Construction is a risky business, and surety bonds are essential in the construction industry to protect owners of projects, general contractors, subcontractors, suppliers and laborers. Surety bonds transfer the financial risk from one party to another in the case of a default by a general contractor or a subcontractor in the way of performance or payment.
Sometimes unforeseen things happen in the construction industry. The contractor can secure insurance to protect them against a loss in the event of losses for liability, worker’s compensation, and various other types of perils. But what happens if the contractor (GC or Sub) is unable to complete a job or pay downstream subs, suppliers or labor? This is where the surety steps in.
A performance bond’s function is to guarantee the completion of a construction project to the beneficiary of the bond (Obligee). The surety stands in the place of the contractor (GC or Sub) if it cannot complete Its obligation under the contract. In the case of a general contractor, the performance bond protects the owner of the project (public or private). If a subcontractor provides a performance bond, the GC is protected in case of the subcontractor’s default. The surety will step in to fulfill the obligations of the contractor. The solutions for completing a performance obligation are:
- Surety funding of the defaulted contractor to completion
- Buying out the contract in a monetary settlement with the beneficiary of the performance bond (Obligee)
- Proffering a bondable replacement contractor to the beneficiary of the performance bond.
A payment bond’s function is twofold. It protects the upstream beneficiary of the bond from liens on the property in private work, and it is a statutory requirement for public work, where liens cannot be placed on public property. The downstream protection of the payment bond is to subs, suppliers and labor to ensure that their invoices and payroll are paid for the job.
Private contracts are typically required to be bonded by the owner of the property or the lender on the project to transfer the construction risk to a surety with the capacity to withstand and handle any claims. There is no statutory requirement for the GC / prime to be bonded, but it is advisable.
General or prime contractors on public jobs that use federal, state or local public funds are required by law to be bonded by qualified sureties. In federal work, the Miller Act dictates the bond requirements for federal projects. In state and locally funded jobs, the bond requirements are outlined in “Little Miller Acts” that have been enacted by the respective state.
Contractor prequalification. One might say “OK this seems to make sense and looks like a fairly easy concept, and where do I order up some bonds to start a project”? The surety will not provide these coverage benefits (bonds) outlined above, until they have performed a complete, financial, credit, and performance analysis on the contractor to be bonded. This science and art to prequalify and underwrite a contractor follows a systematic collection of information from the contractor, the CPA, bank, and job references. The better the package to the surety, the easier it is to assess the risk.
When a bond is underwritten and issued by an AM Best qualified, US Treasury listed surety, it gives credibility to the abilities of the bonded contractor. This prequalification will open more doors for the contractor that will bring him more work and profits. It is up to the contractor, surety and the surety agent to maintain and preserve the relationship and fuel the contractor’s operation.