Understanding Construction Contract Bonds
There are three primary types of construction contract bonds:
- Bid Bonds
- Performance Bonds
- Labor and Payment 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, subcontractors, 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:
- The first bond assures that the contract will be performed.
- The second guarantees that proper labor and material bills for contract-related work will be paid.
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 nonpayment of labor and material bills cannot be attached to public property, it is considered good public policy to assure such payment. This practice avoids forcing material suppliers to add excessive price loads in order 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 to eliminate the 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 (A.I.A.), 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 let, 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 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’s and surety’s liability is the difference between the low bid and the next qualified bid.
If this difference is more than 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.
Example: Bigtowne decides to let a contract for 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 that 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 Construction is the Principal. ABC Bonding Company is the Surety.
- Bigtowne is the Owner/Obligee. The Penalty is $300,000.
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 (not to be confused with Consents of Surety for the release of final payment/retainage, contract modification, etc.), 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 provide 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 to 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 for modifications that 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.
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 skateboard 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.”
Performance Bond Analysis
The standard format for public Performance bonds is very brief and usually consists of just one page. Private performance bonds often follow wording suggested by A.I.A. Form A312, Performance and Payment Bond. This form and the A.I.A. 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.
The key difference between the standard bond form and the A.I.A. bond form is that A.I.A.’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.
Scenario 1: 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 bond forms are used in place of the A.I.A. A312 Performance Bond because this is a public 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 2: Major Construction Company signs a contract with Precision Office for its new office building. The A.I.A. 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:
- Engage another qualified completing contractor acceptable to the owner either by negotiation or by taking competitive bids from two or more independent construction firms. Then arrange to pay all outstanding subcontractor and material supplier obligations. In either case, the surety is not liable for more than the penalties of the Performance and Payment Bonds.
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. As a general rule, 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.
- Waive its right to complete the contract and forfeit the full performance bond penalty to the owner and pay outstanding labor and material bills that remain.
Note: This option is more likely in the early phases of the construction project.
Example: Major Construction agreed to begin work on the Precision Office Building on 11/01/13 but had not even broken ground on 02/01/14. 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.
- Deny liability because of a breach of contract by the owner. Examples of breaches are the owner failing to pay the contractor’s requisitions for work performed according to contract terms, faulty design by the architect as the owner’s agent, and failing to secure the necessary zoning permits. Doing so would probably involve either civil litigation or mandatory arbitration, depending on the contract’s wording.
Example: J & O Construction contracted to build the Lovely Hills Elementary School. The surety is ABC Surety and 06/01/13 is the construction start date. A school board election on 02/01/13 changes the composition of the board 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.
- Under most contract terms and/or bond forms, the surety waives notice of any extensions of the completion time or the number of “change orders” that the contractor and owner negotiate. Change orders can be either additive or deductive changes, such as increasing or decreasing the original contract amount. These change orders do not affect the surety’s total liability under the Performance bond unless it agrees to such a change in the bond penalty by executing a Consent of Surety.
- If there is any variance between the statutory regulations of a public jurisdiction within which the contract is being performed that conflict with the private contract terms, the public statutes supersede any provisions to the contrary. The bond is then construed as a statutory law bond instead of a common law bond.
- Liquidated damages may be assessed against the contractor for delays because it failed to carry out the work on a timely basis. Liquidated damages are actual economic damages due to a delay in completing a project. Examples of these are additional interest on the construction financing or loss of rents from a prospective tenant forced to go elsewhere due to the construction delay. However, there are many others.
- The surety is not liable to the owner or others for obligations unrelated to the contract. In addition, it does not have any obligations to any party other than the owner.
CAUTION! The surety analyst must be suspicious of a 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 or job site condition requirements; unworkable time constraints as to when during the day or night 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.
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 nonstandard 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 were presented at the time of the bid.
Labor and Material Payment Bonds
Labor and Material Payment bonds guarantee payment for work done and materials supplied in connection with a construction project that is 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 relate to the contract.
These bonds can be a separate instrument or part of the Performance bond. The practical reason to combine them is that they have the same parties, penalties, and construction contract. 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 that 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.
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 with 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.
Labor and Material Payment Bond Analysis
Whether combined with a Performance bond or written separately, the terms are essentially the same. The important points are summarized and explained below.
Labor and Material Payment bond provisions are sometimes confusing to the extent of the contractor and surety’s liability for unpaid claims. Because the bond does not specifically name the claimants, the question is the number of tiers of claimants entitled to protection under the bond. The general rule is that Labor and Material Payment bonds have three tiers:
- The general contractor
- Subcontractors (including their suppliers)
- Sub-subcontractors (not ordinarily including their suppliers)
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.
Following the typical surety bond format, the obligation assumed in issuing this bond ends when all labor and material bills are paid. In many cases (while the contract is being performed), the general contractor requires a release of liens to accompany the subcontractor’s monthly requisition for payment. By doing so, the subcontractor waives any future claims for the work the requisition covers.
- Claimants that have a direct contract with the contractor must inform the surety of their unpaid bills and send a copy to the owner that states the amount of the claim. This amount is considered to be substantially accurate.
- Claimants that do not have a direct contract with the contractor must do both of the following:
- Give notice to the contractor and owner within 90 days of the date the labor or material was last furnished. They must supply information as to who received the services or materials, as well as the amount of the claim.
- Notify the surety (with a copy to the owner) accompanied by a copy of the previous notice to the surety.
Note: This applies only if the claimant has not received any communication from the contractor regarding payment of the claim in the 30 days preceding the notification.
The surety must notify the claimant and either deny liability or state the amount it will pay within 45 days after it receives the notice from the claimant. The owner must also receive a copy of this notification
The bond is reduced by the amounts paid to all claimants. The surety’s liability is not more than its penal sum, regardless of the number of claims received and amounts paid.
As with Performance bonds, the surety waives notice of any change orders negotiated between the contractor and owner that either increase or decrease the contract amount or that extend the originally specified completion time.
Any legal action to recover loss by a claimant because the contractor did not pay the subcontractor and/or its suppliers must be initiated within one year of the first notice or claim for materials supplied or work performed. This also applies to nonpayment by a subcontractor to its sub-subcontractor.
Separate Performance and Labor and Material Payment bonds are usually 100% of the contract price but can vary without changing the premium charged. For example, some public owners require a 100% Performance bond and a 50% Labor and Material Payment bond. A separate stand-alone Labor and Material Payment bond can also be provided with a specified premium rate charged.
Many subcontracts contain a “pay when paid” clause. This requires paying a subcontractor when the owner pays the general contractor for the subcontractor’s work being billed.
If you have questions or need help securing a Surety Bond call us at 800-392-6532.
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