A performance bond is a type of contractor bond that is commonly issued to protect the client’s interests during a construction project. They are sometimes also called contract bonds. It is important to note that while performance bonds are often issued by insurance companies, they are not the same as liability insurance. It would be more accurate to think of them as a collateral loan. Depending on your state’s laws for general contractor licensing, you may be required to hold applicable insurance in addition to a performance bond.
How Does a Performance Bond Work?
For public works projects and some private projects, a contractor must initially submit a bid bond. This is a guarantee that they have the resources to complete the project for the client. In the event that their bid is accepted, they will then replace the bid bond with a performance bond.
A performance bond is an agreement between three parties to guarantee the client’s investment. These three parties are: the principal, the obligee, and the surety.
- The Principal: The principal is the party who will be conducting the work, often a contractor.
- The Obligee: The obligee is the client who is paying for the work to be done, and will be reimbursed in the event of unsatisfactory work.
- The Surety: The surety is the entity that is issuing the bond — often an insurance company or bank.
The principal applies for a performance bond and pending their qualification, the surety provides the loan. This bond is accompanied by a very specific contract that details the terms of the work to be completed. This will include details such as the quality of work expected and the time allotted for the project. The parameters are highly detailed to protect the interests of both the principal and the obligee. This will guarantee that, in the event that the work is unsatisfactory or unable to be completed per the contract, the loan will cover the associated damages or the expense of hiring a new contractor. Performance bonds cover issues such as poor-quality work or contractor bankruptcy.
The surety must confirm that the principal has the resources to complete the work per the contract. Therefore, in order to apply for a performance bond, the principal must provide the following information and documents:
- A minimum of two years of financial statements;
- A copy of the contract associated with the work;
- Appropriate collateral that is owned by the contractor;
- An application.
In the case of private contracting work, the need for a performance bond will depend on the nature of the work. Meanwhile, much contracting work related to public works must be guaranteed through a performance bond per legal mandate.
The Miller Act
The Miller Act requires performance bonds for all federal public works contracts valued at a minimum of $100,000. Little Miller Acts are state-level statutes based on The Miller Act. These function similarly, and require performance bonds on state-funded public works contracts. However, the specific parameters vary considerably.
Performance Bond Examples
In the private sector, a contracting job may look like a homeowner hiring a company to build a new shed on their property. If, hypothetically, the associated contract stated that the work would be completed within three months, but the project ends up taking longer due to fault on the part of the principal, the performance bond would compensate the homeowner for damages related to the extended deadline.
In the public sector, a contracting job may look like a firm being hired to build a new school. If there is a condition in the associated contract specifying that room should be left to accommodate a standard-size indoor track, and the principal fails to provide that necessary space, the performance bond would compensate the school district for damages for the lost value on the building.
Performance Bond vs. Payment Bond
A performance bond protects the client from incomplete or shoddy work, while a payment bond protects the laborers, subcontractors, and suppliers, guaranteeing they will be paid for their work, time, or equipment and materials. Payment bonds do not provide protection or insurance to workers who are injured on the job — that is the function of workers’ compensation insurance, which is required of any contractor or construction company with employees, and carries separate costs and conditions. Performance bonds and payment bonds are usually issued together. For contracting projects regarding public works, a payment bond can function as a substitute for a mechanic’s lien.
The Cost of Performance Bonds
The cost of a performance bond can vary widely depending on factors like the unique needs of the project and the creditworthiness of the principal. Typically, however, the value of the performance bond is approximately 1% of the value of the project. However, the rate will usually increase on particularly expensive projects.
Pros and Cons of Performance Bonds
The benefit of a performance bond is fairly clear: the obligee’s investment in a project is protected. However, there are potential drawbacks as well. Most of these drawbacks have to do with how a performance bond can provide legal standing for either party to take advantage of the other. For example, the obligee may find loopholes they can use to claim insufficient quality of the project, thus gaining additional reimbursement. Or the surety may claim that the obligee did not comply with certain terms of the agreement, therefore undercutting them on how much of the bond they are entitled to.
Ultimately, however, the intended purpose of a performance bond is to provide obligees with a sense of security in large-scale investments.
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