A payment bond is a form of surety bond issued to guarantee that all of the contributors, such as suppliers, subcontractors and vendors, on a construction project will be paid for their work and materials.
A payment bond is a contract between three parties: the contractor who owes the payments, a financial company (the surety) that guarantees the payments and a project owner who requires the bond in order to ensure the project is completed free of liens.
Payment bonds are commonly required on construction projects to guarantee that workers, subcontractors and material suppliers are paid for their labor and materials. In fact, payment bonds are sometimes referred to as labor and material bonds.
Why are payment bonds needed?
Although payment bonds are most often used on government contracts and large construction projects in the private sector, let’s illustrate the need for payment bonds by using a more personal example.
Imagine that you are a property owner and you have hired a builder to build an addition to your house. The contractor sends workers to the job, orders materials and hires subcontractors for certain parts of the job, such as electrical wiring or roofing.
The Builder is Unable to Pay
The construction project is off to a good start, but then a problem arises. Perhaps the principal has another job that suffers a serious setback, resulting in a lawsuit. The principal slips into financial trouble and files for bankruptcy protection.
Unfortunately, the suppliers’ material has been delivered and used, the subcontractors’ work has been completed and the workers’ labor has been expended. All of these people need to get paid, and the only entity they can look to for recovery is…you.
Liens on the Owner’s Property
That’s right. Material was delivered and work was at least partially completed. With no other recourse, the workers, material suppliers and subcontractors would have to place liens on your property to recover their money.
It might not be easy to collect the money, but you would not be able to sell your property until the liens were settled, and each one of the parties signed off that their liens were satisfied.
The Bigger the Project, the More a Bond is Needed
Now imagine that you are the Federal government building a dam…or a state government building a highway…or a municipality building a new city hall.
The bigger the project, the more a construction payment bond is needed to protect the project owner and the many honest tradesmen who will contribute their labor and material to the job. Does the owner simply have to trust the general contractor? Not without a payment bond.
Parties to the Payment Bond
Payment bonds include three types of parties to the contract.
The contractor (known in surety bond terms as the principal) buys the payment bond from a financial company (the surety), and the payment bond is issued by the surety to guarantee payment to the workers, material suppliers and subcontractors (the obligees).
Payment Bonds and Performance Bonds
Payment bonds are often paired with performance bonds. While a construction payment bond protects the right of specified entities to be paid, the performance bond guarantees that specified work will be performed satisfactorily, according to the project plans, budget and schedule. Both payment and performance bonds are sometimes referred to as contract bonds.
If the prime contractor does not pay as agreed for the suppliers’ material and for the workers’ and subcontractors’ labor, then the owner or the other obligees can claim the payment bond and the surety company will step in to see that the protected parties are paid (or in the case of a performance bond, that the project is completed).
This is obviously not a desirable outcome for the principal, as the surety will look to be reimbursed for the money paid out to satisfy the payment bond, along with any money damages arising from the failure to pay or perform.
The History of Surety Bonds
The concept of a financial guarantee for performance or payment is as old as the history of commerce. Records in ancient Persia indicated that a farmer who was called to fight in the army could hire someone to tend his fields while he served, and the helper could be required to get a bond from a surety to guarantee fulfillment of the agreement.
The Romans had a sophisticated understanding of bonding, and many of their principles survive to this day in modern surety law. In U.S. history, bonding for projects and expeditions became a standard financial arrangement in the 1800s.
The Heard and Miller Acts
The modern use of payment and performance bonds in government contracting was first defined in the Heard Act and later refined in the Miller Act of 1932, covering all government contracts with value greater than $100,000.
Following the federal example, many states passed “Little Miller” statues requiring bonds for state-funded projects. Even today, payment bonds are sometimes referred to as Miller Bonds, and they are almost always required for a federal or state project, just as they are often required for private projects.
Qualifications for Bonding
Bid, performance and payment bonds must be issued by the same surety bond company, since they have done the due diligence work to determine that the principal is financially stable, has good credit and has a reputation for reliability.
These characteristics are important because, if the obligees are forced to claim the bond and the surety has to guarantee payments, the surety will then look to the principal to recover the money.
How much does a payment bond cost?
The cost of a payment bond is based on the total amount of the contract and the builder’s financial strength.
Payment surety bond costs can vary, based on contractor qualifications. If the principal has a high personal credit score and a company record of financial stability, the surety company will see this as a predictor that contracts will be fulfilled and bills will be paid when due.
With a strong track record, the principal will be offered a lower payment bond cost, with the premium based on one percent to three percent of the total bond amount.
For a large project, the builder is typically required to provide the surety with more detailed documentation on personal and business finances, some personal guarantees or pledge property as collateral.
When a Payment Bond is Claimed
When a principal is having difficulty paying suppliers, subcontractors or workers, one or more of these obligees may go to the surety with a payment bond claim.
When this happens, the surety may first seek to work with the principal to find a resolution to the payments owed. In many cases, new financing, payment restructuring and other techniques can be used to avoid a claim against the bond.
When the obligees have formatted and submitted their claims properly, the surety will step in to investigate the claims, and if the claims are well-founded, the surety will compensate any of the obligees who have not been paid.
Parties to a Payment Bond Agreement are Partners
When a payment bond is claimed and the surety must pay material suppliers, subcontractors or employees, the contractor will be required in turn to repay the surety company.
However, the relationships between the contractor, the surety and the obligees are not adversarial. The surety has an interest in advising and supporting the principal with financial expertise and contacts, the principal wants to put the project back on track, and the obligees want to finish the job successfully, so that all of the parties may work together again in the future.