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Bonding 101 – with Richard Lyons

BONDING 101

When negotiating or bidding a construction contract, a major concern is whether or not the contractor is competent and capable of doing the work. Does he have experience in the type and size work to be done? Is he financially strong enough to finance the work and to pay his sub-contractors and suppliers? Where does the owner stand if problems arise — if the contractor is unable, for whatever reason, to complete the contract?

It is very difficult for an owner to properly check a contractor’s financial credentials. And even if he does, who is to say that the contractor will have anything left if the job “goes south?” An award for Breach of Contract isn’t much good if the contractor has no assets to satisfy a claim. So what’s the answer? What can the owner do to protect himself? The answer – A SURETY BOND! Or more precisely, Performance and Labor and Material Payment Bonds.

A Performance Bond is the promise by a third party (the Bonding Company) to pay – or sometimes perform – if the contractor fails to complete the contract. A Labor & Material Payment Bond can also help protect an owner from liens against the owner’s property if the contractor fails to pay workers, sub-contractors and suppliers. Maintenance Bonds are often required to guarantee the contractor’s performance of certain maintenance over a fixed period of time after completion of the work.

A bond is a three-way contract between the contractor, (the Principal), the owner, (the Obliges), and the bonding company, (the Surety). The Surety is almost always a company licensed by the various Insurance Departments to write bonds, although a private person can on some occasions act as Surety. The contractor is called the Principal because the contract is his or her primary responsibility. The Surety and Principal promise, in the bond, that the contract will be performed according to its terms. Essentially, the Surety promises that if the contract is not performed, it will pay damages if the Principal cannot.

The Obliges, owner, benefits from the promise described in the bond. The Principal and Surety both sign the bond; the Obliges does not. Nevertheless, the Obliges also has obligations under the bond, such as paying the contractor. If the Obliges does not perform his or her own obligations under the contract, neither the Principal nor the Surety is bound. The bond is not an insurance policy. It merely provides an extra level of financial resource behind the contractor, a place to turn if the contractor cannot meet contractual obligations through his or her own assets.

TYPES OF SURETY BONDS

There are two types of bonds of primary interest: (1) Contract Bonds (bid, performance, labor & material payment bonds); (2) License or permit bonds, which are required for many occupations, including contractors. For the purpose of this article we will focus on Contract Bonds.

CONTRACT BONDS

There are three types of contract bonds: bid bonds, performance bonds and payment bonds. A bid bond is an obligation undertaken by a bidder promising that the bidder will, if awarded the contract, enter into the contract and furnish the prescribed performance and payment bond’s) within a specified period of time. A performance and/or payment bond is specifically intended to cover a particular contract. A performance bond covers the contractor’s actual performance of the contract. It guarantees payment – up to the amount of the bond– of such things as the cost of completion or cost to correct deficiencies which are the responsibility of the contractor. A payment bond is intended to pay laborers, suppliers and other contract-related costs which the contractor owes to third parties. The benefit to a private (as opposed to public, i.e. governmental) Obliges is that it provides a source of funds for those who might otherwise be able to enforce a lien against an owner’s property.
Performance and payment bonds may be two separate documents, each with its own penal sum, or they may be combined in one document with a single penal sum. The penal sum is usually the contract amount at the time the bond is executed.

Some things to keep in mind:

For Contractors:

  • The Obliges is generally expected to pay the premium for performance and payment bonds. Thus, contractors must include the cost of the bond in their bids. The premium is an amount in most cases ranging anywhere from 1% to 3% of the contract price.

For Owners:

  • Bond requirements must be included in the original bid and contract documents. One cannot expect a contractor to provide a performance or payment bond unless it is made a requirement of the contract. In fact, one may be in breach of contract by refusing to let the contractor proceed without a bond when none was required in the contract documents. Decide ahead of time what sort of protection without is wanted from a bond. Specify the type of bond’s) in the contract, and require a bond in a form acceptable to the person drafting the contract.
  • The original must be delivered to the Obliges before protection is effective. The Obliges should read the bond carefully to be sure it does what the Obliges wants and note carefully any notice requirements, time limits, and special conditions. If an Obliges does not comply with the bond’s terms, its protection may be lost.
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  • t may be impractical to require a bond for a small contract, since the contractor may not be able to find a Surety willing to write a small bond. Similarly, if a contract is imprecise or legally deficient, it may not be bondable. In addition, a Surety is often reluctant to bond contracts where the work has already begun. If for any reason a contractor cannot produce a required bond, one who has required the bond should consult an attorney before attempting to use this failure as a reason to terminate the contract.

LIMITATIONS OF BONDS

Some important limitations of surety bonds to keep in mind are:

  • A bond is not an insurance policy. It is not a substitute for adequate insurance coverage, either for liability or property damage. A bond will not be liable for personal injuries or for property damage that results from a contractor’s negligence.
  • A bond will not protect the Obliges from valid claims by a contractor. If a contractor sues the Obliges, the Surety has no obligation to defend the Obliges. If a contractor prevails in a dispute with an Obliges, the bond will not pay for what the oblige owes to him or her.
  • A surety is entitled to most of the same defenses that the Principal has. Thus, if the Obligor’s problem with a contractor is a legitimate dispute, the Obliges can expect the Surety to dispute the claim as well.
  • A bond is liable only if the Obliges has performed all the Obligor’s own obligations. This includes the obligation to pay the agreed price (including agreed extras) for the work. The bond is responsible only for excess cost to complete or correct after the Obliges has spent what the Obliges agreed to pay the Principal to do the work.
  • The Surety’s basic obligation is to pay money. In some circumstances the Surety may agree to obtain bids for completion or correction and/or to take over the contract and see that it is completed. The Surety may do this when it believes that it is the least expensive way for it to meet its obligations. In other circumstances the Surety will simply reimburse the Obliges, up to the penal sum, for the Obligor’s excess cost.
  • The Obliges must act reasonably to mitigate (minimize) any damages. An Obliges cannot, for example, let an uncompleted project simply sit so that weather damage increases the cost to complete. An Obliges may jeopardize bond recovery, too, by paying the contractor funds which have not been earned, or amounts in dispute, or amounts which an Obliges is entitled under contract to withhold for delay or for damage correction. Because an Obliges must at the same time be sure that failure to pay does not result in the Obliges breaching the contract, it is important to consult an attorney whenever an important dispute arises.
  • A performance bond covers only completion or correction costs within the scope of the original contract. Thus, if an Obliges hires a new contractor to finish or fix the work, an Obliges must be sure that either (a) the new contract covers only the original work or (b) that the Obliges can segregate and prove what costs went toward finishing the original contract work. Extras added with the new contractor will not be covered by the bond.

CONCLUSION

Most construction contracts have small problems that arise during the progress of the work and most small problems can be resolved between the Obliges and the Principal without the need to involve anyone else, attorney or Surety. As with any human endeavor, a reasonable attitude and willingness to keep communication open will do the most to assure successful completion of the project. On the other hand, no one should be so accommodating as to waive one’s rights under either the contract or any bond one is relying upon.
One must use common sense to determine when a problem is getting out of hand. A clear understanding of the contract, including any bond for it, is the best protection.

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