1. A surety bond is an
instrument under which one party guarantees to another that a
third will perform a contract. Surety bonds used in construction
are called contract bonds.
2. There are three types of bonds used in construction.
The bid bond protects the owner by guaranteeing that the
contractor will enter into the contract at the determined price.
The performance bond guarantees the performance of the work on
schedule and according to the plans and specifications. The
payment bond guarantees that certain workers, subcontractors,
and suppliers will be paid.
3. Construction is a very risky business. More than
80,000 contractors failed from 1990- 1997 leaving a trail of
unfinished private and pubic construction projects with
liabilities exceeding $21 billion. (SOURCE: Dun & Bradstreet
Business Failure Record).
4. Federal law (the Miller Act) mandates surety bonds for
all public works contracts in excess of $100,000. Federal
procurement officials may, at their own discretion, require
bonds on projects below that amount. All states have laws
requiring bonds on public works too (known as Little Miller
Acts). Owners of private construction projects are recognizing
the wisdom of requiring surety bonds to protect their company
and shareholders from the enormous costs of contractor failure.
5. Although surety bonding is considered a line of
insurance, it has many characteristics of bank credit. The
surety does not lend the contractor money, but it does allow the
surety's financial resources to be used to back the commitment
of the contractor, thus enabling the contractor to acquire a
contract with an owner. The owner receives guarantees from a
financially responsible surety company licensed to transact
surety bonds.6. Surety bonds,
through the surety companies' rigorous prequalification of contractors, protect
the owner and offer assurance to the lender, architect, and everyone else
involved with the project that the contractor is able to translate the project's
plans into a finished project. Before issuing a bond the surety needs to be
fully satisfied, among other criteria, that the contractor:
-
is of good character;
-
has experience matching the requirements of the contract;
-
has or can obtain the equipment necessary to do the work;
-
has the financial strength to support the desired work program;
-
has an excellent credit history;
-
and has established a banking relationship and a line of credit.
7. Contract surety bonds:
guarantee the project will be completed;
guarantee that the laborers, suppliers, and subcontractors will be paid;
relieve the owner from the risk of financial loss arising from
liens filed by unpaid laborers, suppliers, and subcontractors;
smooth the transition from construction to permanent financing by eliminating liens;
reduce the possibility of a contractor diverting funds from the project; and
lower the cost of construction in some cases by facilitating the use of competitive bids.
8. With
a surety bond, the owner can be satisfied that a risk transfer mechanism
is in place. The risks of construction are shifted away from the owner to
the surety. If the contractor defaults, the surety may pay for a replacement
contractor, finance the existing contractor, or provide technical and/or
financial assistance.
9. The
costs for bonds vary, but generally are one to three percent of the contract
amount. On very large projects, the cost may be less than one percent.
10. To
bond a project, the owner merely includes the bonding requirement in the
plans and specifications for the project. Obtaining bonds and delivering
them to the owner is the responsibility of the contractor who will consult
with an independent bonding agency.
An
owner wants to be satisfied the contractor runs a well-managed, profitable
enterprise, keeps promises, deals fairly, and performs obligations in a timely
manner. The surety bonding company's prequalification of the contractor provides
these assurances to the owner.
SURETY BONDS: Financial Security * Construction Assurance
Re-printed from the pamphlet "10 Things You Should Know About Surety Bonding" issued by Surety Information Office
