Construction is a notoriously risky industry. As a result, many building projects require contractors to hold a variety of bonds, each designed to reduce a particular type of risk. While payment bonds and license bonds might be more common, performance bonds are still extremely prevalent, especially on public works projects. A performance bond not only protects the owner, but also ensures that other project participants can keep working and continue to get paid.
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What is a performance bond?
A performance bond, also called a contract bond, is a type of guarantee provided by a surety company on construction projects to ensure that the contractor fulfills all of their obligations under the agreement. If they contractor fails, the performance bond provides money and leadership to keep the project going.
How performance bonds work in construction
When a contractor secures a performance bond from a surety company, the bond provides a guarantee to the property owner that the contractor will complete their work according to the agreement.
If the contractor fails to perform, the owner can file a claim against the performance bond. In the event of a valid claim, the bond surety steps in and takes corrective action.
The surety will assess the work that needs to be completed, the cost of any changes, and may find and hire another contractor to finish the work.
Performance bond beneficiaries
While the bond is generally issued for the benefit of the owner, performance bonds can be useful to everyone on a construction project.
When a prime contractor defaults or goes bankrupt during the project, a performance bond can be critical to maintaining steady cash flow and avoiding any delays or work stoppages on the project.
For contractors, a performance bond claim means something has gone seriously wrong on the project, and they’re not able to fulfill their duties. For subs and suppliers, this may mean the entire project is at risk of falling apart, and their payments are at risk.
For sureties, a performance bond claim means they have to pony up the cash to make sure the project is finished (though they will likely recover this money from the contractor later). They may need to secure another contractor to finish the work.
Finally, for project owners, a performance bond claim means there will be some additional stress in making sure the project is finished. At the end of the day, however, that’s what the bond is for: to make sure the job gets done.
How to get a performance bond
The first step in securing a performance bond is contacting a bond surety company. The Surety & Fidelity Association of America and the NASBP are two of the largest surety member organizations in the country. The Treasury Department also publishes a list of certified surety companies.
For performance bonds in particular, it’s important to get the bond from a surety with experience in the type of construction you are performing. This is because, in the event of default, the surety will step in manage the situation. They will need to be intimately familiar with all of the moving parts on a project, the work required to finish the job, and how to find and assess qualified contractors.
Generally, performance bonds cost about 1% of the total contract amount. However, there are a lot of factors that could affect the price and amount of a performance bond. Basically, anything in a company’s credit history could affect the cost of a bond.
When are performance bonds required?
In addition, each state has adopted most of the same bond requirements for public projects under their own “Little Miller Acts.” As a result, performance bond requirements will vary by location for state and local jobs.
While performance bonds are typically not required on private projects, it’s increasingly common, especially for large and complex jobs.
Performance bond claims
Nobody wants a performance bond claim to happen. But, if a contractor finds themselves in financial trouble, or if they can’t complete the job for some other reason, then it might be time to look to the bond for help.
By doing so, the project owner can rest assured that the contractor’s problems won’t derail the entire job. Typically, a performance bond claim will come along with the termination of the prime contractor.
How to avoid a performance bond claim
Obviously, the best way to avoid a performance bond claim is to not default on a contract. But sometimes this is unavoidable. So what should a contractor do if they sense they might not be able to perform? Pick up the phone. Reach out to the surety company. After all, they are trained to deal with these types of scenarios.
Keep in mind that if a claim is successful, that’s more time and money spent by the bonding company. They may be able to work something out or provide financial help. There’s a possibility that the problem can be resolved before the client or the project is affected.
At some point, even the best contractors can fail to meet their contractual obligations. Unfortunately, contractor default can have some serious repercussion. Not just for the contractor’s finances, but also their reputation.
After a claim is filed
If a claim is eventually filed by the project owner, the surety will conduct an investigation. This is to determine if there’s an actual breach and the extent of the damages. Again, this is the time where little communication can go a long way.
The owner may make arrangements to avoid termination. Terminating a contractor can be an expensive process for all parties involved. Termination could be avoided by reducing the scope of work, supplementing the workforce, or advancing payments to keep the project moving. If not, the surety will have to step in.
If the contractor is ultimately in default, then it’s time for the surety company to decide how to take action. There are a few options for sureties to resolve the claim.
- Payout. The surety will pay either the amount of the bond or the cost of completion of the work; whichever is lower.
- Financing. A surety may decide the contractor was so close to completion, that they will finance the contractor’s completion of the work.
- Arrangement. Here, the surety and the client will work together to finish the contract performance. Typically the client will select a replacement contractor, and the surety will absorb any additional costs.
- Takeover. The surety will assume full responsibility for finding and funding a replacement contractor to complete the remaining work.
At the end of the day, the contractor still must compensate the surety for any money that’s to be paid out. Again, that’s why communication is so important when dealing with bond claims. Contractors should always try to find alternative solutions when experiencing problems before the issue becomes too serious, and well before a claim is made.
Performance bonds benefit everyone
Although seemingly geared towards the owner’s protection, construction performance bonds are a great way to build financial security for all parties.
When a prime contractor fails to complete performance, things can spiral out of control quickly. For project owners, they are guaranteed that the contract will be fully performed, and will be compensated in case something goes wrong. For subs and suppliers, this can keep the project moving forward and the cash flowing without having to deal with delays or filing payment bond claims.