Businesses have to abide by the set rules and regulations especially when it comes to contract work. Bonds protect the parties if the job fails to meet the contract. That is why bonds exist. Most contractors¸ do not think about bonding until a time comes when the projects they seek require bonding. Consequently, businesses willing to enter into a contract with corporations or the government should understand the workings of bonds.
A bond acts as insurance to the obligee should the principal fail to meet their obligations. The bond involves three parties, the principal or contractor, a surety and the obligee. The surety company helps the obligee get compensation in case the contractor fails. They also follow up on the terms of the bond with the principal, that is, if there is a need for renewal.
When do you need a bond?
If not every business requires a bond, how will I know if I will need one? The instances which call for one to purchase a bond are;
The state dictates that businesses have permits to conduct their trade. These permits act as an assurance that the company follows the rules and practices good ethics according to the laws. Specific industries require Surety bonds. All construction industries will need a Surety bond when involved in government contracting. The license and permit bonds help businesses stick to their professionalism as per the rules.
For construction contracts
Contract bonds require contractors to provide their financial statements. These statements evaluate the strengths of the company. Contractors bonds are contract specific and required before starting work on the contract. The contract bonds are payment, bid and performance bonds.
For the protection of your business
Insurance companies are good for your business protection, but they may not always cover fraud, theft, and embezzlement. This is where fidelity bond comes in. For this type, you barely feel the pinch as they are inexpensive and optional.
Bonds, no matter how expensive, they are a necessary measure to ensure that all things fall into place for the contractor and in the side of the obligee, they protect them as well.
Types of contract bonds
Having an understanding of what bonds are and why you need them, the next step is to explore the different types of surety bonds to get an even deeper insight to comfortably enter into a contract with the government or the obligee. Below are some of the most common contract bonds.
Bid bonds guarantee the project owner bidding process to guarantee the project owner that the contractor will abide by their proposal. It is a safety measure to deter contractors from changing the terms of the contract after the bid has been won. It restricts them from backing out which can cause a lot of damage to the project owner. One will have to be careful when purchasing the bid bond as forfeiting after the work has been assigned to you, gives the project owner a chance to claim a penal sum in the bid contract. In most cases, the penal sum ranges from 5-20% of the amount the contractor bids with.
Essential Tip – No frivolous or extremely low bids.
Another reason why the government asks for bid bonds is to make the bidding process fair and straightforward. It does not give room to frivolous or extremely low bids. The principals have to quote an appropriate sum for the completion of the project. After winning the proposal, the principals may not alter the prices as this would cause the government to give the contract to the next contractor in line.
Principals should play by the rules of bidding failure to which, the surety can take extreme measures suing the contractor so as they could recover the costs of forfeiting the bid. Bid bonds are mandatory when biding on federal jobs. Private firms have as well followed this move to protect themselves from the risks associated with the bidding process
The principal will require a bid bond, performance, and payment bond as they work hand in hand. After the project award, the winner will submit a bond (bid, performance, and payment) to the principal.
Performance bonds help the government or the obligee to claim compensation for an incomplete job. As per the bidding requirements, the contractor sets the completion duration, and in case they fail or leave the project halfway due to reasons such as insolvency, the performance bond takes effect but under the provision that the work is specific. In case the job description does not give proper instructions and details of what the job entails, contractors can get away with it. It is always in your best interests to specify the job description.
When does the government ask for a performance bond?
We have already established that this bond is important for the contract. But there are unique times that the governments require contractors to have performance bonds and they include;
- a) When the government offers its properties and funds to aid the completion of the project. As well as if the contractor gets to retain the salvaged materials or the funds to act as partial compensation.
- b) When a merger occurs before the end of the contract or the principal sells their assets to another contractor. The government has to determine if the successor is capable of accomplishing the job. Once a successor has been approved, the successor will present the bond.
- c) In case the government contract specifies the job involves demolition, or to remove improvements and dismantle the project. This calls for a performance bond as well.
When is a Bond Required?
According to the Miller Act (40 U.S.C), any contract above $150,000 will have a performance bond. Based on this act, the performance bond requirement cannot be waived unless stated by bond statute or job provisions makes it impracticable.
Failure to complete the job can result in financial damages of up to 100% of the quoted contract price. Additionally, the penal amount increases as the contract price increases, and it should also measure up to 100% of the increased amount.
Handling performance bonds require absolute care, or else its effectiveness does more harm than good. This happens when the obligee underestimates the cost of the project and fails to quantify the suffered losses. The surety can also prevent the obligee from being compensated by demanding the obligee’s mistake to comply with the conditions of the bond or if they prove that the owner deserves less compensation.
There are many parties in a contract job that allows the execution of the project. The subcontractors, suppliers, and laborers have to be included in the contract. The principal is in charge of paying these people, and the payment bond guarantees their pay. The three major participants of the surety bond still apply only that this time, the obligee is the subcontractors, material suppliers, and laborers who are making a claim to the surety company to be paid.
Bonds Work Together
Given the working of the payment bond, it is acquired together with the performance bond to keep the obligees from suffering in case the contractor defaults their obligations as per the set guideline of the bonds. Even though this limits the circumstance of obtaining the payment bond alone, in rare cases, private companies may ask you for the bond alone. But for federal contracts, bid, performance and payment bond are crucial for the success of the contract.
The payment bond takes its effect after the obligee makes claims of payment default and the surety company establishes the legitimacy of the claim. The contractors are on the hook for this type of bond as it reflects poorly to their method of operation and the surety company seeks to be compensated by the contractor after covering the payments to the obligees.
The Miller Act once again provides the scope of the amount to be paid after the payment bond does not hold. The amount to be paid to the obligee must;
- Be 100% of the agreed upon original contract price
- Meet additional costs if the price is increased. The amount payable should be equal to the increased amount of 100%.
- Not be less than the performance bond penal amount.
These conditions hold unless the amount for this payment bond is deemed impractical by the contracting officer. The terms also extend to contracts ranging from $35000- $150000
Apart from being protected by the Miller Act, the government should ensure that the contractor increases the penal sum, obtains an additional bond and/ or furnishes the payment protection methods in case they increase the prices.
What happens to the bid, performance and payment bonds after the work is completed? The bonds do not end there as there has to be a maintenance bond for a certain period to protect the obligee against any defects arising from completed project be it from inferior materials or poor workmanship.
The maintenance bond is sort of a warranty based on the contractor’s job. In most cases, it covers 12-24 months after which the obligee cannot claim compensation, and they start catering for any damages. The maintenance bond is not entirely about making claims and being compensated. This depends on the project owner as they have another alternative provided by the bond. They can choose to ask the contractor to fix the defects or make a claim.
In obtaining the maintenance bond, the principal’s credit situation is evaluated by the surety. The surety establishes whether the contractor can compensate the surety after they pay the project owners for the damage.
So far, the bonds have worked in favor of the obligee but are the contractors left out?
The surety bonds work for the mutual benefit of the parties involved. Also, the contractors benefit from the bonds through;
Avoiding conflicts arising from the contract
Entering into a contract ties the contractor’s hands when things take an unfortunate turn. The bonds help the contractors from facing the wrath of not upholding the bonding’s agreements by dealing with surety companies first. If the surety option does not work, the situation escalates, and the bond is utilized. The Contractor finds themselves cornered. This is why bonds are important to take care of matters before they turn to the worst.
Boosting the confidence levels
Surety bonds favor the contractors by helping the customers see their financial stability. Acquiring the bonds requires commitment, money, and assurance that you, the principal, are capable of handling the project.
Allows fair competition
If there were no rules requiring contractors to have these bonds, anybody would be eligible to get the contract. However, the bonds cross off the unqualified contractors leaving genuine principals to fight for the contract.
The process of obtaining the bonds is a learning process which results in better services. You get to talk to lawyers, engineers, accountants and relevant professionals which broadens your knowledge. Surety bonds also assist contractors in bidding more and win more contracts which add to their revenues. This rigorous process builds the contractors reputation giving them more leverage to win more bids.
Bonds cannot be substituted by insurance, but they are essential in maintaining a good relationship with the obligees to enable smooth completion of projects. You need to familiarize yourself with the bonding specifics (part 28) for your business to remain relevant and increase your chances of winning bids.