commercial construction projects as well.

Three Common Types of Construction Bonds

The most common bonds required in public and commercial construction are bid bonds, performance bonds and payment bonds.

Bid Bond

Large construction projects almost always solicit bids from many builders who will compete to offer the best price for the job. Should a contractor prevail in this process and then refuse to accept a job for the amount of the successful bid, a bid bond pays the obligee the amount needed to give the job to the next lowest bidder. Bid bonds also protect the owner if the contractor forgot to include something in a bid.

Performance Bond

A performance bond is sometimes known as a contract bond. Should a builder use improper materials, cut corners on specifications, fail to complete a job within the specified schedule and budget, or otherwise default on the contract, a performance bond guarantees that the project will be completed, whether or not the contractor needs to be replaced. A general contractor may also require its subcontractors to post a performance bond.

Payment Bond

Should a contractor leave the suppliers, subcontractors or workers unpaid, payment bonds guarantee that project participants are paid for labor and materials. Unpaid creditors have the right to attach liens to the property or to pursue other legal remedies against the owner. Payment bonds eliminate this risk. On some projects, performance bonds and payment bonds are combined as performance and payment bonds.

How much does a construction bond cost?

Bid bonds are typically free of cost. Premium is only charged when performance and payment bonds are required. Construction bond premiums are typically one percent to four percent of the contract price.

Bond Rates are Based on Contractor Qualifications

The bond rates offered by a surety company will also be based on the nature of the project, as well as the track record and qualifications of the contractor making the application. Builders with more experience, greater financial stability and a successful reputation will obtain the best rates.

Who pays for a construction bond?

Although the contractor (principal) applies for the bond and pays the premiums to the surety company, these payments are included in the total cost calculations for the project, so the cost of the bond is eventually passed through by the contractor to the project owner.

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Other Types of Construction Bonds

In addition to bid bonds, performance bonds and payment bonds, there are other types of construction bonds for specific purposes. These include completion bonds, license bonds, maintenance bonds, mechanics lien bonds, public works bonds, retention bonds, subdivision bonds, supply bonds and warranty bonds. We’ll include a brief definition for each of these bonds.

Completion Bond

A completion bond is a commitment by the builder that a project will be completed on schedule, within the budget provided and without liens from suppliers or subcontractors. This sounds like the same thing as a performance bond. However, the obligee for a completion bond is usually a lender, while a performance bond protects the project owner.

License Bond

A license bond may be required by the state to be certain that a contractor is licensed and in compliance with state laws. The obligee for a license bond may be a board of directors. If there is complaint from a client who uses the contractor’s services, the board can make a claim against the license bond.

Maintenance Bond

Also known as a warranty bond, a maintenance bond is a guarantee that any defects in a completed project will be corrected, for a time period specified in the bond. Maintenance bonds are commonly required for public facilities, such as storm drains or water supply lines.

Mechanics Lien Bond

A mechanics lien bond protects a property owner from a lien that may be filed against the property due to a breach of agreement or failure to pay committed by the contractor against a supplier or subcontractor. Rather than carrying a mechanics lien claim that can interfere with the sale or refinancing of the property, the bond guarantees that the principal has the funds to pay off the lien if a court determines the principal is at fault. Doing so will unencumber the property.

Public Works Bond

A public works bond may be required for any project funded by a state, county or other public entity. A public works bond guarantees that workers will be paid and other rules will be enforced according to the labor and payroll regulations of the state. The obligee in a public works bonding arrangement is the government agency that has hired the contractor.

Subdivision Bond

A subdivision bond is a guarantee that a developer will complete common improvements to the subdivision, such as storm drains, sidewalks and electrical lines. The city or county is the obligee, with the right to claim the bond for completion of the specified improvements.

Supply Bond

A supply bond guarantees that building supplies will be provided to the project. A material supplier posts a supply bond with the project owner (or in some cases, the general contractor) as the obligee. Supply bonds are common on public construction projects that cannot be held up by delayed deliveries of concrete or structural steel.

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How does a contractor qualify for a construction bond?

When a surety underwrites a construction bond, it is betting its underwriting capital on the good performance of the contractor. Accordingly, the surety will conduct due diligence to be satisfied that the builder has a financially sound business, a strong credit rating and a reputation for finishing jobs on time and within budget.

Along with the bond application, the surety will require financial statements for the contractor’s business, as well as trade references from suppliers, subcontractors and former customers. The surety will also consider what other jobs the contractor has underway in order to judge whether new work can be added or would begin to strain the contractor’s bond capacity.

The contractor may also have to pledge personal property as collateral. Even if the contractor’s business goes bankrupt, the surety will expect to be repaid by the contractor from personal resources for any claim against the bond for a failure or default.

When a Bond is Claimed

If the contractor fails to meet the obligations, whether for the completion of work or payments owed to partners, the obligee may claim the bond. The claim is made to the surety company, which will conduct an investigation to determine whether the principal is actually in default, whether the claim is justified and how much money is owed.

When the claim is determined to be legitimate, the surety will pay the obligee. Where possible, the surety may hire another contractor to mitigate the damages, or it may negotiate with the principal and the obligee to seek a settlement that would limit the financial impact for all parties.

When a bond is claimed, verified by the surety and the money is paid to the obligee, the last step in the bond process is repayment by the principal to the bonding company. This is the reason a good credit rating and financial history are the most important factors in determining whether a contractor can obtain a bond.

Keys to Managing Many Risks

Construction bonds are effective tools that public administrators, investors, builders and suppliers can use to manage the risks of working as partners in both public and private construction projects.

Construction bonds can be engaged to ensure project completion, confirm builder licensing, avoid liens, streamline retention payments, provide warranty maintenance, secure building supplies, enforce bids and guarantee performance and payment.

For contractors, construction surety bonds are a low-cost way to provide peace of mind to their clients. For the project owners, bonds protect their investment from an unexpected failure or default. And for the surety companies, surety bonds earn a solid return on their underwriting capital.

Whether the contract bonds are for performance, payment or some other aspect of project completion, construction bonds guarantee valuable benefits for all parties involved.

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