When representing clients in negotiating and drafting construction agreements for private construction work, I am often asked: Should we require the contractor to provide a bond? This question doesn’t arise on public works contracts because contractors on public (federal, state, and local agencies) projects are generally required to provide both performance and payment bonds. On privately-owned construction projects, however, the decision to obtain a bond is at the owner’s discretion.
Performance Bonds vs. Payment Bonds
At the outset, it is important to recognize that there is not one bond but actually two separate bonds to consider. A performance bond protects the owner from financial loss if the contractor fails to perform the contract in accordance with its terms and conditions, including meeting the price set forth in the contract and keeping the schedule of time of performance. If the contractor defaults in performance, the project owner may call upon the issuer of the performance bond (the “surety”) to perform and complete the project. A payment bond guarantees that the contractor will pay subcontractors, laborers, and material suppliers in accordance with the terms and conditions of the contract. It is possible to obtain one of these bonds without the other but, in most instances, they are issued together.
Who Pays for the Cost of the Bond?
Returning to the question: Should we require the contractor to provide a bond? While the contractor will work with a surety (typically an insurance company or a division of an insurance company) to provide the bonds, in most instances the contractor will require the owner to pay for the cost of the bonds. And, they are not cheap. The cost of a performance bond issued together with a payment bond can range from one-half of one percent to three percent of the contract amount, depending on the size, type, and duration of the project and the contractor. If the contractor has significate experience and net worth, it will have more bonding capacity and the premium for the bonds will be less. In addition, as a general rule, the premium will be higher for a smaller project. The contractor should be able to quickly provide an estimate of the cost of the bonds. If not, there may be cause for concern.
The Reasons for Obtaining the Bonds
The following are reasons why owners elect to obtain performance and payment bonds:
- Lender required. If a construction lender is financing the construction, the owner may be required to provide performance and payment bonds. This requirement is often spelled out in the commitment letter. So, before making a decision as to whether to purchase such bonds, it’s important to check with the construction lender if there is one. Not all construction lenders require bonds. On a large project where the construction lender is intimately involved in the construction draw process and has confidence in the contractor, bonds may not be required.
- Vetting the Contractor. Sureties don’t like to lose money. They have considerable expertise in evaluating contractors. Their credit unit will scrutinize the contractor’s financial statement and experience as well as its management and operations. If the surety has any concern, it will require guarantees and collateral documents. This vetting of the contractor is one of the most valuable attributes of obtaining the bonds. Once, when I was negotiating with the President of a large contractor as to whether performance and payment bonds would be required, he responded, somewhat tongue in cheek: “the truth is, if a contractor has the ability to provide the bonds you want, you probably don’t need them.”
- More Likely to Finish. Many believe that contractors are more likely to complete bonded projects than non-bonded projects since the surety is likely to have some personal or corporate guarantees. While the owner of the project could try to obtain such guarantees, the contractor is probably more willing to provide them to a surety.
- Contractor Support. One of the benefits of bonding that is often overlooked is the support services that a surety can provide if troubles arise. Especially in the performance bond arena, the surety often will intervene and provide assistance to the project. The surety has the expertise and financial capacity to keep the ship from sinking. The surety may even provide additional capital to a struggling contractor so that they can avoid default.
- Ability to Sleep at Night. A lot can go wrong on a construction project. An owner may feel more comfortable having a surety on board who has vetted the contractor, is watching over the project, and is, perhaps, ready to help if necessary. In short, it enables the owner to sleep at night. While this faith in the surety may be a bit misplaced – not all sureties operate as a big brother to the contractor – bonding the job generally provides some comfort to the owner.
The Reasons Against Obtaining the Bonds
The following are reasons why owners elect not to obtain performance and payment bonds:
- Cost. These bonds are expensive. On a $30 million project, even if the contractor has experience and a reasonable financial statement, a performance bond and payment bond, if issued together, would likely cost about 1% of the cost of the work, or $300,000. That’s real money. It’s hard for the owner to justify such expense if the owner believes it has a good set of plans and specifications prepared by a reputable architectural firm and a reputable contractor who has built similar projects. What could go wrong? Quite often nothing does. But, unfortunately, on occasion, contractors fail.
- The Owner Can Do its Own Vetting. Theoretically, the owner can vet the contractor itself. In truth, however, very few owners have the ability to do so. Furthermore, while the contractor may be comfortable providing access to its financial records to a surety so the surety can do its due diligence, the contractor will likely be unwilling to provide such access to the owner of the project.
- The Benefits of Bonding May Be Illusory. As stated above, sureties do not like losing money. Performance bonds and payment bonds are contractual arrangements. There are numerous provisions which require the owner to notify the surety if certain events occur and prior to the owner taking certain actions. Failure to give such notice or obtain such approvals can negate the owner’s rights and protections under the bonds.
It also important to remember that the surety stands in the shoes of the contractor. Accordingly, the surety has all of the possible defenses the contractor may have, as well as surety-specific defenses.
Furthermore, not all sureties step up and act as a big brother to the contractor. Before acting, many of them scrutinize the file to determine if there is a way to avoid stepping in to remedy a major problem.
Finally, it is not always easy to get the surety to complete the project when the original contractor has left the scene. Even if contractually obligated to do so, it’s often difficult to get the surety to act in a timely matter.
Some Final Thoughts
As a practical matter, the decision as to whether or not to bond the project depends a lot on the size and nature of the project and the size and experience level of the contractor.
- If the project cost is relatively small and the contractor has sufficient financial capacity (i.e. net worth) and experience on similar projects, it may be difficult to justify the cost of bonding.
- If the project cost is fairly large but the contractor is not, the cost of bonding may be justified.
- If the project is atypical, or one with a number of unique components, the cost of bonding may be justified, particularly if such items are unfamiliar to the contractor.
- If the decision is made to require the contractor to provide a performance bond and/or a payment bond, the attorney for the owner must review the bond form and make sure the owner is aware of the notice requirements and understands what actions require the surety’s prior approval.