A Practical Handbook for Understanding Construction Contract Bonds

In the world of construction, risk is always present. Whether you’re building a commercial complex, upgrading infrastructure or managing a public project, the stakes are high. One effective tool for managing risk and ensuring a successful project is the use of construction bonds.
 

What Is a Surety Bond?

A surety bond is a three-party agreement that guarantees one party (the contractor) will fulfill its obligation to another (the owner). If it doesn’t, a third party (the surety) will step in to cover the loss. Unlike an insurance policy where the insurance company pays out after a loss, with a surety bond, if the contractor doesn’t fulfill its contractual obligations, the surety may be required by the owner to step in to cover the costs required to complete the project or pay any subs or suppliers who haven’t been paid. But in turn, the surety will expect reimbursement from the contractor. Issuance of the bond by the surety company is contingent upon its assessment of the contractor’s ability to fulfill the terms of the contract.

Surety bonds come in many forms and are commonly required across a wide range of industries, particularly governmental entities at the state, city and municipal levels for various programs, licenses or ordinances. In the construction industry, the most common bond types are contract bonds. Contract bonds enable a contractor to bid on a project, guarantee its performance and payment under the terms of the contract, and provide a warranty or maintenance term during which the contractor would be responsible for correcting any of its defective work.

What Is a Contract Bond?

Contract bonds, more commonly known as “performance and payment bonds” provide a project owner with a guarantee that the contractor will fulfill its obligations under the construction contract. Contract bonds ensure the quality of work performed meets the contract requirements, payment of material suppliers, subcontractors and other laborers.

There are different types of contract bonds and forms available to meet the needs of project owners on a range of different project types. The underlying guarantee of nearly all contract bonds is to protect the project owner in the event the contractor fails to complete the work, pay for materials or labor on the project, or meet the required deadline.

The parties involved in a contract bond generally include the following:

• The project owner, known as the obligee.
• The contractor, known as the principal.
• The surety company, or surety, which is the guarantor of the underlying bond guarantee.

Key Types of Bonds

1. Bid Bonds

Bid bonds guarantee that a contractor will perform the work at the agreed-upon price if it is awarded the contract. A bid bond is submitted by a contractor during the bidding process to offer a guarantee to the project owner that if they are the successful low bidder that contractor will enter into the contract at the agreed-upon bid amount. A project owner can require bid bonds from a surety on a “flat amount” or a “percentage-of-bid” form.

Use case:

A contractor bidding on a municipal road project would typically be required to provide a bid bond to have their bid submission accepted and considered during the bid opening.

2. Performance Bonds

Performance bonds, sometimes called contract bonds, guarantee the contractor will perform the work in accordance with the contract. Once a project has been awarded to a contractor, it will secure a performance bond from a surety prior to starting the project.

Use case:

On a commercial office build-out, a performance bond protects the project owner from delays, substandard work or the contractor walking off in the middle of the job.

3. Payment Bonds

Payment bonds guarantee that the contractor will pay for labor and materials in association with the contract. These bonds provide a guarantee to the project owner that the contractor will pay material suppliers, workers and subcontractors according to the contract, which mitigates the potential of liens being filed on a project due to nonpayment.

Use case:

A contractor managing a water treatment facility project would provide a payment bond to assure suppliers and subcontractors of timely payment.
 

4. Maintenance Bonds

Maintenance bonds, or “warranty bonds,” are issued for a specified period of time (the “maintenance period”) to protect project owners in case of faulty materials or workmanship on the construction project.

After a construction project is complete and accepted by the owner, maintenance bonds provide financial protection should construction defects arise during the maintenance period.

Use case:

After completing a pipeline installation, a maintenance bond would cover repairs during the maintenance period.

Why a Contract Bond Matters

Often, a contractor must secure and file a bid bond before bidding on a construction project for government-funded or public projects. Then, if awarded, the contract typically states that a performance and payment bond must be secured and submitted to the owner before the contractor can commence work on the project. If the performance and payment bond isn’t provided in a timely manner, the project owner could file a claim on the bid bond and award the project to the next bidder.

Private owners can require bonds as well to guarantee performance for private construction, supply and service-type contracts. General contractors may also require subcontractors to provide bonds to guarantee completion of their subcontracts.

Taxpayers benefit from requisite performance and payment bonds on publicly funded projects by ensuring the completion of public infrastructure projects, from schools to streets and bridges that build communities and support economies, which are funded by taxpayer money.

The Surety & Fidelity Association of America commissioned an EY study, which concluded that construction projects protected by surety bonds have lower contractor default rates, have “lower costs of completion in the case of default” and are finished more quickly than projects that are not bonded.

Common Misconceptions

A common misconception is that only large contractors need bonds; however, many public and private projects require bonds regardless of contract size.

Another misconception is that contract bonds are too expensive. Many owners will not consider accepting bids from contractors who are not able to provide the necessary bid bond to bid the project in order to mitigate their risk. The cost of performance and payment bond generally ranges anywhere from 0.5% to 3% of the contract amount.

The Bonding Process Timeline

The bond underwriting process involves a thorough review of the contractor’s qualifications and financials to ensure it has the experience, credit quality, capacity, financial backing and resources to complete the work outlined in the contract.

In most cases, surety companies review the contractor’s financial statements, which includes a review of both the contractor’s business and personal financial statements. Because bid deadlines can be tight, it is smart for a contractor to prequalify for contract bonds before needing one.

Once a performance and payment bond is put in place, it will remain in effect on that project until the project is complete and all suppliers and workers are paid. These types of bonds cannot be canceled early without release from the owner.

How to Get a Contract Bond

While each surety company is different, the underwriting process typically involves the review of business and personal credit, submission of financial information and demonstration of relevant project experience, in both size and scope.

For smaller bonds, many surety companies may only require a short application and underwrite mainly on business and personal credit, which can speed up the underwriting process.

Regardless of size, almost all bonds will require a signed indemnity agreement, meaning the contractor pledges business and personal assets as a guarantee to the surety company.

Take these steps to obtain a bond:

1. Review bid requirements to determine what type of bond is needed.
2. Prequalify with a surety. This will speed up the process when a project opportunity arises.
3. Work with a surety to secure the bond by submitting required documents in a timely manner to ensure the contractor meets underwriting criteria.
4. Maintain communication and work with your surety throughout the project.

Final Thoughts

Contract bonds are a vital part of obtaining and performing public work, as well as showing project owners that the contractor 
is qualified to perform the work.

Bonds play an important role in securing projects and getting prequalified for surety support can open doors to not only public work, but also larger projects and more opportunities for contractors.

Working with an experienced surety professional can guide contractors through the bonding process to ensure they secure 
the protection they need to meet job requirements and help ensure project success.