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.
Table of Contents
What is a performance bond?
A performance bond is a form of guarantee that the contractor will fulfill all of their obligations under a construction agreement. It is also known as a contract bond. If the contractor fails to complete the contract, the bond provides financial compensation to the property owner up to the amount of the bond. Ideally, a claim against a performance bond would provide enough funding to complete the project.
Parties to a performance bond
There are three parties to any type of bond: the principal, the obligee, and the surety. On a typical performance bond, the principal is the property owner, the obligee is the general contractor, and the surety is the company supplying the bond.
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 performance bonds work
Performance bonds are most common on public jobs, though they may be required on other types of construction projects. When a contract requires a performance bond, a bid bond and payment bond will typically also be required. A bid bond is used when bidding on a job, and guarantees that the contractor will follow through on their bid. A payment bond protects the property from title claims, and guarantees that everyone on the project will be paid.
The general or prime contractor is typically responsible for securing a performance bond, but that requirement can also extend to sub-tier parties. Some public projects may require subcontractors to secure a performance bond as well.
On a federal construction project, the Miller Act requires the prime contractor to hold a performance bond (along with a bid bond and payment bond) if the project exceeds $100,000.
In addition, each state has adopted most of the same bond requirements for public projects under their own “Little Miller Acts.” 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 commercial jobs.
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.
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.
Performance bond cost
Every bond has a specific amount that it guarantees. A performance bond is generally issued for the full amount of the contract, and typically costs about 1% of the total amount. However, there are a lot of factors that could affect the price and amount of a performance bond. Anything in a company’s credit history could affect the cost of a bond.
Claims against a performance bond
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.
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 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. Typically, a performance bond claim will come along with the termination of the prime contractor. However, termination is not always a cut-and-dry scenario.
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.
Every bond has specific terms that must be followed in order for a claim to be valid, often including a timely notice of default. If notice isn’t provided according to the terms, the surety has every right to deny the claim.
While the performance bond is in place to protect the owner from contractor default, the surety actually has quite a bit of authority in exactly how to remedy the situation. In some cases, they even have the ability to reinstate the defaulting contractor, with or without the consent of the owner.
How to avoid a performance bond claim
From a contractor’s perspective, avoiding a claim requires not defaulting on a contract. But even the most qualified contractor can run into an unanticipated problem that . 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, and may be able to resolve the situation before the owner files a claim.
Defense is the best offense, as they say, and that applies to bond claims as well. The best way to avoid a claim is to prequalify contractors before hiring them for a contract.
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.