Performance and Payment Bonds
October 15th, 2007In the last post I discussed the first of the two common bonds required in the construction world, the bid bond.
The second type of bond is the performance and payment bond. These can be a single instrument, or two separate bonds, but either way they are typically used in unison.
The word performance speaks to the owner receiving assurance that there will be sufficient funds available to complete the project should the contractor encounter financial problems.
If you sign an agreement with a contractor that does not require a performance bond, and half way through the job the contractor ceases operating, you will be left with the responsibility of figuring out how to finish the project. Not only will you have to deal with the headaches, but you will also likely incur extra cost in completing the work. You can seek redress from the contractor, but you will likely be at the end of a long list of entities looking for money, and your chances of succeeding are slim. It will take attorney fees to recover any funds that you have lost.
If, however, you have required the contractor to supply a performance bond, the surety will step in and assume the responsibility of finishing the project. They will also ensure that no additional costs are incurred. It is then the surety’s problem to collect any extra costs from the contractor. For him this is a much easier prospect, as he likely has an agreement with the contractor that gives him leverage you do not have.
The word payment speaks to the owner receiving assurance that the contractor will pay all labor, material, and subcontractor costs for the project.
When a contractor starts to have financial problems, the first thing that is likely to happen is he will start stretching out payments to his suppliers. In doing this, he is often using money from one project to pay bills from an older project. It is definitely possible for a contractor to be paid for a project fully by an owner, but for him to still owe money to subs and suppliers. Waivers of lien can help alleviate this situation, but they do not provide fullproof guarantees.
If this happens, the laws in most states allow those subs and suppliers to go back to the owner for payment, causing the owner to pay twice for the same work. At the very least, those subs and suppliers will place liens on the real estate, which can cause an owner considerable grief, especially if there is long term financing that must be closed after the construction is complete.
The payment bond allows employees, subcontractors, and material suppliers to pursue payment from a surety instead of the owner. The owner often will hear about these issues first, and he has an obligation to turn them over to the surety in timely fashion, but if he follows the stipulations of the bond correctly, he should be able to insulate himself from extra costs, and any issue with liens should be quickly resolved. The surety will persuade the contractor to make the payments, or if he makes the payments himself, he is in the same good position to use his leverage with the contractor to recover the funds.
The most typical face value of the bond is 100% of the contract amount, although some owners will require 150%. 100% is generally sufficient because it is unlikely that a struggling contractor will be able to obtain a bond to start with. If he can supply the bond, any issues he has will take time to develop, and a portion of the project will already be complete.
As noted in the last post, performance and payment bonds have premiums associated with them. Those premiums can start as high as 2.5% for very small contract amounts, and they have a sliding scale with a percentage that decreases as the size of the contract increases, so that a $15M project might have an aggregate premium of not much more than 0.5%. The financial strength, size, and history of the contractor will effect his bonding rates, so different contractors may very well have different rates for the same project.
The contractor pays the premium to the surety, but he includes it in the price of the project. So ultimately, the owner is paying for these assurances.
That statement marks a good place to leave off. The next post will address the question:
Should you require a bond for your project?