Contracts are a way of doing business. One way to guarantee that a contract will be performed is to require posting a bond to ensure its successful performance. The bond provides a level of security beyond the signature on the contract. The purchaser of 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 the contract bonds available.
The most common miscellaneous contract bond is the contract bond for supplies. It applies to supplies carried in stock, those readily manufactured by the contractor in the conduct of its regular business or those purchased in the open market that do not normally require any work after delivery. Bid and Performance bonds are usually required in connection with delivery of such supplies to public entities.
Contract bonds also include those for garbage 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 State Postal Service under a mail delivery contract, the bond obligates the surety.
If the selected bidder or contractor defaults in its performance, the maximum liability of the surety is limited to 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 lesser figure then represents the surety’s liability.
In the case of default, if the surety prefers to assume responsibility for performing under the contract instead of liquidating its bond, it may do so, except in cases where the contract involves air transportation. Bonds are required under all contracts for the transportation of mail by highway, except by a bus company under certain circumstances, by domestic water and by air taxi operators.
Most contracts provide a warranty or maintenance guarantee to cover defective or inferior materials and workmanship for a specific period of time from the date of acceptance, 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 stipulated period. Since this provision is incorporated in the contract documents, separate maintenance bonds are rarely required to supplement a performance bond. Some owners prefer having a separate bond to specifically cover the warranty period and, 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. After one year, an annual charge is made, based on the value of the guaranteed work. In unusual cases where a Maintenance bond may be required in the absence of a performance and payment bond, a specific premium charge is made, 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. Consider arrangements for roofing systems. While most sureties usually resist a five-year warranty, they may oblige their better roofing clients. Ten years for any client would almost certainly be considered prohibitive, even if a manufacturer’s warranty backed the roofer’s commitment for defective materials excluding labor.
It is important to distinguish between warranties for defective materials and workmanship and 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. Where these types of exposures exist, and if this work has been subcontracted, the subcontractor may be required to furnish a bond to the general contractor so that the risk is transferred to the subcontractor’s surety.
General contractors require Performance and Payment bonds from their subcontractors. These bonds guarantee that the subcontractor will faithfully perform the subcontract according to its terms and pay bills for labor and material incurred because of the subcontracted work.
Some intermingling of responsibility exists in practically 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 almost never do all the work required in a large construction job. They sublet 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 have no employees or equipment at all. For this reason, they sublet all the work to subcontractors. Since subcontractors actually complete the job in many cases, Subcontract bonds are critical.
Under the Subcontract Performance bond, 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 of completing the 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 the payment of any costs or expenses of a suit brought by a subcontractor claimant. No claimant can commence any action or suit, with respect to claims:
Sureties generally avoid furnishing bonds to both a general contractor and a subcontractor for the same project. This could place the surety in the awkward position of alienating and possibly losing either or both clients. Consider the ramifications of a general contractor filing a claim under the sub’s bond. If the general contractor was required to furnish a bond, the surety’s liability could be compounded by the following event:
In a case like this, the surety could be liable under both bonds from the same job. In general, most sureties will only consider a double bonding situation if the general contractor and sub are both highly capable and valued clients have had some experience in working together on previous projects, and the general contractor accepts its bond on behalf of the sub. Of course, the surety must also make the general contractor aware of the implications of double bonding. If the surety either refuses to provide the sub bond or the general contractor refuses to accept it, the sub is usually forced to apply to another surety company.
In order to assist its subcontractor client in such situations, a surety may request that another company front for it and provide the sub bonds. This is generally accomplished by the regular surety 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 such subterfuge is often revealed if the general contractor files a claim under the sub’s bond.
A subdivision bond is an obligation in favor of a county or municipality as obligee on behalf of a developer/home builder principal. It indemnifies the obligee against the builder’s failure to install the off-site improvements required under local building codes, such as streets, curbs, gutters, and sidewalks.
These improvements are financed and installed by the principal and the bonds are normally required at the time the building permits are issued. Sureties consider this a very hazardous obligation because of the highly speculative nature of real estate development and the burden of both the financing and performance responsibilities resting on its principal. When authorized, the surety usually requires collateral in addition to a bond from the contractor actually doing the work if it is not the developer. In this case, the developer is the obligee. Where construction loans are involved, the surety may require that the cost of the improvements be escrowed and set aside. As various phases are completed, incremental payments are distributed from the escrow account.
The owner usually provides a Completion bond to a lender or mortgagee. It guarantees the successful financing to completion of a construction project free of liens. This should not be confused with a Performance bond given by the contractor to the owner guaranteeing faithful performance of the building or construction contract.
The general underwriting approach for both surety underwriters and commercial loan officers is satisfaction with their client’s 3 Cs: Character, Capacity and Capital. When any of these is questionable or raises concerns, the underwriter should avoid the risk completely.
In most cases, evaluating character is a very subtle process. The evaluation may be accomplished by closely observing a client’s work ethic.
This factor is the most mentally challenging as well as being the one that takes up most of the underwriter’s time. A proper financial evaluation requires analysis of the client’s financial statements, work-in-progress schedules, personal statements, trade reports, long and short-term credit availability and other relevant financial data.
This factor addresses organizational depth, adequacy of plant and equipment and experience. Past experience in the type of work the contractor proposes to undertake is an important underwriting consideration.
For new accounts, all information must be submitted for review prior to the bond being issued. Subsequent regular updating of information facilitates a prompt and timely response to future bond requests. After an account has been approved for surety, the need exists for a properly executed General Indemnity Agreement, a corporate indemnity and/or personal indemnity of owners/stockholders.
