7.1 Introduction

Surety bonds are very widely used in construction contracting, on both public and private construction projects. The use of surety bonds is, however, not unique to the construction industry; rather, surety bonds are used frequently in many applications in business and commerce.

In the law, a surety is a party that assumes liability for the debt, default, or failure in duty of another. A surety bond is the term for the contract that describes the conditions and obligations pertaining to such an agreement. It should be understood that a surety bond is not an insurance policy. Rather, it serves as an extension of credit by the surety, not in the form of a financial loan, but in terms of an endorsement whereby the surety company makes certain guarantees with regard to the actions or omissions of a contractor. Insurance protects a party from the risk of loss, while a surety guarantees the performance of a defined contractual duty.

Construction surety bonding involves three parties. By the terms of a construction surety bond, the surety agrees to indemnify the owner, who is called the obligee, against default or failure in duty of the prime contractor, who is called the principal. When the contractor has properly fulfilled all of its obligations, and following the expiration of any warranty period defined by the contract and covered by the bond, the bond itself expires, and the bond agreement is discharged and is no longer of any force or effect. Regardless of the reason, however, if the prime contractor fails to fulfill its obligations as defined by the bond, the surety must assume the obligations of the contractor and must see that the contract is completed, with the surety paying all costs up to the face amount of the bond.

It should also be noted that dual obligee bonds are sometimes used. Such bonds protect both the owner and the lending institution that advances construction funds to the owner. The need for surety bonds is in large measure a consequence of the fact that construction is a very risky business, with failures of construction enterprises, both prime contractors and subcontractors, a commonplace occurrence.

7.2 Basic Elements of Understanding

Every construction bond has three components: the bond instrument itself, the face amount of the bond, and the premium for the bond. Understanding these terms, and a few others included in this section, will facilitate understanding of surety bonds.

The bond instrument is the actual contract that is entered into between the bonding company and the principal, who is the general contractor. Each bond instrument has a name and a defined function. The bond instrument contains the terms and provisions as required by the owner, the obligee, and as set forth in the contract documents for the project. While subsequent sections will describe other types of bonds that may be used, the three most common forms of bonds are the bid bond, the performance bond, and the payment bond. The purpose, content, and provisions of these bonds will be discussed in sections to follow.

The face amount of the bond is the maximum dollar amount for which the surety is liable in fulfilling the guarantees of the bond instrument. The owner will typically set forth, in the contract documents, what the required face amounts will be, for each of the bonds the owner requires the contractor to provide.

The bond premium is the dollar amount the contractor pays to the bonding company in return for the surety taking the risk in behalf of the contractor, and for writing the bond instrument as required for the project. This bond premium is a nonrefundable dollar amount the contractor pays to the bonding company. Bond premiums vary with a number of factors, which will be discussed in sections that follow.

Default is the term used for the contractor's failing to fulfill one or more of the provisions of the bond instrument. In the event of default by the contractor, the bonding company, upon notification by the obligee, is then required to make remedy to the owner in accord with the provisions of the bond instrument, up to a maximum of the face amount of the bond.

The term bonding capacity generally refers to the maximum amount of uncompleted bonded construction contract work the bonding company will allow the contractor to have in progress at a point in time. The bonding company will establish this bonding capacity amount based on its evaluation of a large number of factors. These factors will be further discussed in a subsequent section of this chapter. When the contractor has reached the limit of his bonding capacity, the bonding company will write no more bond instruments for him. This means that the contractor must complete some of the construction projects he has underway before submitting a proposal for any additional work.

7.3 Forms of Contract Bonds

By the terms of the construction contract with the owner, the prime contractor accepts two principal responsibilities: to perform all of the requirements of the contract documents and to pay all costs associated with the work. Both of these obligations can be included within a single bond instrument, and combined performance and payment bonds are written on a few projects, almost all of these being privately financed. However, it is usual practice for construction contracts to require two separate contract bonds, one bond covering performance of the contract and the other guaranteeing payment for labor and materials. The separate forms bear the endorsement of the American Institute of Architects (AIA), and virtually all statutory bonds on public work are in separate performance bond and payment bond forms.

Under the single type of bond, there is a potential conflict of interest between the owner and persons furnishing labor and materials. Because the owner has priority, the face value of the bond can be entirely consumed in satisfying its claims. Thus, in many instances, the single bond form has afforded little or no protection for material dealers, workers, and subcontractors. In addition, there have been serious problems with the priority of rights of the persons covered. The double form of bond covers separately the interest of the owner and that of subcontractors, material suppliers, and workers. The premium cost of the bond protection is not increased by furnishing two separate bonds rather than one.

7.4 Bid Bonds

Bid bonds are often required by owners in competitive bid contracting. The owner typically stipulates that the bid bond provide four guarantees to the owner:

1. A valid bid in good faith by the contractor.
2. The contractor will, if selected by the owner to be the contract recipient, actually enter a construction contract with the owner.
3. The amount of the contract will be the same as the amount of the contractor's proposal.
4. At the time the agreement is to be signed, the contractor will provide such other bonds the owner may have specified in the contract documents, usually a performance bond and a payment bond.

The first guarantee, a valid bid in good faith, is intended to demonstrate the owner's seriousness of purpose in receiving proposals from general contractors, and to serve notice that frivolous proposals are unacceptable. Coupled with the second guarantee in the bid bond, this provision also connotes the fact that the owner is engaging in this process for the purpose of entering a construction contract.

The second and third guarantees of the bid bond are straightforward and direct. If the owner selects a contractor to be the contract recipient, he expects that contractor to sign an agreement, that is, to enter a construction contract within the time period stipulated in the contract documents, with the contract amount to be the same as the amount of the contractor's proposal. If the contractor is unwilling or unable to fulfill both of these conditions, unless he has a valid legal excuse, he is declared to be in default of the bid bond.

The fourth requirement is usually fulfilled by the surety providing the contractor a statement to submit in accompaniment with his proposal on bid day. This statement certifies that the bonding company will provide the other bonds that are required. Appendix I, “AIA Document A310–2010, Bid Bond,” written by the AIA, contains a sample bid bond form.

Face amounts of bid bonds vary somewhat, but are usually stipulated to be on the order of 5 to 10 percent of the contractor's proposal amount. The usual language of the bid bond requires that in the event of contractor default, the surety must then pay the owner the difference between the contractor's proposal amount and the next higher valid proposal that the owner accepts, up to the face amount of the bond, whichever is less. A bid bond that contains this provision is referred to in bonding vocabulary as a “bid spread” form of bid bond.

Sometimes owners elect to require the bonding company to structure the bid bond language in terms whereby the bonding company is required to pay the entire face amount of the bond to the owner in the event of default by the contractor. A bid bond that contains language of this kind is referred to as a forfeiture bid bond.

Premiums for bid bonds vary by contractor, and by the exact nature of the language the bond is to contain. Most bonding companies have established very low premiums for bid bonds, with the premium frequently being little more than a handling charge. This is due to the fact that the risk is relatively low, coupled with the fact that if the contractor is selected as the contract recipient, the bonding company will be submitting performance and payment bonds, and the premium for these bonds is much higher. Contractors rarely default on bid bonds.

7.5 Performance Bonds

The basic guarantee of the performance bond is that the contractor will fulfill all of the requirements of the contract documents in his performance of the project for the owner. It guarantees that the contract will be performed in its entirety and that the owner will receive its structure, built in substantial compliance with the terms of the contract documents. A performance bond incorporates by reference the terms of the contract, and the responsibility of the contractor is the measure of the surety's obligation.

The contractor is in default of the performance bond if, for any reason, he is unwilling or unable to complete the project and to fulfill all of the requirements set forth in the contract documents. In the event of default of the contractor, the burden of contract performance becomes that of the surety.

A performance bond also typically covers any warranty period that may be required by the contract. The warranty period is most often one year from the time of substantial completion by the contractor and acceptance by the owner.

Performance bonds have a face value that acts as an upper limit of expense the surety will incur in finishing the contract should that action become necessary. This face value is established by the owner and is usually expressed as a fixed sum of money based in a percentage of the total contract price. It is not uncommon for owners to require performance bonds to be written with a face amount equal to 100 percent of the contract amount.

Appendix J is a copy of AIA Document A312–2010, “Performance Bond,” published by the AIA. This document is widely used as the performance bond form for building construction projects in private construction work, and its provisions are similar to those written by other surety bonding companies. The standard form of performance bond used by the federal government for its building construction projects provides that the bond shall apply to all contract modifications and that the life of the bond must include all extensions of time and any guarantee period required.

7.6 Payment Bonds

A payment bond acts primarily for the protection of third parties to the contract, and guarantees payment for labor and materials used or supplied in the performance of the construction project. However, the owner frequently requires the contractor to provide a payment bond because ultimately this bond provides a protection for the owner that is very important to him. Specifically, the language of the payment bond provides that if there are any bills or debts incurred by the contractor in conjunction with any aspect of the performance of the construction project, the payment bond will assure that they are paid. In private construction, this means there can be no lien filed against the owner's property by workers, subcontractors, material vendors, or other unpaid parties to the work.

Although a private owner ordinarily decides for itself whether or not to require contract bonds from the contractor, it is noteworthy that there are a few state statutes that require payment bonds on privately financed work. It is typical for public construction projects to require payment bonds.

Appendix K presents AIA Document A312–2010, “Payment Bond,” published by the AIA. Payment bonds exclude from their coverage parties who are remote from the general contractor. It is to be noted that the bond form in Appendix K includes only those claimants who have a direct contract with the prime contractor or one of the subcontractors.

This bond, which is typical of common-law payment bonds utilized by corporate sureties for privately financed projects, provides the following:

• The claimant must have had a direct contract with either the general contractor or a subcontractor.
• Labor and materials include water, gas, power, light, heat, oil, gasoline, telephone, and rental of equipment directly applicable to the contract.
• Written notice must be given by the claimant, other than one having a direct contract with the general contractor, to any two of these: general contractor, owner, or surety, within 90 days after claimant performed its last work or furnished the last of the materials.
• The owner is exempted from any liabilities in connection with such claims.
• Claims must be filed in the appropriate court.
• No claims shall be commenced after the expiration of one year following the date on which the general contractor stopped work, barring a statute to the contrary.

It is noteworthy that a subcontractor's supplier may have the right to recover payment under a general contractor's payment bond, even though the general contractor had made payment in full to the subcontractor. In many areas, the prime contractor is, under its bond, subject to double payment obligations if a subcontractor has not paid its suppliers. When the general contractor does not require payment bonds from its subcontractors, it must use special procedures, called releases of lien, when paying these parties. Releases of lien are discussed in another chapter of this book.

7.7 Statutory and Common-Law Bonds

Payment bonds are either statutory or common-law in form, and there are important differences between the two. The bonding requirements on public projects are prescribed by law, and a statutory bond, at least by reference, contains the provisions of the statute that make the bond a requirement. Private projects use common-law bonds whose coverage and language are based entirely on the provisions contained in the bond instrument itself.

The distinction between statutory and common-law bonds is an important matter to the parties for whose protection the payment bond is written. On public projects, the action of claimants to obtain protection under the bond must be taken in accordance with the language of the applicable statute. This applies whether or not the statutory requirements are contained in the language of the bond itself. When payment bonds are required by statute on public projects, the right to recover on the bond is limited by the conditions of the statute to the same extent as though the provisions of the statute were fully incorporated into the bond instrument. If a claimant fails to comply with the statutory requirements applying to enforcement of rights under the bond, it will not be permitted to recover.

A common-law bond is used when there are no statutory requirements. It is a contract that stands by its own language and that is enforced in the usual manner for contracts. In this case, a claimant must proceed as described on the face of the bond.

On private projects the use of the standard common-law payment bond as published by the various surety companies or professional associations is the usual practice. This form is standardized nationally and is approved by professional groups such as the AIA. When statutory bonds are required, most public agencies that have substantial building programs have developed standard bond forms that conform to the applicable statute. Because the laws pertaining to bonding requirements differ somewhat from one jurisdiction to another, bond forms for public contracts are not standardized nationally. The federal government and many states and municipalities use their own bond forms.

Whether specific instances of workers providing labor, material suppliers, or sub-subcontractors on public projects are protected by statutory payment bonds depends on the language of the related statute. Because liens cannot be filed against public property, the payment bond may well be the only protection that vendors, workers, and subcontractors have, to assure their payment on public projects.

The standard payment bond used by the federal government is written to comply with the provisions of the Miller Act, which is discussed in the following section. This statutory bond protects laborers, material vendors, and subcontractors who perform work or supply materials for the project, although the extent of this protection depends on how far removed the unpaid party is from the general contractor.

7.8 The Miller Act

The Miller Act is a federal statute that prescribes the requirement of performance and payment bonds used in conjunction with federal construction projects. Enacted in 1935 and subsequently amended, this statute provides that on all federal construction contracts of more than $100,000, the contractor shall furnish a performance bond for the protection of the United States and a payment bond for the protection of persons supplying labor and materials in the prosecution of the work. A 1994 amendment also specified that a bid bond should be submitted on all projects that require payment and performance bonds.

The act provides that the performance bond be written in such amount that, in the opinion of the contracting officer, the interests of the United States are adequately protected. Under issued regulations of the comptroller general, federal agencies customarily require a performance bond in the amount of 100 percent of the contract amount. Payment bond amounts are established in accordance with the following sliding scale: 50 percent of the contract amount if the contract is $1 million or less; 40 percent if the contract is more than $1 million and not in excess of $5 million; and a fixed sum of $2.5 million if the contract price is above $5 million. In order to ensure that such bonds are supplied to the U.S. government by a financially responsible surety, the U.S. Department of the Treasury maintains a list of surety companies acceptable for providing federal bonds. This list is published annually in the Federal Register.

The Miller Act provides workers, subcontractors, and material vendors who deal directly with the prime contractor the right to sue on the prime contractor's payment bond if payment is not received in full within 90 days after the date on which the last of the labor was done, or the last of the material was furnished. The law further provides that any person having a direct contractual relationship with a subcontractor but no contractual relationship with the prime contractor shall have a right of action on the prime contractor's payment bond provided the claimant gives written notice to the prime contractor within a 90-day period. There is no requirement for notice in the case of a party who deals directly with the prime contractor.

Under the Miller Act, first-tier subcontractors and material suppliers and second-tier subcontractors and material suppliers are protected, but the payment protection of this federal statute extends no further. In addition, second-tier parties must deal with first-tier subcontractors. A subcontractor under the Miller Act has been held to mean one that performs for the prime contractor a specific part of the labor or material requirement of the project. Thus, the term subcontractor has been construed by the courts to include a party who supplied custom-made materials but did not install them. An unpaid bond claimant cannot sue on the payment bond until 90 days after the last of the labor was performed or the last of the material was delivered. However, suit must be brought within one year after the last work or delivery. Suits authorized by law are brought in the name of the United States, for the use of the party suing, in the appropriate district court. Suit is brought and prosecuted by the unpaid party's own attorney.

Since passage of the Miller Act, all 50 states have followed with the enactment of their own statutes that apply to projects financed by the states and establish contract bond requirements similar to those imposed by the Miller Act. These state bonding statutes do differ, however, with regard to which parties can recover under the payment bond.

7.9 Claims for Payment

An unpaid party to the construction process that looks to the prime contractor's payment bond for compensation must process its claim in accordance with the terms of the bond instrument on private projects or by the provisions of the governing statute on public work. The processing of such a claim is a technical procedure requiring the services of an attorney. However, attorney's fees cannot normally be collected by a Miller Act claimant. To perfect a claim, the claimant must be generally aware of the notice and time requirements involved. On a private project, the unpaid party can obtain a copy of the payment bond from the owner, surety, or architect-engineer. Public owners or surety companies can provide information concerning statutory claim requirements.

The party seeking compensation may be required to provide written notice of the outstanding debt. However, the notice requirement varies with the type of owner involved, and also with the form of payment bond used. On most private projects, no notice is required from an unpaid party who is in contract with the principal (general contractor) on the payment bond. Notice to any two of the bond principal, owner, or surety is needed if the unpaid party has no contract with the principal. Under the Miller Act that prescribes bonding requirements on federal government construction, a person or firm who has privity of contract with the prime contractor has no notice requirement. Otherwise, notice must be given to the prime contractor.

Where written notice of an unpaid debt is required, this notice must be provided within a specified time period. Under the Miller Act, as well as under the usual bond forms used on private work, a claimant who was not in contract with the prime contractor must give notice within 90 days after furnishing the last work or material for which the claim is made. An unpaid party must bring suit on the payment bond within the time limits specified by the bonding statute on public works or by the bond instrument itself on private jobs.

7.10 Contract Changes

Construction contracts typically provide the owner the right to make changes in the work after the formation of the contract for construction, and while the work on the project is under way. Because the contract comes before the bond, and the bond guarantees the contract amount, it is commonly assumed that extension of the contract bond to include changes in the contract is automatically provided for. However, because the construction contract is made between the owner and the contractor, and the surety bond is a contract between the contractor and the bonding company, in the event of changes, the surety is placed in the position of being obligated by the terms of a contract to which it is not a party. Common law does not allow two contracting parties to bind a third without its consent.

Additionally, the premium that the contractor pays to obtain a bond is, at least in part, a function of the face amount of the bond, which is in turn a percentage of the contract amount. For these reasons, it is always advisable for the owner to obtain the prior written consent of the surety as a part of the change order process, when making any change or modification of the contract. To illustrate this point, it is standard practice for a completed consent-of-surety form to be attached to each project change order. Approval of a contract change in writing is needed because of the application of statutes of frauds to contracts of suretyship, as noted earlier.

Another aspect of the matter of contract modifications worthy of consideration is that it may be possible for the surety to be exonerated from its original obligation, regardless of any provision that may be in the construction contract, stating that changes to the contract do not release the surety under any bond previously provided. Some courts have held that when the changes in the contract have constituted a material departure from the original contract, or have substantially changed the manner of payment, or the manner in which the contract is to be performed, or the time allotted for performance in such a way as to make the contract significantly more difficult or costly to complete than it was originally, then the surety can be released from its obligation on the basis that the contract was not the one the surety originally underwrote and agreed to be bound by. For relief in such cases it is necessary to show that the contract change was made without the consent of the surety, and a showing is required that the change in the contract substantially increased the risk for the surety and for the contractor. As a broadscope and general rule of thumb, changes in the contract that increase the amount of the contract by more than 10 percent are considered to be significant.

A second consideration in obtaining written consent of the surety for a contract change is that the surety is not obligated to provide bond guarantees for any additional or modified work unless the surety has expressly waived the right of notice. In this regard the AIA performance bond form in Appendix J provides that the surety waives notice of any alteration or extension of time made by the owner. However, the payment bond in Appendix K, also published by the AIA, contains no such waiver clause. Some bond forms used by the federal government stipulate that the surety waives notice of all extensions or modifications to the contract. However, a number of these bond forms now also contain a provision that limits the value of changes that can be made in a bonded contract without the consent of the surety, to a maximum of 10 percent of the amount of the contract.

7.11 Bond Premiums

The amounts of the premiums that contractors pay for surety bonds are subject to many variables. In summary, the premium the surety company will charge the contractor is a function of the risk the company sees in the contractor, as well as in the project itself. Some of the variables which affect the contractor's bond premium include the following considerations: number of years the contractor has been in business; experience history of the contractor on bonded and unbonded construction projects in the past; financial strength of the contractor, as indicated by financial statement, balance sheet, and a number of financial ratios; adjudged competence and capability of the contractor and key management personnel; number and kind of projects the contractor presently has in progress; size of the project for which the current bond is being written; the type of work and special considerations in the project for which the current bond is being written (e.g., high-rise building, underground construction); the form of contract being employed for the current project; the amount of time allocated for the completion of the current project; time of year and climate in which the work will be conducted; warranty provisions of the contract for the current project; and so on. Further discussion of the factors evaluated by surety in determining whether it will write bonds for a contractor, and if it chooses to do so, what the contractor's bond premiums will be, is presented in another section of this chapter. It is highly unlikely that two different contractors would pay exactly the same premium amount, even for the same bond to be provided for the same project.

As a very broad guideline, for companies having a fine record of proven performance and a strong financial position, bond premiums might be on the order of 1 to 3 percent of the face amounts of the bonds. For companies with a poorer track record and/or a weaker financial position, bond premiums may range from 5 to 15 percent of the bond face amounts. It can be clearly discerned, therefore, that contractors having outstanding records of proven performance and a strong business financial structure accrue significant advantages with regard to the premiums they pay for bonds. Since bond premiums are a cost of doing business, and are incorporated into the amounts of estimates and proposals, contractors with good business acumen place themselves in a better competitive position when their proposals are evaluated by owners.

As will be further discussed in sections to follow, construction surety companies are regulated by the several states in the same manner as are insurance companies. They operate under charters and file their schedules of premium rates with designated public authorities. The individual states must approve basic advisory rates that are submitted by surety companies and associations to state insurance commissions. These rates can vary somewhat with the surety company, and there are many deviated rates that may be used. Such rates are typically adjusted up or down periodically, in order to reflect loss experience.

When a contractor decides he wishes to include in his business plan the performance of projects on which bonds are required, he will seek out a surety bonding company and establish a business relationship with that firm. The bonding company will subject the contractor and all of his history and assets and credentials to a very rigorous examination. This is for the purpose of the surety company's assessing the amount of risk it perceives it will experience if it elects to write surety bonds for the contractor. That determination will yield the decision as to whether the surety approves the contractor to be a bond customer. Then, when the contractor plans to prepare a proposal for a project on which bonds are required, the bonding company will calculate the bond premium he will pay.

The premiums for contract bonds are payable in advance, and the contractor includes the bond premiums in his estimates and in his proposal price for projects. The bonds, except for the bid bond that accompanies the proposal when it is submitted, are typically delivered to the owner at the time the contract is signed. The premium payment that the contractor has made is subject to later adjustment, based on the ultimate contract amount, reflecting final work quantities on unit-price contracts, and including all change orders and contract adjustments on lump sum projects.

7.12 The Surety

Essentially all contractors utilize the services of national corporate surety companies whose specialties are the writing of construction bonds for contractors. As noted earlier, these firms are subject to public regulation in the same manner as are insurance companies. They operate under charters and file their schedules of premium rates with designated public authorities.

Because the true worth of the bond is no greater than the surety's ability to pay, and because there are numerous companies that write construction bonds, the owner typically reserves the right to approve the surety company and the form of bond. The federal government requires that corporate sureties proposed for use on government projects be approved by the U.S. Treasury Department. This list of surety companies that have been approved for federal projects can be a valuable reference for private owners when faced with approval of a contractor-proposed surety. Another source of information in this regard is a report called Best's Insurance Reports (www.ambest.com/), which provide financial ratings for insurance and surety companies. Additionally, the Small Business Administration maintains a listing of preferred surety bonding companies (www.sba.gov/content/preferred-surety-bond-companies).

On very large construction projects, which seemingly are becoming ever more common, a single surety may seek protection for itself by enlisting other sureties to underwrite a portion of the contract. The original surety remains completely responsible for guaranteeing the proper performance of the contract. If the bond is invoked, it is up to the original surety company to get its underwriting sureties to stand behind it in the completion of the contract.

Similarly, in some instances the owner will require that the contract bonds be provided by co-sureties, which means that two or more sureties divide the total contract obligation among them. On very large contracts, this practice spreads the risk over the participating co-sureties and correspondingly reduces the magnitude of the risk to which any one of them is exposed. This procedure also affords the owner a measurable degree of protection against possible financial default or failure by a single surety. Occasionally, it is necessary to have co-sureties on large federal contracts because of limits established by the U.S. Treasury Department on the maximum amounts of single contract bonds that a given surety is authorized to execute.

7.13 Indemnity of Surety

It is important to recognize that by the terms of the bond contract between the general contractor and the surety bond provider, the contractor must agree to indemnify the surety against any claim that may be brought against the surety because of the contractor's failure to perform in the manner prescribed by the bond. Legal fees incurred by the surety because of claims under the bond are also recoverable from the principal, that is, the contractor. In summary, if the contractor defaults on a bond, the surety will make payment to the obligee in accord with the provisions of the bond instrument. Thereafter, the surety will collect from the contractor the amount of any damages that the surety paid in his behalf, plus any associated legal fees.

Before the surety will provide bond service, it will require the contractor to sign a formal application form or contract of indemnity. The net result is that the contractor agrees to indemnify the surety and to hold it harmless from expenses of every nature that the surety may sustain by reason of the invocation of the bond.

When the application to obtain a bond is signed by an individual contractor or a partnership, each principal in the firm is obligated to the entire extent of his personal fortune. If a corporation makes application, only the corporation assets are pledged. However, the corporate officers and company shareholders often submit their personal contracts of indemnity to the surety in order to increase the firm's bonding capacity.

7.14 Investigation by Surety

Before a surety will furnish a new or unknown contracting firm with a bid bond or with contract bonds, a thorough program of investigation is carried out to establish the past record and current condition and commitments of the company. To establish a bond relationship between a contractor and surety is a time-consuming, costly, and laborious process for the contractor.

The experience, character, reputation, financial standing, equipment, integrity, personal habits, and professional ability of the firm's owners and key personnel are carefully examined by the surety. A track record of satisfactorily completed projects, owner satisfaction, and prompt payment of financial obligations is essential. The surety checks to see that the construction company is well managed, has a history of meeting its financial obligations promptly, is reliable, deals fairly, and performs its work in a timely fashion. An attempt is made to identify the key employees of the company, and to evaluate their experience, education and credentials. The bonding company will seek to determine whether the company has adequate estimating, scheduling, construction, and administrative experience to accomplish the proposed construction work.

The surety also checks the adequacy of the contractor's financial assets, its construction equipment, and physical facilities. Company financial statements, both for the current period and for some years past, are subject to study and analysis. The firm's bank credit is verified, together with its relations with its sources of credit and with its sources of supply. Detailed information must be provided to the surety regarding the company cost management and accounting systems. The information outlined above assists the underwriter in evaluating the ability of the contractor to complete work undertaken in accordance with contract terms and to meet the resulting financial obligations. In summary, the bonding company will investigate every aspect of the contractors past and current operations, in order to assess the amount of risk it perceives in the event the surety makes a decision to write surety bonds for the contractor.

The provision of bonding services to a contractor is a highly individual matter. An exception to this general rule, however, can be found in the surety bond guarantee program that has been used by the Small Business Administration to assist qualified small businesses and minority-owned businesses to obtain construction bonds that they could not otherwise obtain. Under this program, the U.S. government guarantees to repay the participating sureties 80 percent of any loss caused by the default of a covered contractor. The Small Business Administration will guarantee bonds only for firms with average annual revenues under $3.5 million working on projects worth less than $1.25 million.

Once a contractor has firmly established a business relationship with a bonding company, the contractor's bonding capacity becomes reasonably well established, and future investigations by the surety underwriter are concerned primarily with keeping the contractor's records current and investigating the individual bond requests as they are submitted. If the contractor's workload is well below its limit and contracts of the usual variety are being proposed, a bond application is generally approved without delay. However, when the maximum bonding capacity is to be approached, or when an unusually large or completely new type of construction project is proposed, approval of the bond application may require a considerably longer period of time or may not be forthcoming at all.

When the contractor makes application for a bond for a new project, it will find the surety is interested in many aspects of the work that is proposed and for which it is being asked to write a bond. The following presents a summary of some of the most common and most important subjects of investigation by the bonding company:

1. The essential characteristics of the project under consideration, including its size, type, and nature. Evaluation of the hazards of construction cannot proceed until the surety is apprised of the work. Included here would be the identity of the owner and its ability to pay for the construction as it proceeds. The surety will seek to assure itself that the contractor has adequate equipment, expertise, experience, and resources to perform a project of the type and size proposed.
2. The total amount of uncompleted work the contractor presently has in progress, of both the bonded and the unbonded type. This must, of necessity, include work that has not yet been awarded. The obvious point of concern here is to prevent the contractor from becoming overextended with regard to working capital, equipment, capability, and organization.
3. The adequacy of working capital and the availability of credit. The contractor can assist its own cause by keeping the surety fully apprised regarding all of its activities, and by keeping the bonding company informed regarding its financial condition, with up-to-date financial reports.
4. The amount of money the contractor “left on the table,” that is, the spread between the low bid and the next highest, on its most recent proposal submittals and contract awards. Competitive conditions in the construction industry are such that a spread of more than 5 to 10 percent between the two lowest bidders can be the cause of some concern on the part of the surety. The surety is endeavoring to assure that the contractor's estimating and bidding procedures are sound.
5. The largest contract amount of similar work the contractor has successfully completed in the past. Inexperience in a new field of construction has been the cause of a great many contractor failures. The surety would like to see the contractor remain with a pattern of performing the kind of work in which it is most experienced, and with which it has been the most successful. If the contractor wishes to change to another type, the surety will urge that the first steps be small ones until the contractor acquires the necessary experience with the new type of work. If the contractor is not properly equipped for performance of the new type of work, the surety will demand that the contractor provide assurance with regard to how the equipment problems are to be solved.
6. The terms of the contract and bonds to be required, details regarding how payment will be made to the contractor, retainage provisions, time for project completion, liquidated damages amounts, and the nature of project warranties, all will be scrutinized by the surety. Analysis of all of these factors will influence the surety's appraisal of the contractor's ability to successfully perform the work on the project.
7. The amount of work, as well as the specific items of work, the contractor will perform by subcontracting and the qualifications and financial condition of the subcontractors. The surety's concern here is that the prospective subcontractors possess the necessary organization, experience, and financial resources to successfully complete their portion of the work on the project.

Following the completion of each bonded project, the surety typically sends a request for information to the owner asking for a final report on the contractor's performance. The owner is asked to submit to the surety a statement concerning the contractor's management and conduct of the project, and the contractor's handling of changes that were made in the work, and the final total contract amount. This latter figure is used as a basis for any final adjustment of the bond premium.

7.15 Rationale for Requiring Construction Bonds

Certainly, owners wish to avail themselves of the specific protections that are provided to them by the provisions of the bond instruments they require contractors to provide for their projects. Given the risks that are inherent in construction contracting, owners can moderate their own exposure by requiring contractors to provide bonds.

From the discussion in the previous sections, however, it can also be clearly ascertained that a surety company will conduct a comprehensive and detailed analysis of every aspect of a contractor's construction company, as well as all of the operations of the company, past and present. The intent of the surety company is to write construction bonds only for contractors who have the necessary track record, competence, financial capacity, expertise, manpower, equipment, and management ability to successfully and profitably complete construction projects they undertake. In summary, surety companies perform a detailed risk analysis on every aspect of the construction enterprise before they will agree to write bonds in behalf of that company.

Owners are acutely aware of this intense scrutiny and analysis on the part of the bonding company. It can be said that this is another of the reasons for which owners require bonds to be furnished for their contracts for construction—the fact that a contractor can obtain the necessary bonds indicates that in all likelihood the construction firm is capable and well managed and that it is therefore a good business risk for the owner.

7.16 Bonding Capacity of Contractors

A concept widely used by the construction industry is the term bonding capacity or bonding line. These terms have no precise definition but generally refer to the maximum dollar value or contract amount of uncompleted work the surety will allow the contractor to have on hand at any one time. A contractor's bonding capacity is a function of its net worth and cash liquidity, and can vary depending on the volume of work on hand, accumulated retainage on current projects, type of work involved, time durations of outstanding contracts, and other considerations.

Bonding capacity, or the amount of surety credit that will be extended to a given contractor, is commonly obtained as a multiple of the contractor's net quick worth, perhaps augmented by the amount of money the contractor could realize by liquidating its fixed assets such as real estate and equipment. Net quick worth is obtained as quick assets minus current liabilities (see Chapter 9). A contractor's quick assets are those that are immediately convertible to cash. The multiple applied to net quick worth can vary substantially with the individual contractor and the field of construction involved, along with the bonding company policy. On building construction, where 75 to 80 percent of the contract is normally subcontracted, this factor may be 10 to 20 or more. In heavy construction contracting, where few subcontracts are involved, but large amounts of expensive equipment are required, and the work is often in isolated areas, the multiple is likely to be somewhat smaller. New contractors will have a smaller value than older and more experienced firms. When a surety grants a line of credit to the contractor, it may require that no one contract shall exceed a certain percentage of the total work on hand.

The difference between a contractor's bonding capacity and its current total of uncompleted work, both bonded and unbonded, is a measure of the additional work for which the surety will consider bonding the contractor. There are, of course, other factors involved, such as the type of new work being considered and the size of the project.

7.17 The Surety Agent

The local representative of the surety company is the surety agent. This is the person with whom the contractor will first deal with regard to all matters pertaining to bonding provided to his company generally and to specific bonds required by owners for the projects the contractor performs. Most contractors consider it extremely important to establish and maintain a good business working relationship with this person.

There are many advantages to be gained by the contractor in selecting a thoroughly qualified and experienced agent who has bona fide surety company affiliations that enable the agent to act on behalf of the surety company he represents, and to provide prompt and effective bonding service. The surety agent is a very important member of the construction process and is one who can contribute significantly to the success or failure of a contractor's business. The agent is a trained observer of the construction industry who has a detached point of view and whose advice is therefore particularly valuable to the contractor.

Most bonding agents are sincere and astute representatives of large corporate sureties whose businesses are solidly based on long experience and competent service. From the foregoing sections it is easy to understand how the contractor may sometimes form the impression that the surety representative is unduly meddling in its affairs or is overly limiting its volume of work. In all fairness, however, the contractor should realize that the surety is interested in helping the contractor avoid the many pitfalls associated with the management of a construction firm. The contractor must realize that both he and the surety are working toward the common goal of a prosperous and successful contracting business. Some surety agents are, of course, more conservative than others. It is the responsibility of the contractor to select a bonding representative who is responsive to the needs of the contractor within the limits of responsible practice and competent service.

7.18 Default by the Contractor

When a contractor fails to fulfill one or more of the provisions that a surety bond guarantees, he is said to be in default of the bond. When the obligee, who is in most cases the owner, notifies the bonding company, the surety bonding company will fulfill its obligations as set forth in the bond instrument. After the surety has fulfilled this duty, it will vigorously seek to recover from the contractor (principal) the amount of any dollars which the bonding paid in fulfilling the provisions of the bond.

In the case of a performance bond, if for any reason the contractor is unwilling or unable to fulfill all of the requirements of his contract with the owner, and provided the owner has not defaulted on his obligations under the contract, the bonding company assumes the duty of completion of the contract requirements for the owner. The bond instrument will stipulate the options by which the surety bonding company may fulfill this obligation.

The performance bond included as an example in Appendix J provides that in the event of contractor default on the performance bond, and upon fulfillment of certain requirements by the owner, the bonding company may:

• With the consent of the owner, arrange for the contractor to complete the project.
• Undertake to complete the project itself, with its agents or by the use of independent contractors.
• Obtain bids or negotiate proposals from qualified contractors who are acceptable to the owner, and arrange for preparation of a contract to be signed by the owner and the new contractor selected with the owner's concurrence, this new contract secured with performance and payment bonds, and pay the owner the difference between the new contract and the original contract.
• Waive its right to complete the contract, and after investigation, determine the amount for which it may be liable to the owner, and then make payment to the owner in this amount.

Contract bonds can sometimes offer the contractor a genuine advantage when its ability to proceed has been temporarily curtailed by legal or financial difficulties. If the financial condition of the contracting firm is basically sound, the surety may choose to help it get back on its feet and into business again. It may elect to advance the contractor credit in sufficient amount for the contractor to proceed with its work. If claims have tied up the contractor's capital, the surety may furnish bonds to discharge these claims, thereby enabling the contractor to proceed on its own. Such arrangements are made privately, while the surety is fulfilling its fundamental responsibility to the owner under the terms of the bond.

When the contractor defaults and the surety undertakes to complete the work, the surety becomes entitled to all of the remedies the owner has against the contractor under the contract. In addition, the surety is entitled to receive from the owner the balance of the contract price, which is defined in the bond example in Appendix J as “the total amount payable by Owner to Contractor under the Contract and any amendments thereto, less the amount properly paid by Owner to Contractor.” Provisions of the governing statute apply to this matter when a statutory bond is used. The surety may also press any claims against the owner that the defaulting prime contractor might have had. Regardless of the bond wording, the surety often finds that it must compete with other claimants for the retainage withheld by the owner.

The surety also has another right in its relationship with the owner. If the owner defaults, for example, by not making progress payments, the contractor is released from liability under the contract. Because the responsibility of the surety to the owner is the same as that of the contractor to the owner, any act of the owner that would release the contractor from its contractual obligation also releases the surety.

When the owner is performing a construction project through use of the separate contracts system and there is more than one prime contractor on the project (as discussed in Chapter 1), each prime contractor is normally required to provide the owner with a performance and a payment bond. When one prime contractor fails to perform in accordance with its contract, there may be a question as to whether the defaulting contractor's surety is liable to the other prime contractors for interference or disruption to their work. The majority rule in this regard is that the surety of the defaulting contractor is not liable to the other prime contractors for additional costs that they may have suffered by reason of the disruption. Most jurisdictions deny that one prime contractor is a third-party beneficiary of the bonds provided by another prime contractor.

7.19 Contract Bonds and Type of Contract

The preceding sections of this chapter have presented the basic workings of surety bonds. The face values of performance and payment bonds are dictated by provisions of the construction contract in private work and by governing statutes in public work, with 100 percent of the contract amount being the typical face amount for each bond type. The details of such bonding are quite variable with the type of contract however, and can become very complex in some instances.

It should be noted that when the owner contracts with an architect-engineer for project design, the owner receives a professional service and no contract surety bond is involved. The owner's interests are protected, not by a surety bond but by the architect-engineer's professional liability insurance (see Chapter 8).

The general bonding procedures normally utilized with the usual construction contract types are as follows.

1. Single prime contractor, fixed-price (lump-sum) contract. With this traditional contract arrangement, the single prime contractor provides the owner with the required performance and payment bonds. In the case of a lump-sum contract, the face values of the bonds are determined from the original contract amount. The premium paid is adjusted at project completion to reflect any change in contract price caused by change orders. When the contract is unit-price, the same procedure is followed, with the bond amounts being based on the estimated total project cost. Here, again, the bond premiums are adjusted at contract completion to reflect the final contract price.
2. Multiple prime contractors, fixed-price contract. In this type of contract arrangement, each prime contractor provides the owner with bonds whose provisions pertain only to that contractor's work on the project and whose face values are based on that individual contractor's contract amount. In the usual instance, each of the prime contractors is free to use the services of its customary surety company. Where multiple prime contractors are involved and one of the contractors defaults, the bonding company of the defaulting contractor can be held liable to the other prime contractors for delay damages they may have incurred as a consequence of the default.
3. Cost-plus-fee contract. In this contractual arrangement, the contractor provides the owner with contract bonds whose face values are determined from the initial target price established for the work to be done by that contractor. As in other types of contracts, the bond premium amount is finalized when the work on the project has been completed and the final contract price of the project has been determined.
4. Joint venture. In a joint venture agreement, each participating contractor normally undertakes a specific amount or percentage of the total contract. Accordingly, each of the contractors bonds its proportionate share of the contract price. The normal procedure is that the usual sureties of each of the joint venturing contractors will jointly underwrite the project, and will sign bonds provided to the owner as co-sureties. Each surety provides its contractor's share of the contract bonds provided to the owner.
5. Construction management. The construction manager, acting as an agent of the owner, manages the project from its inception through the construction process. The construction manager is typically paid a professional fee of a percentage of the total cost of construction as compensation for its managerial services. In so doing, the construction manager actually carries out many of the duties ordinarily performed by the architect-engineer, especially during the construction process. These functions of the construction manager are in the area of professional services, where contract bonds are not used. The construction manager also performs many management duties usually done by the general contractor. In the usual construction management arrangement, the owner contracts directly with a series of prime trade contractors who perform the actual construction. The construction manager coordinates, schedules, and controls the work of these contractors.

   In the standard agency form of CM, the construction manager does not provide contract surety bonds to the owner, on the basis of the rationale discussed in the paragraph above. Rather, these bonds are provided to the owner by each of the prime contractors who actually perform the work on the project. Protection for the owner from CM negligence is provided by professional liability insurance provided by the CM.

6. Design-construct. When the design-construct concept is used, the owner receives professional design services and project construction services from a single contracting party. As previously discussed, project design is a professional function and is not bonded. Consequently, the design-construct contractor provides the owner with contract surety bonds to cover only the construction process. A complication here is that the final cost of construction is often not accurately known at the time the design-construct contract is consummated and the construction bonds are procured. As a result, the initial face amounts of the contract bonds are typically based on an initial, approximate cost of construction. The amounts of the bonds and their premiums are adjusted at a later date when the design is complete and the final construction cost has been determined.

7.20 Subcontract Bonds

Previous discussions in this chapter have pointed out that the general contractor is responsible for the job performance of the subcontractors with whom he enters subcontract agreements. In addition, the general contractor can also be held liable if a subcontractor fails to pay for materials, labor, or sub-subcontract amounts pertaining to that project.

Sometimes a general contractor, to protect itself against subcontractor debt and default, or if the prime contractor believes that there is risk in entering a subcontract agreement with a particular subcontractor, may, at his election, require certain or all of the subcontractors to provide performance and payment bonds to the general contractor. In this instance, the subcontractor is the principal and the prime contractor is the obligee.

A factor of major importance to be emphasized at this point is that such a bond serves in no way to replace honesty, integrity, and competence on the part of the subcontractor. With or without a bond, an inferior subcontractor on a project means trouble for the general contractor. Although the bond will afford the general contractor some measure of protection against financial loss directly attributable to a particular subcontract, it does not and cannot cover all of the costs in time and dollars caused by work stoppages, delays, and disruptions of the overall construction program that inevitably result from subcontractor default.

7.21 Contract Bond Alternatives

If a prime contractor is not able to obtain the customary surety bonds from a commercial surety company, alternatives are occasionally used. Under the Miller Act, such bonds on federal construction projects can also be provided by personal or individual sureties, or they may take the form of U.S. bonds or notes, certified or cashier's checks, bank drafts, Postal Service money orders, or cash. A personal surety can be a company principal or stockholder who pledges personal assets, or any other individual or group that agrees to answer for the debt or default of the contracting party. Such personal sureties must provide evidence of having a specified net worth or collateral sufficient to back up their surety obligation. The bonding statutes of many states, and some private owners as well, also permit prime contractors to use such alternatives for the usual commercial surety bonds. Additionally, sometimes prime contractors permit their subcontractors to furnish similar forms of securities.

The Office of Federal Procurement Policy contains a rule that allows contractors to use an irrevocable letter of credit in lieu of payment and performance bonds on federal construction contracts. This policy is designed to give more flexibility and contracting opportunities to smaller firms that may not be able to secure bonds. Such letters of credit are called “guaranteed letters of credit,” as distinguished from the usual commercial letters of credit that are commonly used in sales transactions. These guaranteed letters of credit are backed by the contractor's funds being held by the bank that writes the guarantee letter.

It is to be noted that certain legal aspects of letters of credit differ greatly from the usual surety bonds. With letters of credit, for example, the bank's obligation to pay is not conditioned on the mutual performance of the terms of the construction contract by both the owner and contractor. The bank is obligated to pay the owner if the owner presents the proper documentation regarding contractor default, even if the owner has failed to perform as required by the construction contract. If the owner presents the documentation specified by the letter of credit to the issuing bank and if these documents conform with the letter of credit requirements, the bank will pay the owner. The bank will then seek reimbursement from its customer, the contractor, for the amount paid. However, a contractor who disputes that it is in default can file suit to enjoin the bank from paying the owner on the letter of credit.

Letters of credit, unlike surety bonds, place the financial burden of a default dispute on the contractor rather than the owner. With a surety bond, if there is a dispute about whether a contractor is in default, the owner must wait until the dispute is resolved in its favor if it is to get its money from the surety. With a letter of credit, the owner gets its money immediately and the contractor must then sue the owner if it disputes the default. Contractors must be aware of the risks involved with letters of credit before making use of them.

7.22 Additional Surety Bonds

In addition to bid, performance, and payment bonds, surety bonds of various kinds may be written in certain situations. Some of the additional variations of bonds that may be used include the following:

7.23 Summary and Conclusions

Surety bonds are a vital component of the construction contracting environment. While not all owners and contractors will elect to utilize bonds on their projects, certainly construction contractors must be aware of the existence of surety bonds, and their variations and key provisions. Many contractors make a business decision early in the life of their business enterprises to develop a bonding capacity for their companies, and thereby to become qualified to tender proposals and to enter construction projects where the owner requires bonds. Other construction company owners may elect initially not to develop a bonding capacity for their company, and therefore to perform only those construction projects where bonding is not required, but may decide at a later date to develop the capacity to perform bonded construction projects.

Chapter 7 Review Questions

1. Define the term surety.
2. What is a contractor's bonding capacity, and how is it determined?
3. State three key provisions of a typical bid bond.
4. Explain why an owner will often require that the contractor provide a payment bond. Why does the owner care whether all parties who have furnished materials, supplies, or labor for a construction project have been paid?
5. When there is a 100 percent performance bond on a project and the contractor serves notice that he cannot complete the project, what are the owner's options, as typically stated in the provisions of the bond?
6. What is the term for the occurrence where the contractor fails to fulfill one or more of the provisions guaranteed by a bond? Explain why a contractor will typically do almost anything in his power to prevent having the owner notify the bonding company that the contractor has failed to fulfill some of the provisions guaranteed by a bond.
7. Explain two key similarities and the major element of difference between bonds and insurance policies.
8. State three reasons why the bond premiums might be different for Contractor A and Contractor B, for the same bonds on the same construction project.
9. State the key provisions of the Miller Act as they relate to construction bonds.
10. Explain why, if there is a performance bond on a project, the bonding company needs to be notified when change orders are being considered.