Construction surety bonds are securities issued by an insurer that guarantee financially that a construction company will perform their duties or pay a penalty to the contracting entity. The construction company, which could be a general contractor or subcontractor, is called the principal. The contracting entity, often a government or large corporation, is called the obligee.
Types of Construction Bonds
In construction contract surety there are a number of different types of bonds that could be required to be issued. These are, most commonly bid bonds, performance bonds and payment bonds.
Bid bonds guarantee that a principal will make good on their proposal to provide their services to the obligee at a given price. Many obligees stipulate that a “bid security” is provided by a bidder on a construction contract. This is usually in the form of a refundable cashier’s check or a bid bond. The amount of the bid security is usually at least 5% of the bid amount, but is often 10% or potentially higher. The bid security or bid bond is an assurance that the lowest qualified bidder will sign the contract and provide the required surety bonds to guarantee performance. If this doesn’t occur, the obligee keeps the security amount (or makes a claim on the bond) to cover the price difference between the lowest bidder and the next cheapest bidder.
A performance bond, sometimes also called a contract bond, is a security issued by a surety company that guarantees that a principal completes a project to the satisfaction of the obligee. Typically, for smaller projects, performance bonds can be as high as 4% of the cost of the job. For larger projects the percentage falls with the principal required to pay 2%, 1% or even less to obtain the surety bond.
A payment bond is a surety bond posted by a contractor to guarantee that its subcontractors and material suppliers on the project will be paid. They are required in contracts over $35,000 with the Federal Government and must be 100% of the contract value. They are often required in conjunction with performance bonds. These bonds take the place of mechanics lien filings as the remedy for payment issues on public works construction projects since a mechanics lien cannot be filed against a piece of public property.
And less commonly, bid requests may stipulate that warranty bonds and subdivision bonds are also issued for specific types of projects.
A warranty bond, sometimes called a maintenance bond, is a legal document that guarantees to the project owner that the contractor who did the work will come back and fix defective work or material should an issue arise during the warranty period specified in the contract.
Subdivision bonds are a type of surety bond that guarantees that a contractor makes certain public improvements to a property (such as creating sewer pipes and laying electrical lines) usually by a specified timeframe. The obligee in this case is a public entity and the principal is typically the owner of the land that is being developed. Large track home projects purchasing land from public entities are required to post subdivision bonds. Likewise, in rare cases, a government may only allow a sale of undeveloped land between two private parties subject to a subdivision bond being posted by the buyer.
The obligee is typically a large property owner, usually a public entity like the US Federal government or a smaller political subdivision like a state or county. In fact, the federal government is required by the Miller Act to require surety bonds (in specific a performance bond and a payment bond) for all contracts that exceed $100,000. States, which have their own statutes often referred to as Light Miller Acts, usually have similar requirements in their bidding processes.
General Contractors (GCs) are typically principals but can often also be obligees. Here is why: GCs will put parts of that same contract out to bid to subcontractors who specialize in certain areas of building. For assurance, a GC may require the subs to get surety bonds as well, making the GC an obligee to its sub-contractors (who in turn will become principals).
The Underwriting process
For a Contractor to qualify for these bonds, they must demonstrate to the surety company that they have the experience, expertise, depth and character to properly deliver the work they propose to do. Personal credit of the principals almost always plays a role in the underwriting process, though for larger projects the prospective principal must allow the underwriter to analyze their financial records to determine the business’ cash flow and reserves. While in the past, all contractors were required to provide significantly more financial information in order to qualify for contract surety support.
“[A surety bond obligee] is typically a large property owner, usually a public entity like the US Federal government or a smaller political subdivision like a state or county.”
Today, there are many surety bond companies and banks that have adjusted their entry level requirements to allow contractor to get started with their first few surety bonds via an easier path with fewer financial reporting hurdles. These “Application Only” programs just require an application to be filled with some limited financial information attached. These are usually surety bonds for single jobs up to around $500,000. Some bonds are issued with total multi-job surety up to $1 million or sometimes more.
These programs help new contractors win smaller projects. Once a contractor starts to bid on bigger jobs, they will need to provide more financial information in order to secure a larger surety bond.
Zero Appetite for Risk
The main difference between traditional insurance and surety bonds is which entity is responsible for making payment in the case of a claim. In regular casualty insurance, the insurance company pays out a claim for malpractice or errors and omissions committed by the insured and the insured does not need to pay a dime.
Surety bonds differ in that the principal is required to pay the damages in the claim directly to the obligee. If this can’t be done, then the surety company will pay it, then go after the principal in order to be repaid the debt.
Surety companies underwrite bonds with the understanding that their guarantee will never have to be acted upon. Therefore in the underwriting process, the surety company concludes that a prospective bond might result in a claim, then they will decline the principal outright. Surety companies only extend their credit to highly qualified applicants.
The Claims Process
Claims against surety bonds can happen despite the best efforts of the underwriting process. Surety companies understand this and expect the contractor to step up and take care of the problem, as necessary. How a contractor manages the problems says a lot about their character and once a problem is managed and resolved, the experience can even help the contractor going forward since they have shown the ability to do what is necessary to solve the problem. Often a positive result to a job problem provides the surety underwriter with a better comfort level in regards to the character of the contractor, which can help when trying to grow their surety support.
Are you in a situation where a claim is being made against your surety bond? Having the support of a law firm that has extensive experience in construction contract law could be very helpful in negotiating a settlement that works for all parties. Failing that, you could also rely on your experienced legal counsel for representation in court if the matter ends in litigation.
South Florida Law, Construction Law Experts
When preparing your paperwork to obtain a surety bond on your next construction bid be sure to do so with the assistance of a local attorney that has extensive construction law experience. With South Florida Law, you benefit from both big firm resources and small firm attention-to-detail and service. We have the construction law experience and local knowledge necessary to protect your business’ interests. In the process of applying for a surety bond for an upcoming bid? Reach out to South Florida Law today on (954) 900-8885 or via our contact form.