Performance Bonds on the Easy Side With CSBA
The most common types of surety bonds that a construction contractor will run into other than their contractors license bond are bid bonds, performance bonds, and payment bonds. All of these bonds mentioned are classified as types of surety bonds.
Surety bonds unlike most insurance policies involve three parties, the Principal or Contractor, who is responsible for performing the work they have agreed upon with the owner (Obligee). Then there is the Obligee, which is the party that the bond is made out to protect against any loss. And then there is the Surety, which guarantees the work of the Principal and is responsible to the Obligee for the failure of the Principal.
Bid bonds are usually issued along with the contractors bid to an Obligee (owner or party having the work done), and this bid bond guarantees to the Obligee that if they are awarded the project that they will enter into the contract for the dollar amount that they bid the job for and also provide the Obligee a performance bond and payment bond.
The performance and payment bonds are usually issued together, where in so many words the performance bond is to protect the Obligee from the contractor defaulting on a project and the payment bond, also referred to as labor and material payment bonds, is guarantee that any subcontractors and/or suppliers are paid in full by the completion of the bonded project.
To go into the details of a performance bond, it is a third party guarantee typically issued by a Surety company. The performance bond is made out to the Obligee to specifically guarantee that the work being performed by the Contractor (Principal) is completed according to the plans and specifications, that the Obligee and the Principal agreed upon via contract/agreement. The performance bond is usually in the amount of 100% of the agreed upon contract price.
By issuing the performance bond the Surety is vouching that the contractor is qualified to execute the terms and conditions of the contract, and the Surety guarantees to the Obligee that if the Contractor does default they will compensate them for any loss that the Contractor has causes them.
To qualify a contractor for a performance bond, or any of the previously mentioned bonds, a surety company takes the following things into consideration: credit rating, prior project experience, and looks at their personal and company financial standing. Some surety’s have bond programs such as the Construction Bonds Express program, which only require the contractor to meet a minimum credit score and that have had a minimum of 2 years working experience. The Construction Bonds Express program allows contractors to only qualify up to a limited bond amount since it uses minimal information to qualify.
For a contractor to qualify for larger performance bonds above the limits in the Construction Bonds Express program, sureties would typically have to look at the contractor’s company and personal financial information, and would need to get an idea of the size and nature of the projects that they have previously completed. Once the surety company analyzes this information and everything is satisfactory they will typically give the contractor a bond program that outlines what size bond the surety is willing to support on a single job size, and they also outline the dollar amount of project they are willing to support at a single time, also called the aggregate amount.
As mentioned performance bonds are to protect the obligee from a contractor defauling on their work. So in order for a valid claim to be made on a performance bonds the Obligee must prove that the Contractor has defaulted on their work defined in the contract specifications within the time allowed. Once a rightful claim is made on the performance bond the surety usually has several options to indemnify the losses that the Contractor has caused to the Obligee depending on what the language of the bond form allows.
One of the options the Surety may have when executing a claim on a performance bond is to continue to use the contractor that was already on the project. This may be a useful way to mitigate risk for the bond company if the Contractor’s work is satisfactory, but the contractor may have ran out of money to continue the work.
Another option the Surety has when executing a claim on a performance bond is to replace the Contractor completely. This is typically what takes place, and is usually more costly to the surety since they need to get new bids on the project, which tend to be more than the original Contractor’s bid.
Another option the Surety has when executing a claim on a performance bond to have the Obligee administer the completion of the work and the Surety will pay for the additional cost above the unpaid balance that would have been paid to the original Contractor.
Lastly the bond company can always just pay out the penal some of the performance bond to the Obligee.
Whichever route the Surety ends up taking to indemnify the Obligee, the Surety always reserves the right to reimbursement from the Contractor for the cost that they incurred. This right of reimbursement is agreed upon between the Surety and the Contractor through the General Indemnity Agreement (GIA), which should be signed by the Contractor before the Surety issues any bonds. The Surety also reserves the right of reimbursement for any payout on the performance bond through Obligee’s rights to the Surety or through subrogation.
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The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.