Bonds and the construction process
What is a bond?
No party enters into a construction contract expecting any party to default. Contracting parties, however, must manage the inherent risk of the unexpected during construction projects. Construction bonding is a method commonly used by contractors, subcontractors and owners to redistribute the risks associated with defaults during the life of a construction project.
A bond is a contractual obligation undertaken by a surety company (often, an insurance company) to perform or pay a specific amount of money if the principal (often, the general contractor or installation contractor) does not perform or pay. A surety relationship is a three-party contract that guarantees that the principal will fulfill its obligations to the third party, the obligee (often the project owner for performance bonds).
In other words, by taking out a bond, the principal and surety have made a contractual promise to complete the principal’s obligations or to pay the obligee the costs of completion up to the agreed-upon surety amount (called the “penal sum”). The principal will thereafter have a reimbursement obligation to the surety for any amounts the surety may pay out on the bond to the obligee.
Types of bonds
The three most common construction surety bonds include:
- Performance bonds which secure the general contractor’s promise to perform the contract in accordance with its terms and conditions. The surety bond provides for compensation to the obligee (generally the owner/developer for the project) for financial losses if the principal (traditionally the general contractor) fails to perform.
- Payment bonds which guarantee the principal’s obligation (typically being the general contractor) to make payments to subcontractors and suppliers hired by the principal; the surety is also responsible for defending and indemnifying the project owner against claims of nonpayment and assumes the responsibility for paying these claimants.
- Bid bonds which provide protection to the obligee (again, generally the owner) if a winning bidder (the contractor) fails to follow through with executing the contract.
Insurance vs. bonds
Although surety bonds and insurance are both risk-management tools, surety bonds are not a form of construction insurance and are quite different in many important respects. An insurance policy is a two-party agreement where the insurer generally expects losses from covered events (and generally the insurer does not seek reimbursement from the insured). A surety, on the other hand, does not necessarily expect losses, will take steps to prequalify principals before they can be bonded, and will generally seek reimbursement from the principal. Likewise, where an insurance policy’s coverage comes into play when unexpected or fortuitous events occur, a surety bond is triggered only upon default by the principal regardless of the reason for the default (with certain exceptions). In a way, a surety bond is more like a tripartite credit agreement with the surety guaranteeing financial support on behalf of the principal.
The goal of the suretyship is to provide (conditional and necessary) financial support to owners and contractors (as well as lenders and equity investors) in the event of a default in order to keep a project moving forward. While there are certainly advantages and disadvantages to any construction risk management method, suretyship is an excellent fiscal tool to provide confidence to the key stakeholders of a construction project that the project will be completed and will be free from encumbrances.
No matter the type of surety bond, these are contracts, and these contracts require careful review so that all parties – owners, contractors, sub-contractors, lenders, investors, and public officials – understand their respective rights and obligations. Parties also need to follow state and federal laws governing the bonding of public and private projects. A review of these issues, including suretyship obligations and protocols, defenses, claims, the form agreements and recent case law in suretyship is beyond the scope of this article. Nonetheless, such issues must be carefully considered before a bond should be issued.