(February 2023)
There are three primary types of construction contract bonds:
Different bonds and different pricing are necessary because each phase of the construction process involves a different set of risks.
Contractors never know their final construction costs until their work is complete. The longer the projected completion time, the more exposure contractors face from numerous variables that can dramatically affect the final outcome. That is why the party who tries to assess a job's full cost of labor, materials, sub-contractors, and other job-related expenses is often referred to as an estimator. The period between the estimating stage and the final "punch list" immediately before the owner accepts the job can be very long. Various obstacles may arise along the way, and this is where the protection a surety bond provides enters the equation.
The surety provides contract-bonding service with two different bonds:
Many states, cities, counties, townships, and villages follow the language within the Miller Act, enacted by the U.S. Congress in 1935. This Act requires a separate Labor and Material Payment bond for federal public works and building contracts in addition to the Performance bond. The state and local contracts that follow the federal Miller Act contracts are commonly referred to as “Little Miller Act” contracts.
Private construction projects also use this dual bond approach because the separate payment bond minimizes the need to file labor and/or material liens against the owner's property that might encumber its title. While a lien for non-payment of labor and material bills cannot be attached to public property, it is considered a good public policy to assure such payment. This practice avoids forcing material suppliers to add excessive price loads to address otherwise unsecured risks.
Performance bonds give the owner financial protection against contractor default, guarantee against defective workmanship or materials, and encourage adherence to the contract's provisions. An excellent by-product of the guarantee to pay labor and material bills is the elimination of possible expense, litigation, and embarrassment to the owner that arises from unpaid contractors’ bills.
Contract bonds have gone through a series of changes because of economic conditions, public demand, and groups such as public authorities, the American Institute of Architects (AIA), and various surety industry groups that recognize that outmoded forms of Contract Bonds should be updated.
If a contractor defaults, the surety is usually responsible for obtaining bids from contractors to complete the job and awarding the remaining work to the successful bidder. The owner may want to participate in this process, and the surety generally welcomes it doing so. However, if the owner is permitted to participate, it is nothing more than a courtesy because the surety has total control of the bidding process and it alone awards the contract for work.
Contract bonds rarely explain the specific liability of the contractor and the surety. The contract's obligations, the requirements of the plans and specifications, and the statutes that apply to the work are the controlling factors.
The bid bond is only a prelude to the final bond or bonds and is not usually accompanied by a premium charge. By the time the bid is assigned for performance, the surety should have completed its underwriting and should be prepared to furnish the final bonds if its client is awarded the contract. If the client bidding on the job decides not to enter into the contract after learning that it submitted the low bid (perhaps because it discovered an error in its bid), it must promptly ask permission to be excused from entering into the contract. A demand for all or a part of the bid bond penalty may be made if the project owner or principal denies the request. In most bid bond default situations, the contractor and surety's liability is the difference between the low bid and the next qualified bid.
If this
difference exceeds the bid bond penalty amount, it is referred to as a
"full penalty" loss. If the low bidder fails to respond, the
principal can call for payment from the surety. After making the payment, the
principal's rights are subrogated to the surety, and it can then proceed to
recover its loss from the defaulting bidding contractor.
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Example: Bigtowne decides to get a contract for the construction of a new administration building and advertises for bids. Its invitation requires bid security in the form of a 5% bid bond, a cashier’s check, or a certified check. XYZ Construction decides to investigate the opportunity, and its estimating department proceeds to "take the job off" by preparing an estimate of all job-related costs. XYZ's front office adds in amounts for overhead and profit. XYZ finally arrives at a bid price and decides it has an excellent chance of coming in with the low bid. At this point, XYZ calls its bonding agent, advises him that the estimate is $6,000,000, and requests that he secure a bid bond. The agent contacts XYZ's surety (ABC Bonding Company) and requests authorization to issue the bid bond. Once the authority is granted, the agent prepares the bond in his office. It contains the following components:
XYZ describes the work to be performed according to the description that Bigtowne provided. A condition states that the successful bidder will enter into a written contract and furnish 100% Performance and Payment Bonds, commonly referred to as final bonds. |
Other forms of bid security may be found in bid letters, Consents of Surety or a Surety Agreement. Regardless of the name used, they guarantee that the surety will furnish the final bonds if its contractor principal is awarded a contract. Unlike bid bonds, these forms of bid security are issued without a dollar limitation. The principal is usually not joined as a party to these commitments, and these bonds may be issued as sole bid security or in tandem with a bid bond.
Performance bonds guarantee that work will be fully and satisfactorily completed according to the terms of the Contract Document. By definition, the Contract Document includes the Agreement between the contractor and the owner (including all subsequent modifications), the General Conditions, Drawings, and Specifications. The bond incorporates by reference all contract documents with which the contractor must conform.
While the penalty for both performance and payment bonds is generally 100% of the contract price, there are situations where the owner may require a different amount. However, the price is the same because the premium for both bonds is based on the contract price and not on the aggregate bond penalties.
Most performance bonds include a provision that requires the surety to waive its right to be notified of any alteration of time agreed to by the owner and the principal. This generally involves increases or reductions in the contract price and/or extensions of the completion date that result from Change Orders. These changes usually occur because of changes to the original plans and specifications as work progresses. Change orders can be based on events such as substituting different building materials, redesigning certain systems, additional work the owner orders, unavoidable delays not charged to the contractor, and similar issues. The performance bond penalty remains the same, regardless of the number of changes. In other words, the surety does not have any control over any contract modifications the principal and owner decide to make.
There is
an exception. Modifications are not permitted when they radically change the
"scope" of the original contract. However, this is a very gray area,
and disputes are usually resolved in the courts. In order to
prevent such disputes, some owners require an executed consent of surety for
each change, regardless of size or the waiver provision in the bond form.
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Example: Grand Construction is hired to construct a community center for Anytown. After the project begins, Anytown receives a grant to build an indoor skateboard arena and decides to add it to the community center project. Grand agrees, but neither party notifies the surety on the project, Graceful Surety. The arena adds six months to the projected completion time, and because Grand has never built a skateboarding arena, it fails to meet its project obligation and defaults. Anytown turns to Graceful Surety for the penalty. Graceful refuses to pay because it believes the change in orders was beyond the scope of the initial project, and it had not been notified of the change. The matter moves to court, where it lingers for a final decision. |
Once the contract is fully completed, the surety adjusts the premium charge based on the final contract price. If the final price is less than the original, the surety issues a return premium, commonly referred to as an "under-run." If it is more, it charges an additional premium, usually called an "over-run."
The standard form used for public performance bonds is very brief. Private performance bonds often follow wording suggested by AIA. Form A312, Performance and Payment Bond. This form and the AIA. Standard Form of Agreements between Owner and Contractor Form A101 and Bid Bond Form A310 are widely used in private or nonpublic construction contracts because they are uniform and meet the construction industry's exacting legal standards.
Note: The Federal Performance bond is Standard Form 25 and was revised in 2016. It consists of only one double-sided page.
The key difference between the standard bond form and the AIA bond form is that AIA's consists of three pages. It incorporates many of the normal contract provisions found in other public and private work contract documents. Standard performance bonds refer to the construction contracts themselves and state that the bond must respond to the entire construction contract as though it was included in the bond wording itself.
Note: The A.I.A. bonds were revised and
introduced in 2010.
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Examples: Scenario one: Major Construction Company signs a contract with Government City to construct an office building. The construction contract is extremely detailed as to the contract’s terms and obligations. Standard Form 25 is used in place of the AIA. A312 Performance Bond because this is a federal contract. The surety agrees that it is obligated under the construction contract’s exacting terms even though the bond itself is only one page. Scenario two: Major Construction Company signs a contract with Precision Office for its new office building. The AIA A312 Performance Bond is drawn to conform to the common law legal aspects of private construction contracts. |
The basic terms of Performance bonds are summarized and explained below.
The contractor and surety are jointly and
severally obligated to the owner to perform the contract according to its terms
and conditions. The terms and conditions include the plans, specifications, and
any supplemental conditions. If the contractor fails to fulfill any of the
contract's provisions, the owner declares it to be in default, and the contract
is terminated by the owner's notice to the contractor and the surety. At this
point, the surety has several options. The preferred first choice is to have
all three parties meet, resolve the issues, and allow the contractor to
continue the work. If that is not possible and the owner insists on default,
the surety can do one of the following:
The completing contractor submits
payments of approved monthly requisitions or earned estimates to the owner as
work progresses. The owner pays the surety, and the surety then remits the
payment to the completing contractor.
If there is a combined Performance
and Payment bond with a single penalty, the surety’s liability is limited to
the one amount as its aggregate liability. Generally, the bond penalty is
usually required in an amount equal to 100% of the contract price, but it can
be less without affecting the premium charge.
Note: This option is more likely in the early phases
of the construction project.
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Example: Major Construction agreed to begin work on the Precision Office Building on 11/01/2022 but had not even broken ground on 02/01/2023. Precision Office considers Major to be in default and notifies ABC Surety. ABC decides to forfeit the penalty instead of getting involved in a long-term building process and because the other bids during the competitive bidding on the project were considerably higher than Major's. ABC is concerned that the contract price may not be adequate to complete the job. |
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Example: J & O Construction
contracted to build the Lovely Hills Elementary School. The surety is ABC
Surety, and 06/01/2022 is the construction start date. A school board
election on 02/01/2023 changes the board's composition, and the new board wants
to review all contracts. The new board begins to alter the original plans and
changes the start date. When the board attempts to make a sixth change to the
contract, J & O informs the board that it can no longer honor the
contract. The board demands the surety penalty, but ABC refuses because it
contends that the board first breached the contract. |
While the default conditions are
the most important part of the bond, there are additional aspects to consider.
CAUTION! The surety analyst must be
suspicious of manuscript or nonstandard bond forms and contract documents. The
first type of clause to be wary of is the exculpatory clause. This clause
attempts to place all responsibility on the contractor and relieve the owner of
any negligence or breach. The second type of clause is the one that places
burdens and responsibilities on the contractor that are considered onerous
because they are difficult for the contractor to meet. These could be
unreasonable time frames, job site conditions, acceptable times during the day
or night when the contractor is allowed to perform its work, and other unusual
terms. The contractor and surety should carefully examine such forms before
signing the contract and issuing the bonds.
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Example: Jerry
is excited because his bid for a new daycare center was accepted. He thought
he was working with standard contract terms and is surprised when he receives
a non-standard contract to sign. The contract requires that all work be
conducted between the hours of 6:00 P.M. and 5:00 A.M. It also requires that
all sharp objects be removed from the job site at the end of each workday.
Jerry notifies the daycare center that he cannot meet these conditions and
refuses to enter into the contract. The daycare
demands a bid bond penalty that the surety denies because none of these
conditions was presented at the time of the bid. |
Labor and Material Payment Bonds guarantee payment for work done and
materials supplied in connection with a construction project under contract. Their
main function is to protect suppliers of labor and material on a specific
project, but they also protect the project owner. Except for public work, subcontractors and suppliers are entitled to
file liens against the property under construction if they are not paid their
monthly requisitions within 90 days from the date work was last performed or
materials were furnished. These subcontractors and suppliers can put liens
against the property if the contractor does not pay them.
This bond amount is required to be sufficient to protect all claimants. Each claimant has the right to maintain a separate suit on the bond commencing 90 days after (and ending one year after) the date when the claimant last furnished the labor or material for which it makes a claim. The owner is not liable for any costs or expenses of such a suit.
The term "labor" is self-evident. Material means supplies necessary to complete the work, as well as water, gas, power, light, heat, oil, gasoline, telephone service, or equipment rented that directly relates to the contract.
These bonds can be a separate instrument or part of the Performance Bond. The practical reason to combine them is to have the same parties, penalties, and construction contracts. However, issuing a separate bond protects the rights of suppliers. This results in an extra level of protection for the parties that provide labor and material and prevents them from attaching liens to a building.
All federal contracts are subject to the Miller Act, which requires that these bonds be separate. This means there must be one bond for performance and one bond to pay labor and material bills on all federal projects. Many states, counties, and municipalities have adopted the Miller Act's payment provisions and incorporated them into their public contracts. These are commonly referred to as the “Little Miller Acts.”
Labor and Material Payment Bonds are customarily issued along with Performance Bonds and are provided without an additional premium charge.
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Example:
Real Construction wins
the bid to build a project for One Time Realty. Six months after the contract
is signed, the work has not started. One Time notifies ABC Surety of a breach
and demands the surety penalty. Real Construction contracted with Kraft
Cabinets for custom cabinets and Teigler Equipment for a two-year lease on a
cherry picker. Scenario
1: Real Construction has
a single Performance and Labor and Material Bond. It is sufficient to pay for
another contractor to finish the job but is not sufficient to pay Kraft
Cabinets or Teigler Equipment. They both attach liens to One Time Realty’s
property. Scenario 2: Real Construction has a Performance Bond
and a separate Labor and Material Bond. The Performance Bond penalty pays for
another contractor to finish the job. The Labor and Material Bond pays the
obligations to Kraft Cabinets and Teigler Equipment. |
Whether combined with a Performance Bond or written separately, the terms are essentially the same. The important points are summarized and explained below.
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Example: A subcontractor has a direct sub-contract with the general contractor. In this case, the subcontractor and its suppliers are protected. The sub-subcontractor has a contractual relationship with the contractor and is protected, but its suppliers usually are not. |
Note: This applies only if the claimant has not received any communication from the contractor with respect to payment of the claim in the 30 days preceding the notification.