Performance Payment Bond for Construction
The construction world can be complex and carry with it high risk, for all parties. Over the years laws and regulations have evolved to protect the various parties involved. One of the biggest being the requirement of bonds, to comply with public legal requirements and some private sector financing arrangements. Two types of bonds commonly required include performance bonds and payment bonds. A closer examination of each of these options reveals what their differences are, how they work together and most importantly, what the process is for obtaining one.
What is a Performance Bond?
A performance bond is issued by a Surety (aka ‘bonding company’) which guarantees the satisfactory completion of a project by one party to another. Performance bonds protect the project owner, the ‘Obligee’, in the event that the contractor or construction company, the ‘Principal’, fails to complete their contractual obligations. If the contractual obligation is not met, resulting in a default of the Principal, the surety company’s obligation is to complete the project and satisfy the requirements of the construction contract. Although issued by an insurance company, bonds are quite different from insurance. Any costs incurred by the Surety become the obligation of the Principal to repay.
Government entities contracting for projects require performance bonds in order to protect the assets of the stakeholders, investors or taxpayers. In this regard, performance bonds also safeguard the public. Private project owners have the option to require bonds for the same benefit.
What is a Payment Bond?
Performance bonds and payment bonds are both typically required on construction projects, however serve different purposes. Unlike performance bonds, which guarantee that the job will be completed according to the contract, payment bonds serve as a guarantee that the construction company or contractor will make payment to all companies and individuals providing labor, subcontracted services or material supplies to the bonded contract. In this way, payment bonds also indirectly protect the project owner.
Payment bonds work similar to performance bonds in that in the event of a contractual default, the surety company will pay valid claimants up to the limit of the bond. These monies paid out are required to be repaid by the principal.
How do Performance and Payment Bonds work together?
How do Performance and Payment Bonds work together?
Why are Performance and Payment Bonds Required?
Performance and payment bonds are required by law to protect the taxpayers interest, as well as that of subcontractors and laborers. There’s actually a very good reason for that.
Nearly a century ago, the federal government became concerned about the significant failure rate among private firms that were working on public construction projects. In far too many cases, the contractor awarded the job was either insolvent at the time the job was awarded or became insolvent prior to its completion. As a result, the government was often left with incomplete projects, tax payers were stuck paying the additional costs incurred by the contractor’s default and a domino effect of failures followed from unpaid vendors and equipment suppliers.
Because property owned by the government is not subject to actions, such as mechanic’s liens, the workers, subcontractors and material suppliers had no recourse if they were not paid. In 1894, the Heard Act was passed by Congress, allowing the use of surety bonds to secure construction projects. In 1935, this act was replaced by the Miller Act, which is the present law requiring and governing performance and payment bonds. Virtually all states have since enacted their own “Little Miller Act” for projects constructed below the federal government level.
Used in conjunction, performance and payment bonds protect all parties involved in a project, public or private in nature. Together they ensure that, should the contractor default in any way, everyone from the owner to the individuals working at the job site will be made whole.
How Much Do Performance and Payment Bonds Cost?
The cost of these bonds depends on a number of unique factors. First, it depends on the amount of the contract and nature of the contractual obligations. It also depends on such things as the financial health and creditworthiness of the applicant, as well as experience, project history and other active projects. Similar to insurance policies, bonds are paid by way of a premium. The premium for small to mid-sized performance bonds can average around 3% of the bond amount while larger contracts may qualify for rates as low as 1%.
In order to obtain the performance and payment bonds required to bid on a project, you’ll need to demonstrate that you are capable and creditworthy. This is typically done by providing the surety company with historical financial statements for your business that demonstrate that you have sufficient working capital, cash flow, equity and profit.
The accountant prepared financial statements include, but are not limited to:
Cash flow statement
Complete notes and disclosures
Work in progress schedules