A warranty bond is a financial guarantee made by a builder to protect the owner of a construction project from defects in materials or workmanship that might arise after the project is completed. A warranty bond is sometimes called a maintenance bond.
More Than a Warranty
Most of us are familiar with product warranties, in which the seller promises to fix a defect, as in a new car warranty, or promises to replace the product, as with a new appliance. These warranties are essentially backed by the desire of the seller to maintain its reputation and goodwill of the business.
A Promise with Financial Backing
A warranty bond or maintenance bond takes the promise one step further by creating a contractual obligation that makes the builder financially responsible for correcting any defects in the project for a warranty period specified in the contract.
Three Parties to a Warranty Bond Arrangement
Warranty bonds are contracts between three parties.
- The first party is the principal, typically the prime contractor or subcontractor in a construction project.
- The second party is the obligee, the project owner or group, general contractor or public entity that has hired the principal.
- The third party is the surety, an insurance company providing the bond.
How does a warranty bond work?
The principal purchases the bond from the surety for the benefit of the obligee. If no defective work or defective materials are found in the finished project during the warranty period, the principal simply pays the premiums until the end of the agreement and the financial backing of the surety bond is never required.
Even when a defect is found in a completed construction project, the principal can voluntarily correct the defects and if the obligee is satisfied, a bond claim is not necessary.
When a Warranty Bond is Claimed
However, if poor quality workmanship is found and the contractor fails to correct the problem, the obligee is entitled to claim the bond. When a claim is submitted, the first action taken by the surety will be to investigate the claim to verify that the defect is the fault of the principal.
For example, if the builder followed the plans and specifications in every detail and the defect arose from the architect’s original design, that is not the fault of the builder. However, if the surety’s investigation finds that the defect is due to the principal using sub-standard materials or allowing poor workmanship, then the surety will reimburse the obligee.
Depending on the terms of the warranty bond, the surety may have the option to hire another contractor to correct the defects or may simply pay the amount of the surety bond to the project owner.
In either case, the surety is then entitled by the legal document to require the principal to repay the amount of the bond. Because this possibility exists, a principal must be financially qualified to compensate the surety, should that become necessary.
How a Principal Qualifies for a Warranty Bond
When an obligee requires contractors to post a surety bond, they must apply to a surety company for bonding. The surety will want to document the stability of the both the business and the contractor’s personal finances.
The surety firm will require a credit report on the builder, financial records for the business, bank statements and trade references from previous clients. The builder may also be required to pledge personal property as collateral in the event of business bankruptcy.
When a Warranty Bond is Required
Warranty bonds are required on most projects with state or federal funding, as well as larger projects with private funding. In the early 20th century, a construction bond became a standard feature of federal projects after the Heard and Miller Acts, which were passed by the U.S. Congress to protect taxpayers from unscrupulous builders.
Warranty bonds are also required by municipalities to guarantee public improvements of new developments are built to code and free of defects.
Proper Motivation for the Contractor
Major construction projects often require a performance bond for completion of the project, a payment bond to ensure that suppliers and workers are paid, and a warranty bond to hold the builder accountable for finished quality.
With performance and payment bonds, the risk of satisfactory completion is shifted from the project owners (or the taxpayers) to the contractors, who are properly motivated by the bond commitment to fulfill their performance, payment and warranty bond guarantees.
Warranty Bond or Maintenance Bond Cost
Warranty bond cost is primarily based on the cost and unique nature of the particular project. The surety fee paid by a contractor might be anywhere from 0.5 to 4 percent of the total bond amount, and it will be lower or higher based on the length of the warranty period and the surety’s assessment of the contractor’s credit score, financial statements and reputation in the trades. A candidate with bad credit still may be able to qualify for a bond, but will pay the highest rates.
Warranty Bond Example
A new construction project has been designed with skylights that enable natural lighting. During the warranty period of the bond/contract, several skylights begin leaking, causing water damage to office equipment and furniture.
The owners appeal to the contractor, who refuses the repair, contending that the original design is at fault. The owners then submit a claim against the warranty bond, and the surety hires an engineering firm to investigate.
The engineering investigation finds that the architect’s design was sound, but the builder did not install the skylights properly. The surety brings these findings to the attention of the builder and offers to bring in engineering assistance to develop corrective measures.
Faced with the engineering report, the contractor agrees to the corrective measures. The total bond amount is not required, but the corrections, engineering support and other costs of the claim are applied to the bond, which is paid out by the surety and in turn repaid by the contractor.
The warranty bond ensures that the contractor would take corrective action. The contractor’s general liability insurance policy would cover the third party damage due to water damage to the office equipment and furniture.
A Win-Win-Win Arrangement
Warranty bonds are popular in the construction industry because they provide valuable benefits for all parties.
- Project owners enjoy long term assurance that any defects in the finished project will either be corrected by the builder, or they will receive financial compensation.
- Sureties can put their capital to work at relatively low risk, with a good return on continuing bond premiums.
- Contractors can win preference over competitors based on their financial commitment to the bond and with the expectation that this job will continue their reputation for strong performance and finished quality.
A win-win-win arrangement.
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