(February 2020)
Contracts are a necessary part of doing business. One way to guarantee that a contract will be performed correctly is to require the posting of a bond. The bond provides a level of security beyond the signature on the contract. The party that purchases the services is assured that the contract will be carried out or that the surety will provide compensation. This section identifies and explains a number of contract bonds that are available.
The most common miscellaneous contract bond is for supplies. It applies to supplies carried in stock, those readily manufactured by the contractor in conducting its regular business, or those purchased in the open market that do not usually require any work after they are delivered. Bid and Performance bonds are usually required in connection with delivery of such supplies to public entities.
Contract bonds also
include those for trash and ash removal, for carrying U.S. mail, and for
demolition or wrecking contracts. In most cases, the surety executes a bid
bond. Once the principal accepts the bid (such as the United States Postal
Service under a mail delivery contract), the bond obligates the surety to
execute a performance bond. If the selected bidder or contractor defaults in
its performance, the surety's maximum liability is the amount of the posted
bond. If the total cost of replacement service exceeds the original contract
cost by less than the amount of the posted bond, the surety's liability is the
lesser figure.
|
Example: Klimate First bids on a
recycling contract with Green City. The accepted bid is for $1,250,000. ACB
Surety issues the performance bond. Klimate breaches its contract and ACB is
obligated for the penalty. Green City rebids the contract and Almost Great
bids $1,500,000. ACB is obligated to pay Green City $250,000, the difference
between the original contract and the replacement service contract. |
In case of default, the surety is permitted to assume responsibility for performing under the contract instead of liquidating its bond except in air transportation contracts.
Bonds are required under all contracts that involve domestic water and air taxi operators that transport mail on highways. However, there are some exceptions when a bus company transports mail.
Most contracts provide a warranty or maintenance guarantee to cover defective or inferior materials and workmanship for a specific period of time after the project is accepted. The period is usually one year. Because this provision forms a part of the bonded contract, the surety and principal remain liable under the Performance bond during the specified period. This provision is incorporated in the contract documents and separate maintenance bonds are not usually required to supplement a performance bond.
Some owners prefer to have a separate bond to specifically cover the warranty period. While there may be some redundancy in this requirement, the surety usually agrees and furnishes it for a one-year period without a premium charge. An annual charge is made after one year based on the value of the guaranteed work. In unusual cases, such as where a Maintenance bond may be required when there is no performance and payment bond, there is a specific premium charge based on rating procedures in the SFAA bond manual.
Warranty provisions may not be uniform during all phases of construction. For example, a warranty might apply to all completed work for one year, but it may apply for longer periods to particular phases, such as five years for roofing, three years for boilers, and two years for landscaping. The underwriter must be satisfied that these longer-term guarantees do not commit the principal and surety to excessive or unusual periods of liability. Roofing systems are a good example. While most sureties usually resist five-year warranties, they may agree to them for their better roofing clients. Ten years for any client would almost certainly be considered prohibitive, even if the manufacturer's warranty backed the roofer's commitment for defective materials (excluding labor).
There is an important distinction between warranties for defective materials and workmanship and those considered efficiency guarantees. For example, guarantees that boilers will operate at designated pressure levels or that climate control systems will maintain room temperatures at a specific level are considered efficiency of operation guarantees. When these types of exposures are present, this work may have been subcontracted, the subcontractor may be required to furnish a bond to the general contractor to transfer the risk to the subcontractor’s surety.
Under Subcontract Performance bonds, if the subcontractor is declared to be in default, the surety may promptly remedy the default. In that case, the balance of the subcontractor price is credited against the reasonable cost to complete performance of the subcontract. However, the aggregate liability of the surety never exceeds the amount of the bond.
Under the Subcontract Labor and Material Payment bond, the owner is not liable for paying any costs or expenses of a suit brought by a subcontractor claimant. No claimant can commence any action or suit, with respect to claims, under either of the following circumstances:
Under the subcontractor Payment bond, claimant is defined as one that has direct contact with the principal, and this translates to the principal's suppliers and sub-subcontractors. Here again, Payment bond liability stops at the second tier. A subcontractor does not usually require a bond from a sub-subcontractor.
The general contractor usually has the discretion as to whether or not to require that a subcontractor furnish a bond. There are cases where the general contractor's surety may require that major subcontractors secure bonds. There are also cases where the owner may require the bond. In the case of separate prime contracts, all bonds run to the owner as obligee. When work involves subcontracts, the subcontractor Performance and Payment bonds follow the same format as those for the general contractor, except that the general contractor is the obligee.
There is some
intermingling of responsibility in nearly all construction and building
operations under contract. The three major parties involved are the owner, the
general contractor, and the surety. Certain parts of a project or contract may
include subcontractors as another party. General contractors rarely do all the
work required in a large construction job. They subcontract parts of the work
to other contractors that specialize in trades such as plumbing, heating,
drywall or plastering, electrical wiring, roofing, painting, landscaping, and
other component parts or elements of the overall construction contract. In most
cases, the general contractor may not be familiar with or have the time,
equipment, or personnel to handle the entire contract. Some prime contractors
do not have any employees or equipment at all and subcontract all the work
instead.
|
Example: XYZ, the General Contractor, awards the heating, ventilating, and air conditioning (HVAC) phase to ABC Mechanical Contractors, Inc. ABC does not fabricate the sheet metal ducts it needs for its subcontract and negotiates with RST Ducts, Inc. as a sub-subcontractor to furnish them. ABC's direct contractual relationship is with XYZ and ABC's is with RST. The owner does not have any recourse against either ABC or RST and XYZ does not have any against RST. |
Some owners (private or public) may bid and award the general contractor, electrical, HVAC, and other work as separate prime contracts. While the general contractor's responsibility may be to coordinate the various specialty trades, it does not have any direct contractual relationship with any of them and does not assume any liability on their behalf. This arrangement can cost the general contractor the leverage it might otherwise enjoy against them as subcontractors, particularly in the area of directly controlling the "purse strings." With separate contacts, the owner maintains leverage over the various contractors. This can lead to problems if the owner and the general contractor disagree concerning decisions to withhold payment or to declare a subcontractor to be in default.
Sureties avoid furnishing bonds to both the general contractor and a subcontractor that work on the same project. Doing so could place them in the awkward position of alienating and possibly losing either or both clients. Consider the ramifications of a general contractor that files a claim under the subcontractor's bond. If the general contractor was required to furnish a bond, the surety's liability could be compounded when the two following claims are presented:
In a case like this, the surety could be liable under both bonds from the same job. In general, most sureties consider a double bonding situation subject to both of the following:
In addition, the surety must also inform the general contractor of the implications of double bonding. If either the surety refuses to provide the subcontractor bond or the general contractor refuses to accept it, the subcontractor is usually forced to apply to another surety company.
In order to assist its subcontractor client in such situations, the surety may request that another company front for it and provide the subcontractor's bonds. The regular surety usually accomplishes this by fully reinsuring the fronting surety without the fronting surety having the benefit of full underwriting data on its temporary client. However, this is a highly questionable practice and is revealed if the general contractor files a claim under the subcontractor's bond.
The owner usually provides a Completion bond to a lender or mortgagee. It guarantees the successful financing of a construction project to completion free of liens. This should not be confused with a Performance bond the contractor gives to the owner that guarantees faithful performance of the building or construction contract.