What is a contract bond?
A contract bond is a contractual guarantee given by the party accepting a contract, which protects the party offering the contract. The financial backing for a bond is provided by an insurance company specializing in underwriting contract bonds. There are two main types of contract bonds – performance bonds and payment bonds.
Parties to a Contract Bond
Contract bonds are financial agreements with three parties: (1) the party offering the contract, known as the obligee; (2) the party accepting the contract, known as the principal; and (3) the party providing the capital to underwrite the funds, known as the surety.
How a Contract Bond Provides Protection
In practice, the principal pays a premium to the surety to secure the bond for the protection of the obligee. In this way, a contract bond works something like insurance. If the party accepting the contract fulfills its obligations, the offering party enjoys the protection of the bond until the project’s completion.
However, if the contracted party fails to perform as promised, the party giving the contract is still protected because the surety will fulfill the contracted party’s obligations under the contract or provide financial compensation for its losses and then look to contractor to be repaid.
Contract Bonds in Government Contracting
Contract bonds became an important feature of the construction industry with the passage of the Miller Act, which required surety bonds for all federal government contracts.
These laws require contractors to put up a performance bond to protect the completion of the project for the government agency, as well as a payment bond to ensure that material suppliers, subcontractors and workers on public projects would be duly paid.
Prior to the Miller Act, contractors would sometimes underbid to win a government project and then refuse to complete the work unless they were paid more, essentially holding the taxpayers hostage.
With the requirements for surety bonds, the government transferred the risk of failure from the taxpayers to the contractor, who would now have a surety’s backing to fulfill its obligations or be forced to repay the performance bond or payment bond guarantees.
Types of Contract Bonds
Because contract bonds are so common in the construction industry, four of the most common types of contract bonds are bid bonds, performance bonds, payment bonds and maintenance bonds.
Bid bond – a promise to accept a contract at the bid price. If the contractor wins the bidding process and then refuses to proceed, a surety bond will compensate the obligee for the difference between the winning bid and the next lowest bid or the penal sum of the bond, whichever is less.
Performance bond – a promise to complete a project according to the terms of the contract and relevant specifications of the work. If the contractor fails to meet the terms or specifications, the surety bond will ensure the contract obligations are fulfilled or compensate the obligee.
Payment bond – a promise to pay suppliers for their material, to pay subcontractors for their portion of the job and to pay workers for their labor. Surety bonds protect the project from liens. Construction projects sometimes require performance and payment bonds.
Maintenance bond – a promise to correct any defects that are found in the finished project after completion for a time period specified in the contract.
Qualifying For a Contract Bond
To qualify for a contract bond, a builder must have solid business and personal financials, a track record of successful project completion and a good personal credit rating. Although all parties are hoping that a bond claim will not be needed to compensate for a failed project, the surety must be confident that the builder can repay the bond, if that should become necessary.
The surety company will evaluate the builder based on its results and reputation, including:
- Accounts receivable aging – Is cash flow healthy or does money go uncollected?
- Bank references – What is the builder’s record of borrowing capacity and repayment?
- WIP –What is the current cost to complete for all open projects?
- Insurance – Are there hazard, professional and general liability policies with suitable coverages?
- Trade references – What do suppliers and subcontractors think of the builder?
- Client references – Are former customers satisfied with their completed projects?
- Legal issues – Has the builder been a party to any lawsuits or other legal problems?
- Business financials – Does the balance sheet show equity and liquidity?
- Personal financials – Can the builder guarantee commitments with personal assets?
Help for Small Builders
The Small Business Administration (SBA) has a surety bond guarantee program to help small applicants in the bonding application process. The SBA can provide the surety company with guarantees for up to 90 percent of contract liability on bonded projects of up to $6.5 million in value.
How much do contract bonds cost?
Typically, a contract bond will cost the principal from 1-3 percent of the value of the project, depending on the type of project and the qualifications of the builder.
A Win-Win-Win Arrangement
Contract bonds are a proven solution to an age-old business problem: How does the party offering a contract avoid losing money if the party accepting the contract does not deliver? With the help of a surety company, a bonding agreement transfers that risk of failure from the project owner (obligee) to the contractor (principal).
The surety earns a good return on its capital through underwriting premiums paid by the principal. The obligee can invest with full confidence, knowing that it is protected from the losses of a failed project. And the principal can provide its customer with the assurance of a surety bond for the reasonable cost of 1-3 percent. A win-win-win arrangement.