Published November 9th, 2020
Practically all public construction work in the US is fulfilled by private section firms. These firms take on construction projects by participating in the open competitive bidding system. Should they win the bid, surety bonds, such as bid, performance, and payment bonds, play a crucial role in making the systems work.
The first of these bonds is the bid bond. The bid bond is insurance protecting project owners against frivolous bidders, assuring that they will enter into their contract and provide the necessary surety bonds. If the winning bidder fails to honor these commitments, the bid bond protects them for an amount that typically equals the difference between the winning bid and the next best alternative. After this, the contractors must provide performance and payment bonds.
Difference Between Performance and Payment Bond
Performance and payment bonds are requisites for all federal construction projects, as stipulated by the Miller Act of 1935. Additionally, “Little Miller Acts” are state statutes based on the Miller Act that require the same surety bonds for state construction projects instead of federal ones.
The performance bond secures the contractor’s guarantee to complete the construction project under the contract terms and conditions, at the agreed-upon price, within the allotted time frame.
On the other hand, payment bonds protect the various subcontractors, laborers, and material suppliers against nonpayment.
Why this law was put in place
A little over a hundred years ago, the government experienced problems and high failure rates with private firms performing public construction projects. In many cases, the contractors were found to be insolvent after being awarded the job or became insolvent before the project was completed. This meant that the government was frequently left with unfinished jobs and needed taxpayers to cover the additional costs arising from the contractor’s default.
Because mechanic’s liens do not cover government property, they needed to develop a solution to protect themselves, subcontractors, material suppliers, and other related parties. So in 1894, Congress passed the Heard Act, which authorized corporate surety bonds to secure federal construction projects performed by private firms. Later in 1935, the Heard Act was replaced by the Miller Act, which required contractors to post performance and payment bonds on federal construction projects costing over $100,000.
What is a performance bond?
A performance bond is typically between prime contractors and government entities or property owners. As its name implies, this type of bond ensures a contractor’s performance to its principal (client or project owner). If for any reason, the contractor does not deliver on all aspects of the contract, then the principal submits a claim against the performance bond. The surety company will then pressure the contractor to complete his end of the bargain or cover the bond’s full face value.
Public entities regularly require contractors to post a performance bond before bidding on a project. The Miller Act requires contractors to post both performance and payment bonds on projects exceeding $100,000. Some states require performance bonds for projects that cost much less, and these policies vary between states. Contractors needn’t post performance bonds for private projects, but project owners may stipulate so in their contracts.
Another key difference between performance and payment bonds is that suppliers and subcontractors typically do not have any rights under a performance bond. However, they may still benefit from performance bonds. With a performance bond in place, it maintains pressure on the contractor to complete projects. This provides extra security in avoiding cash flow issues and work delays.
What is a payment bond?
Payment bonds typically go hand-in-hand with performance bonds. And like performance bonds, they form a three-way contract between the contractor, the principal or project owner, and the surety. This surety bond guarantees that all parties, including subcontractors and suppliers, will receive payment for their materials and services.
These bonds take the place of mechanics lien claims in payment issues, as mechanics lien cannot be filed against public properties. A payment bond is essentially an insurance policy if contractors cannot or will not pay the other parties that performed work in a construction project.
Why are these bonds necessary for construction projects?
The primary use of these bonds is security. They guarantee that the parties involved will be covered whether the project will or won’t be finished. Another reason is that these bonds build reliability and reputation for prime contractors. For contractors to file for bonds, surety companies need to do a thorough background check to see if you’re eligible for them. They will typically look at the following things:
- A contractor’s operations – Surety companies will look into your work history for projects of similar size and scope to determine whether or not you have the capacity to fulfill your contract.
- Financial position – This aspect is probably the most crucial one for surety companies. They want to know if you have enough cash flow or working capital to handle the backlog in the bonded contracts you propose to take on. They also want to see if you have enough equity to absorb any losses should contractors experience a bad year.
How much do these bonds cost?
Performance bonds typically cost between 0.5% to 1% of the contract price, depending on several factors:
- The credit strength of a company.
- The amount of bond premium they’ve produced over time.
- The project’s complexity
- The bond value project owners desire
The greater the credit strength and amount of bond premium they’ve produced, the lower a rate they can command. Similarly, the less complicated a project is, and the lower the bond value project owners desire, the lower the rate they’ll pay.
Payment bonds vary by state. You will have to see if the contract amount on a project reaches the qualifying amount for a payment bond. Bond amounts will also vary by state, so there isn’t one definitive answer.
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About The Author
Terrence Tan Ting is an industrial engineer by profession but a full time writer by passion. He loves to write about a wide range of topics from many different industries thanks to his undying curiosity.