When are Bonds Used?
Demand for surety, or contract, bonds usually arises out of one of the following situations:
1. Federal/State/Municipal statutes that mandate their use in public works projects
2. A private owner/developer of a project or their lender (as a second interest) who requires their contractor to provide contract bonds
3. A prime contractor requiring one from its subcontractors
Four Types of Surety Bonds
In general, there are four different types of contract bonds: bid bonds, performance bonds, payment bonds, and maintenance bonds.
Bid bonds guarantee that if the contractor is the lowest, responsible bidder, they will enter into the contract and provide the required performance and payment bonds. If the bidder fails to do so, then the owner is protected up to the amount of the bid bond for the difference between the low bid and the next higher bid.
Performance bonds guarantee that the contractor will fully and satisfactorily complete the work in accordance with the contract documents. The owner/obligee (and any other dual obligees listed on the bond – such as a lender) has the right of recovery up to the penal sum of the bond if the contractor fails to fulfill their obligations under the contract.
Payment bonds guarantee that the contractor will rightfully pay the laborers, suppliers, and subcontractors that provided goods and services on the project. Mechanic’s liens cannot be placed on public property – so the payment bond is protection for legal claimants if they have not been paid for the goods and services they provided. The right of recovery under the payment bond extends to all unpaid claimants who are legally entitled to payment under the contract. Legal claimants are subcontractors with direct contact with the general contractor, or material suppliers and second-tier subcontractors. Any suppliers to these second tier subcontractors are not included. Payment bonds are also limited to the penal sum of the bond.
Maintenance bonds guarantee the workmanship and materials on the project for a specified period of time from successful completion of the project. This is generally a one year obligation.
Why are Surety Bonds Relevant?
There are many contractors in the marketplace competing for work. They all believe they are qualified to build the project. Some sort of prequalification process is clearly needed. The surety assumes the responsibility of prequalification for owners who require bonds on their projects. Sureties are responsible for underwriting the contractor, its financials, its experience, and the contracts it would like to pursue. If the surety’s underwriting proves the contractor is satisfactory, they will provide surety bonds for the contractor. Therefore, the surety protects the owner against a loss if a bonded contractor should default.
It is a common misconception that a surety bond is simply an insurance policy. Many surety bonding companies are often related to larger insurance companies – but the services provided are different. In my next post I’ll delve into the distinctions between the insurance and surety business.
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