A performance bond, sometimes known as a contract bond or a surety bond, is a unique financial instrument that protects the owner of a large project by underwriting successful execution by the prime contractor. Performance bonds are common in the construction industry, especially on projects that involve government entities or large investors in the private sector.
Major Projects in Construction and Real Estate
We have all read news stories announcing important public construction projects and real estate developments. Investor group A will commit $300 million to erect a downtown high rise. Developer B is offering 200 new single-family homes in a real estate development that was once farmland. County C is planning a major airport expansion that will expand regional air service. All of these project owners are likely to require their contractors to obtain performance bonds.
Big Projects Carry Big Risks
Big projects like these are exciting for the community and can be very rewarding for the participants. But big projects also carry big risks. How does the county protect itself if the chosen contractor fails to execute? How do the investors get their money back if the builder of the high rise goes bankrupt? How do owners manage the risk when one party must entrust the other party with the success or failure of a large project?
The answer is a performance bond. General contractors can purchase performance bonds from an insurance company specializing in surety. A surety company is a third party to a contract that protects the owner by issuing contract bonds guaranteeing the performance or financial responsibility of the contractor.
Performance bonds work the same for certain commodity contracts. The seller of the commodity is required to get a performance bond to guarantee the buyer of the commodity that if the seller fails to deliver, the buyer will be compensated for financial loss or other damages arising from the failure of the contract.
In commodities markets, bonds are called margins, requiring a good faith deposit of money as collateral to secure fulfillment of performance obligations under future contracts.
Performance Bond Cost is Based on Confidence and Financial Qualification
Performance bond rates depend on the size of the project and experience of the contractor, but typically cost about one percent of the contract value. The surety company is likely to study the track record of the contractor, their personal credit score, the contractor’s financial stability and the type of project before setting a performance bond premium.
In any case, when the contractor has purchased a performance bond, the project owner can proceed with confidence, knowing that if the contractor should fail to successfully complete the project, the surety company can provide funds to either support the completion of the project or to compensate the owner for losses or damages.
Not Every Contractor Will Qualify
Although performance bonds are not expensive, many otherwise qualified contractors are not able to meet the performance bond requirements due to their credit history, lack of a strong financial or performance track record, or unwillingness to pledge sufficient collateral. Surety bond companies will require contractor applicants to have the financial strength and credit scores to repay the bond in the event of a claim.
The cost of surety bonds is less important than the surety’s estimation of the contractor’s ability to repay the bonding company if there should be a claim. In many cases, the cost of the performance bond is included in the contractor’s bid as an itemized project expense, so in effect, the financial guarantee is paid for by the construction project owner.
How is contract default defined?
When creating a performance bond, the owner must set forth detailed contract terms and specifications that define the work to be performed, the expected results, the contract amount and the deadline for completion.
The performance bond may also require a claim should the contractor declare bankruptcy or face financial or legal problems that would prevent successful completion of the project.
Parties to a Performance Bond
As we have shown, there are three parties to a performance bond arrangement:
- The Obligee. This is the property owner who is the customer or buyer of the project. The obligee can be an individual, a company or a government entity. The obligee is the potential beneficiary of the performance bond.
- The Principal. This is the builder or general contractor whose services are being contracted to execute the project according to the bid budget and specifications. The principal is the party required to purchase the performance bond.
- The Surety. This is the financial institution providing a guarantee that the principal will fulfill the contract according to the project specifications. The surety is the party providing the funds to guarantee the performance bond.
The History of Performance Bonds
The need to underwrite contractor performance has been with us as long as there have been civilizations capable of major building projects.
More than 2,000 years ago, surety bonds that included an owner, a contractor and a financial guarantor of contractor performance were recorded in ancient Persia.
The Origins of Surety Law
In the second century AD, the Romans already had a highly developed body of surety law concerning the performance bond, some of which survives today in legal principle.
American surety bond companies were first organized in the mid-1800s. At the turn of the century, the U.S. Congress passed the Heard Act, which required major construction contracts issued by the Federal government to be backed by performance bonds.
The Miller Act and Little Miller Statutes
This performance bond standard was refined in the Miller Act of 1932, which applied to all contracts with value greater than $100,000. The Act provided for surety bonds to protect the government from losses incurred due to an unfinished project and also guaranteed that sub-contractors and workers would get paid for finished work.
In turn, many states passed “Little Miller” statutes requiring performance and payment bonds on projects funded by the states.
Steps in the Bonding Process
The county commission has levied a special tax to fund an expansion of the county airport. Architects and engineers have created a project design, complete with a contract price, specifications, a project budget and an estimated timeline to completion.
As the owner, the county advertises for project bids, allowing potential contractors to examine the specifications to prepare their offers. Because the county will require a performance bond to the low bidder, all of the contractors who are candidates to win the job must provide a bid bond with their bid package.
When the successful bidder is awarded the job, they secure the performance bond, which is issued by the surety to the obligee, in this case, the county purchasing authority. When the contract is finalized, the contractor, now known as the principal under the bond agreement, starts the airport expansion project.
When the Obligee Claims the Performance Bond
When a project is created, the project owner establishes performance specifications and advertises for bids. The principal is often the winning bidder among competitors. If the project is successful, everyone is happy. However, if the principal fails to complete the contract, the obligee may claim the bond.
When a performance bond is claimed, the surety can compensate the obligee for the bond amount, or the surety may hire another contractor to finish the project. In either case, the principal could be required to repay the financial institution that acted as the surety.
The final amount may also include administrative expenses, professional fees related to the cost of the investigation and interest based on how long the bond amount remained unpaid by the principal.
A Performance Bond is Not Insurance
Although performance bonds may be issued by insurance companies, it is important to understand that a bond is not an insurance policy. If the obligee claims the bond, the surety will cover the bond for the obligee, but will have the right to seek repayment from the principal. For this reason, builders who bid on jobs requiring performance bonds usually have to meet minimum standards for financial stability and a track record of job success.
Requirements for Contractor Stability
When a general contractor applies for a performance bond, the surety will conduct due diligence to confirm their qualifications to be a bonded principal. The surety will want to review their financial statements, preferably certified by a CPA, for the past two or three years of business results. The surety may also require that the principal pledge real estate or other valuable property as collateral in the event of insolvency or bankruptcy.
In many cases, the obligee, especially when a government entity, may also require a payment bond for the project. This is an affirmation by the parties to the performance bond that any sub-contractors, material suppliers and workers on the job will also get paid for their work or materials if there is a default by the prime contractor.
When a Performance Bond is Claimed
When an obligee claims a performance bond, the surety will launch a complete investigation. First, the surety will confirm that three conditions have been satisfied: (1) that the obligee has properly submitted a valid claim; (2) that the contractor has actually breached the terms of the bond and is in default; and (3) that the obligee has properly fulfilled their side of the agreement.
When the foregoing conditions have been met, the surety has four options: (1) help the principal, either by providing funds to the contractor or by obtaining external financing; (2) find a new contractor, prepare a new contract and seek agreement from the project owner; (3) step in as the prime contractor and manage the project to completion; or (4) withdraw from the bond agreement and leave the completion of the project to the obligee.
When a Performance Bond Claim Goes Wrong
A performance bond gives the project owner assurance that if the contractor cannot or will not fulfill their contractual obligations, the surety will step in and give the job to someone else, or the owner will receive enough money to complete the project.
While this arrangement has proven its value to government and private industry, there are also circumstances in which claiming the bond will not set the project back on course.
If the obligee fails to comply with all terms and conditions specified in the bond, the surety can withhold some or all of the bond amount. In some circumstances, the surety may ask the obligee to accept a less costly solution to the failure of the principal, or may offer a settlement based on a lesser amount of money.
Finally, if the project runs over cost, or if the cost of the principal’s underperformance is more than the obligee originally estimated, the surety may not be willing to provide additional funds to move the project forward.
A Win-Win Agreement
Performance bonds are a key component in the standards and practices that enable builders and investors to partner in some of the most important construction and real estate projects. For the surety bond company, they are an excellent product. And there are benefits for each of the other parties involved.
For the Owner/Obligee
A performance bond gives the obligee a way to be compensated when a contractor fails to deliver. In addition to giving the project owner recourse in a default, performance bonds provide a guarantee that all claimants will get paid for their work or materials. Bond guarantees help the owner manage the risk of putting their project in the hands of a contractor, motivating the contractor to be accountable for success.
For the Contractor/Principal
On the other side of the agreement, surety bonds give the principal a way to guarantee satisfactory completion, and the surety’s legal team can assist the principal in disputes with the oblige. A performance bond will provide an extra level of motivation to do the job right, on time and within the budget. Accepting and completing a bid bond, performance and payment bond also gives the principal strong credibility, with the immediate partners in the existing agreement and with future customers who will know and respect their reputation.
Higginbotham is your solution to addressing your concerns regarding performance bonds. Contact us for assistance.