When planning and coordinating a private construction project, owners often are mired in a sea of details and ideas. However, one item that should be considered on any such project is the need for performance and payment bonds. These bonds, which are purchased by contractors and issued by sureties, protect the owner from the financial loss that often flows from default by the general contractor by assuring that either the obligations of the contractor will be performed or damages will be paid. This article provides a basic understanding of these bonds.

Performance Bond

A performance bond protects the owner against a general contractor's inability to complete the project. Upon default of the contractor, a performance bond generally requires the surety to provide the owner with the performance required by the contract or the funds by which to obtain it. This provides an owner with the means by which to have a project completed for the contract price even though the cost of completion under such circumstances usually exceeds the balance of the unpaid contract price.

Payment Bond

A payment bond protects the owner when the general contractor fails to pay its subcontractors and suppliers. Upon default, the payment bond generally requires the surety to pay unpaid subcontractors and suppliers. This, of course, provides an owner with a means by which to manage lien claims and to secure continued performance from unpaid subcontractors and suppliers.

Not Insurance

Performance and payment bonds are not insurance. A typical insurance policy shifts the risks covered by the policy to the insurance company – that is, in exchange for the premium paid by the insured, the insurance company pays the claim and thereafter cannot seek reimbursement from its insured. Performance and payment bonds shift the risk covered by the bond to the surety; however, unlike an insurance policy, the surety retains a right to seek reimbursement from the party whose performance was bonded, i.e., the contractor.

Options for the Surety

Performance bonds provide the surety with the option of choosing from several alternative means by which performance may be provided to an owner. The surety usually has four courses of action from which to choose: (1) it may arrange, if permitted by the owner, for the defaulting contractor to continue performance to complete the project; (2) it may complete the project itself or enter into contracts with other contractors to complete the project; (3) it may pay damages to the owner, thus allowing the owner to enter into contracts with contractors of its choosing to complete the project; or, (4) it may attempt to "buy back" the bond by paying lump sum damages.

Pitfalls for the Owner

Performance and payment bonds contain certain requirements with which an owner must comply before it may obtain their benefits. The requirements often are complex. They not only arise out of terms stated expressly in the bonds but also are tied to the contract. For example, an owner must have declared the contractor to be in default before the surety's obligations arise under the bonds. However, before an owner can declare a contractor to be in default, many commonly-used contracts require the owner first to obtain certification of justification from the architect, to provide notice of default to the contractor, to allow the contractor an opportunity to cure the default, and to attempt to meet with the contractor and the surety to discuss the matter. Failure of an owner to comply with any of these requirements can provide justification for a surety to avoid the obligations imposed by the bonds and almost certainly will set the stage for a costly dispute with the surety, which usually has the financial wherewithal to fight. Thus, it is imperative for an owner to read carefully the terms of the bonds and to comply with their conditions.

Benefits of Bonding Contractors

In order to purchase performance and payment bonds, a contractor must meet certain requirements of the surety. The surety generally evaluates the applicant's business operations, expertise and reputation, financial strength, exposure and progress on other contracts, and ability to perform the contract that is the subject of the bond. Further, it considers the contract documents and the size and location of the work. Thus, when an owner requires performance and payment bonds, it receives increased assurance of having a qualified general contractor on the job.

However, the owner who requires performance and payments bonds also must investigate the quality of the surety. Several sources that rate insurance and surety companies include A.M. Best, Standard and Poors, Moody's Fitch Ratings, and Weiss Ratings. In addition, the United States Department of the Treasury annually publishes a list, Department Circular 570, which provides the names of the sureties that are qualified to write bonds on federal projects. State insurance departments also maintain a list of surety companies that are licensed to do business within that state. To obtain direct information regarding a surety's reputation and solvency, an owner can check with insurance agents and other known sources.

Applicability of Bonds to Subcontractors

General contractors also may require performance and payment bonds for protection against default from their subcontractors and against claims from sub-subcontractors and suppliers. As with bonds for contractors, sureties likewise evaluate the subcontractors to be bonded. This provides increased assurance to the general contractor that qualified subcontractors will be on the job. In addition, because these bonds require the general contractor, in case of default, to comply with their terms and procedures, the general contractor also should read them and be familiar with their requirements.

The Downside of Bonds - Cost

Obtaining bonds adds to the cost of a project. The benefit to an owner of obtaining bonds is a reduction in the risk associated with default by the contractor in performance or payment. Considering the events that have occurred over the course of the last several years, this is a risk that is real, even when an owner engages an apparently solid contractor. Ultimately, an owner, which must bear the additional cost of the bonds, must decide whether this cost is justified by the benefit.

Conclusion

Owners and general contractors on private construction projects, especially large, complex construction projects, should consider requiring performance and payment bonds. Members of our Construction Practice Group have experience with these types of bonds in cases of default.

To learn more about performance and payment bonds, contact any member of the Construction Practice Group ( Jenna Fruechtenicht Butler, Donalt J. Eglinton, Merrill G. Jones, II, Cheryl A. Marteney, James W. Norment, C. H. Pope, Jr., Stanley M. Sams, Ryal W. Tayloe, or Kenneth R. Wooten).