Construction Bond
What Is a Construction Bond?
A construction bond is a type of surety bond used by investors in construction projects.
Construction bonds are a type of surety bond that protects against disruptions or
financial loss due to a contractor's failure to complete a project or failure to meet
contract specifications. These bonds ensure a construction project’s bills will get paid.
KEY TAKEAWAYS
A construction bond is a type of surety bond used by investors in
construction projects.
The bond protects against disruptions or financial loss due to a
contractor's failure to complete a project or failure to meet project
specifications.
By submitting a construction bond, the party managing the construction
work states they can complete the job according to the contractual policy.
When a contractor fails to abide by any of the conditions of the contract,
the surety and contractor are both held liable.
The three main types of construction bonds are bid, performance, and
payment.
How a Construction Bond Works
Construction bond, also known as a contractor license bond, is a required bond for a
construction project. A contractor is required to have construction bonds for nearly all
government and public works projects. A contractor vying for a construction job is
generally required to put up a contract bond or construction bond.
The construction bond provides assurance to the project owner that the contractor will
perform according to the terms stated in the agreement. Construction bonds may come
in two parts on larger projects: One to protect against overall job incompletion, and the
other to protect against nonpayment of materials from suppliers and labor from
subcontractors.
There are generally three parties involved in a construction bond:
The investor/project owners, also known as the obligee.
The party or parties building the project.
The surety company that backs the bond.
The project owner or investor is typically a government agency that lists a contractual
job it wants to be done. To reduce the likelihood of a financial loss, the obligee requires
all contractors to put up a bond. The contractor selected for the job is usually the one
with the lowest bid price since investors want to pay the lowest amount possible for any
contract.
By submitting a construction bond, a principal—that is the party managing the
construction work—is stating that they can complete the job according to the
contractual policy. The principal provides financial and quality assurance to the obligee
that not only does he have the financial means to manage the project but that the
construction will be carried out to the highest quality specified. The contractor
purchases a construction bond from a surety which runs extensive background and
financial checks on a contractor before approving a bond.
Both the surety and contractor are both held liable if the contractor fails to abide
by any of the contract's conditions.
Special Considerations
When a contractor fails to abide by any of the conditions of the contract, the surety and
contractor are both held liable. The owner can make a claim against the construction
bond to compensate it for any financial loss that ensues if the principal fails to deliver
on the project as agreed or for costs due to damaged or defective work done by the
principal. In cases where the contractor defaults or declares bankruptcy, the surety is
held responsible for compensating the project owner for any financial loss. A surety
that takes on the liability of a claim can sue the contractor for the amount paid to the
owner if the terms of the construction bond permit it.
Requirements for Construction Bonds
Companies that get construction bonds generally follow these steps:
Reviewing job requirements to see if a construction or contract bond is needed.
Getting a bid bond from the surety agent and submitting it with the proposal.
If awarded a contract, approaching the agent for a performance bond.
Completing the job.
Getting a maintenance bond, if required, once the job is completed to do any repairs.
Most government jobs require the use of a construction bond. However, there are
some lines of work that don't qualify for construction bonds from American companies
even when the job may be posted by the government. Any projects that take place
overseas or on Indian reserves, projects involving private home remodeling, or even
multi-year construction projects will not receive construction bonds.
Many U.S.-based surety companies may consider these projects too risky to insure.
Laws, rules, and regulations may differ internationally or on native reservations, leaving
the surety company in a rut if the contractor either doesn't complete the job or violates
the terms of the contract. And contractors may not qualify to do the work cited after a
certain period of time, which makes it difficult to bond a longer-term project.
Construction Bond Types
A surety bond is the financial guarantor of a construction bond, guaranteeing the
obligee that the contractor will act in accordance with the terms established by the
bond. Surety companies will evaluate the financial merits of the principal builder and
charge a premium according to their calculated likelihood that an adverse event will
occur.
A surety can assist a contractor in having cash flow problems and may also replace a
contractor who abandons a project. There are three main types of construction bond
provided by a surety:
Bid Bond
A bid bond is necessary for the competitive process bidding. Each contending
contractor has to submit a bid bond along with their bids to protect the project owner in
the event a contractor backs out of the contract after winning the bid or fails to provide
a performance bid, which is required to start working on the project.
Performance Bond
A bid bond is replaced by a performance bond when a contractor accepts a bid and
proceeds to work on the project. The performance bond protects the owner from
financial loss if the contractor’s work is subpar, defective, and not in accordance with
the terms and conditions laid out in the agreed contract.
Payment Bond
This bond is also called a labor and material payment bond, which is a guarantee that
the winning contractor has the financial means to compensate their workers,
subcontractors, and suppliers of materials.
