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Performance Bond

What is a Performance Bond?

A performance bond is a type of contract bond.  A performance bond is a surety bond that is issued by a large surety company (usually a very large insurance company or bank).  It guarantees that a party will complete an agreement according to the terms located within that agreement.   Thus, a bonding company will assure the owner of a piece of property that another party will live up to its word when completing a contract.

Let’s look at an example: Let’s assume that the Owner of a piece of developmental land wants to build an office building on it.  That owner then gets bids from a variety of general contractors and other small business owners to work on the office building (from design and architecture to concrete to interior design).  Given the large scope of the contract, the owner cannot be assured that the general contractor can meet all of the terms within the contract (like if they went bankrupt, for example).  The owner would worry that there would be some unforeseen problem that would cause the project to falter.  The owner instead asks the general contractor to get a performance bond.

The general contractor then contacts a bonding company for the bond to guaranty that they will live up to the terms of the agreement.  The bonding company, likely a large insurance company (like CNA, AIG, Liberty, etc.) would then review the general contractor’s ability to complete the work and financial stability.  Then the surety would underwrite the bond and provide it to the owner to guarantee the work.  If the general contractor were then unable to complete the work according to the terms of the agreement, then the surety bond company would find another contractor to finish the work, or pay the owner compensation for any damages pursuant to the terms of the bond.

Another example of this type of bond is in a commodity contract situation.  Here, a buyer of goods requests from the seller for a performance guarantee.  Thus, if the good being purchase is not delivered (whether due to supply or delivery issues), then the buyer would at the very least receive payment for the loss of the goods and payments already made.  You can also see this term used to describe a deposit of collateral, such as good faith money, which secures a futures contract.

What is a Payment Bond?

A payment bond is generally used in conjunction with the performance bond.  It is standard practice to issue a payment bond at the same time as the performance guarantee.  The payment bond is a bit more strict than the performance guaranty.  A payment bond provides a guarantee that one party will pay material and labor costs pursuant to the terms of the agreement.

Again, a good example can be found in the construction world.  Here, let’s assume that the general contractor actually performs like they are supposed to, but they don’t pay all of their subcontractors or material suppliers.  A payment bond protects against these contingencies.  The owner, instead of having a multitude of lawsuits and liens files, gets to make a claim on the payment bond.  The surety company then makes sure that everyone gets paid.

What is the Miller Act?

The Miller Act was enacted in 1932.  Under the Miller Act, all contracts by the Federal Government for construction purposes must have a Performance and Payment Bond attached to it.  That is why these are so prevalent in construction agreements.  Each state has passed its own “Little Miller Act” for those construction contracts on projects that receive state funding.

Given that performance and payment bonds are so common, given that they are required on all governmental jobs, they have now become a fairly regular experience in the private sector.  You now see many (if not most) of all large private construction projects require a bond for each small business owner.

How are Performance and Payment Bonds different?

Payment bonds are really a subset of a performance bond.  Instead of guaranteeing the entirety of the contract, a payment bond only guarantees the payment of contractors.

Of course, a payment bond contains a risk that a performance bond does not.  In a performance situation, you can easily see whether the work was done according to the terms of the contract (it either was, or wasn’t).  However, in a payment situation, the owner could end up paying twice.  That’s because they could pay the general contractor who could run out of money and not pay his subcontractors or material suppliers.  Then the owner would have to pay them directly (equivalent of paying for that twice).  Thus, the payment bond is much hard to police than a performance bond.

How much does a Performance Bond cost?

The cost of a performance bond is based upon a couple of different factors.  First, the underlying contract is the start of the analysis.  The contract will detail the type of bond needed (whether a performance, payment or maintenance bond) as well as the amount that is being bonded.  Finally, an analysis of the applicant is needed.  Is the contractor a stable company?  Do they have plenty of expertise in the area being contracted?  Do they have a history of good payments?  What is their credit score?

The underwriters for each surety bond company have a sophisticated set of actuarial information that they utilize to determine the historical claims made on each bond type.  This set of lengthy history has helped them determine the risk inherent to a specific bond type (for example, a notary bond is not as risky as a motor vehicle dealer bond).  This risk is then calculated as a premium.  It’s important to note, however, that the surety assumes NO risk regarding the contractor being bonded.  Instead, the bonding company only writes companies that they assume will pay.  The premium is based on the historical risk (with an assumption of no losses).

The standard cost is between 0.75% and 3.0%, with a variance based on the amount of the bond as well as the risk of the company being bonded.  A premium is asked for performance bonds where the small business is perceived as having some company-specific risk.

How are Claims Made of Performance and Payment Bonds?

You need to understand that a Performance and Payment bond is not the same thing as having insurance.  If a claim is made (by the owner, subcontractor or other party), then the surety company will first assign someone to investigate the claim.  This person is generally an attorney or qualified insurance agent.  The surety has a duty to defend the contractor against suits that are frivolous or otherwise in dispute.

What you need to know, though, is that the surety company will look to be reimbursed for any costs associated with the performance/payment bond claim.  This includes any payments made under the bond as well as any defense costs or damages.

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