In general, a bond is a type of security interest where one party promises to repay the money they borrowed from another party by a specific date and at a fixed rate of interest.
For example, a company may issue a bond to an investor in order to borrow a large amount of money. At some point, the company will need to pay back the investor for the money that they borrowed. Depending on the terms of the bond, the company might have to either pay a monthly interest on the bond or completely reimburse the investor by a certain date.
What are Performance Bonds and Payment Bonds?
Performance and payment bonds are types of bonds that are intended to protect its issuer (usually a bond company or a bank) in a construction project against failure of performance or payment on the part of a contractor or subcontractor. Hence, performance and payment bonds are also referred to as construction bonds.
Specifically, a performance bond provides security that the contractor or subcontractor will fulfill all of their obligations set out in the construction contract. This can include promises to perform the construction project within a certain time frame or at an agreed upon price.
A payment bond on the other hand is one that provides security that the contractor or subcontractor will promise to pay their workers, material suppliers, and outside subcontractors for the cost of materials and labor.
Finally, performance and payment bonds were initially created to address the high rate of failure in construction projects sponsored by the federal government. Today, performance and payment bonds are most commonly used in real property developments, such as the building of houses or other types of residences (e.g., an apartment complex).
How Do Performance and Payment Bonds Work?
As previously mentioned, a bond is a written obligation to pay a fixed monetary sum on the happening or non-occurrence of a specified event or condition.
In the case of performance bonds, the specified event that may trigger compensation is when a project stops in the middle of construction and it is never completed. As for payment bonds, the specified event is typically the non-payment of workers or other parties who are necessary to complete the project.
The way in which these bonds operate is that a contractor will typically purchase a bond from an insurance company and then transfer the cost to the party who hired them (i.e., the owner of the construction project).
In return, the insurance company will provide the project owner with monetary compensation for losses in the event that the project is not completed or if the parties are not being properly paid.
As such, performance and payment bonds really focus on protecting the owner of a construction project, rather than on the contractor or the subcontracted workers. In general, performance bonds and payment bonds are normally costly for the contractors since they must take out a separate bond for each specific construction job.
Additionally, bonds are more commonly issued for larger construction projects, ranging from $25,000 and up. Also, a contractor who has already been approved by a bond company is usually considered to be more reliable than non-bonded construction operations.
What Happens If a Contractor Defaults on a Construction Project?
In the event that a contractor suddenly stops working on a construction project and does not finish it, the owner of the property will have several options to get it done. For instance, most performance bonds will give the owner three choices, including:
- They can finish the rest of the project using a “completions contractor”, which is a party who specializes in completing unfinished construction projects;
- They may hire an entirely new contractor who will then contract directly with the project owner to finish the job; or
- The owner will be allowed to complete the project themselves, with the insurance bond company paying the remaining costs.
Alternatively, the owner of the project can sue the contractor for any losses or so that they may recoup the costs of wages and materials in a non-payment scenario. Bonds can also be applied where the quality of work is very poorly executed.
If the bond company has already rendered financial assistance to the owner, however, their amount of recovery in court may be reduced or even prohibited. In that case, the owner may seek equitable remedies instead, such as an injunction, which will require the contractor to either make the necessary payments or complete the work.
Do I Need to Hire a Lawyer for Performance Bonds and Payment Bonds?
As is evident from the above discussion, construction projects can be very expensive and complex ventures. Also, they often involve several parties, sometimes more than five or six, which can include a project owner, a general contractor, an insurance bond company, a handful of subcontractors, and material suppliers.
Therefore, it would be wise to consult with a local business attorney if you feel that performance bonds or payment bonds are needed to complete your project. An experienced business attorney can help protect your interests and they can draft a contract that outlines bond provisions, which may provide you with better benefits.