Bid, Performance and Payment Bonds

By Daniel M. Deschenes

We have all heard the stories regarding construction projects that have run well over budget, did not finish on time and caused municipalities great grief, anxiety and expense. Now more than ever, municipalities are on tight budgets with their resources stretched thin. In this economic climate, how can a town know whether the contractor bidding on its construction project is competent and financially able to complete the work? How can a town protect itself if a contractor doesn't finish and simply walks away?

One answer is surety bonding, which provides a town with appropriate security to ensure that projects are completed within the established contract price. This article provides an overview of the basic surety bond concepts, explains the benefits of surety bonds and examines three types of surety bonds: Bid Bonds, Performance Bonds and Payment Bonds as they relate to public projects in New Hampshire. A basic understanding of these three bonds is critical because it is up to the town (the "owner") to insist upon bonding and to include the form of the bond at the outset of a project.

Basic Surety Bond Concepts
A surety bond is a contractual relationship between three entities: the general contractor (or the "Principal"), the project owner (the "Town" or the "Obligee") and the bonding company (or the "Surety").

  1. "Principal" = General Contractor
  2. "Obligee" = Owner/Developer ("Town")
  3. "Surety" = Bonding Company

By definition, a surety bond is a promise made by the surety (a corporation licensed by the state to make such financial promises) to pay the owner a certain amount if the contractor fails to meet its obligations, such as performing the terms of a contract. For example, with a Performance Bond, the bonding company promises the town that the contract work will be performed and completed at the agreed contract price, even if the contractor leaves the project. If the contractor fails to perform the obligations stated in the bond, both the contractor and the surety company become liable on the bond. The amount in which a bond is issued is the "penal sum," or the "penalty amount," of the bond. Except in a very limited set of circumstances, the penal sum or penalty amount is the upward limit of liability on the bond.

As described below, these bonds provide the necessary financial security and assurance to the town that the project will be completed for the agreed price and that the labor and materials will be paid for in full.

Benefits of Bonds
Surety bonds serve two essential functions: security to the town that the work will be completed and assurance that the contractor is qualified and/or able to complete the work. The benefits provided by bonds make them a wise investment considering their relatively low-cost (usually 1 to 3 percent of the project). As described more fully below, a bond provides security because the town is "guaranteed," for example, that the project will be completed for a certain price, or the surety will pay the difference in price. Another less recognized benefit is that the bonding process also serves to "vet" potential contractors because bonding companies will only issue bonds to worthy contractors. Given the difficult economic climate, contractors are extending their geographic range and bidding on projects well outside of their established regions in the hopes of securing work. Furthermore, known "local" contractors may have been hit especially hard by the recession and no longer have the financial resources and staffing they once did. For these reasons, there is a significant amount of uncertainty in the bidding and contracting process. Thus, before entering into construction contracts that may represent a substantial portion of a town's annual budget (or perhaps several years' budgets) it is critical that towns thoroughly evaluate their general contractors and obtain the necessary security prior to the start of construction.

Although some towns may be proficient at "vetting" contractors, the fact remains that it is very difficult for towns to obtain financial documentation and fully investigate a contractor's financial and professional credentials. Surety bonds provide the first line (and most reliable source) for vetting general contractors because sureties evaluate contractors every single day. Unlike insurance, where insurance companies collect premiums and expect a certain number of losses based on actuarial tables, bonding companies never expect a loss. For this reason, bonding companies are cautious in the issuance of surety bonds (and the amount of those bonds). Thus, in approving a contractor for bonding, the surety is essentially prequalifying the contractor for the town. In making that determination on bonding, the surety will look at what the industry calls the three "C's": Character, Capital and Capacity.

Character. Here, the surety is concerned with a contractor's references, reputation and relationships. The best indicator of whether a contractor will finish a project is often their success on other projects. Thus, a surety will examine the contractor's history, list of successfully completed projects and course of conduct in promptly performing its obligations. Most sureties will also look carefully at the experience and reputation of the contractor's management or key personnel. This is especially true when evaluating newer construction companies which may not have a proven track record.

Capital. A surety will also examine the contractor's current financial position to determine whether it will have the necessary cash flow to satisfy its financial obligations during the course of construction. In performing this evaluation, the surety will examine the contractor's available cash on hand, cash flow, accounts receivable, debt, credit history and work in progress. A surety will also be interested in how much the contractor is worth, not just in cash but in current and future contracts, and any fixed assets (such as property). This will help the surety assess whether the business is financially stable and whether it has the financial capacity required to complete the particular project. The surety is also concerned with the contractor's ability to make the surety whole if the contractor defaults and the surety is obligated to make a payment under the bond.

Capacity. Finally, the surety is concerned with whether the contractor has the capacity (manpower, equipment, etc.) to complete the work guaranteed by the surety bond. This concept does not relate just to newer companies-even a long-established, reputable company can become "over-extended" and not be able to complete a given project. Thus, the surety will look carefully at a contractor's work in progress, number of employees and amount of equipment. This analysis is used not only to decide whether to provide bonding but to determined a bonding limit for that contractor, both for an individual project and the total of all projects currently ongoing.

Types of Bonds
Bid Bonds. The primary purpose of a bid bond is to assure the owner that the low-bidding contractor will enter into a contract for the price quoted in his bid (and also will provide performance and payment bonds if required by the bid documents). Bid bonds prevent the contractor from increasing the bid on the project after entering into a contract with the owner and protect the owner if the "winning contractor" refuses to honor its low bid. For these reasons, bid bonds are commonly required by owners on both public and private construction projects.

In the event the lowest qualified bidder fails to enter into the construction contract, the surety becomes liable on the bond for any additional costs the owner incurs in "re-awarding" the contract to another contractor. This liability is often limited to the difference between the lowest qualified bidder and the next-lowest qualified bidder, up to the amount of the bid bond penalty (usually 5 to 10 percent of the bid).

For example, if a contractor bids $3 million for a project and fails to enter into the contract, the bid bond will provide security up to the amount of the next lowest bidder (generally capped at $150,000 or 10 percent). Thus, if the "second contractor" will perform the contract work for $3.1 million, the surety will be contractually obligated to tender the difference, $100,000, to the town. It is easy to see how this provides the owner with peace of mind in the initial contracting phase.

Note that the surety will not provide security if the owner "materially changes" the scope of work or delays in making the award (resulting in increased costs), or if there was a "material mistake" in the bidding process.

Performance Bonds. A performance bond guarantees the owner that the contract work will be completed according to its terms including price and time. If the contractor voluntarily defaults, becomes financially insolvent, walks off the job or is terminated for default by the owner, the owner may call upon the surety to complete the contract. (Performance bonds are statutorily required on federal projects (Miller Act) and on public projects in many states (Little Miller Acts), although are not currently required in New Hampshire.) Whether the contractor is in default will be determined by the construction contract itself; some common defaults are the contractor failing to make progress as dictated by the contract, failing to pay subcontractors or suppliers or abandoning the project outright. Generally, the owner will be required to formally declare the contractor in default by the notification method set forth in the construction contract.

After a claim is made by the owner by the express procedure set forth in the bond, the surety has the duty to investigate and determine whether to honor the claim. The surety will evaluate the owner's claim that the contractor is in default of its contract and that it had the contractual right to terminate the contractor. Because an improper termination could reduce or eliminate the owner's rights under the bond, careful consideration (and thorough documentation) must be performed in addressing a contractor's alleged default. The surety will also determine whether it has any contractual defenses to the claim, including the failure of proper notice or other bond requirements.

After the surety completes its investigation, it usually has the following options (depending on the express language of the bond):

  • Finance the Existing Contractor: The surety provides funds directly to the defaulting contractor so that it may finish the project;
  • Complete Performance: The surety directly hires a new contractor to finish the project at the surety's expense;
  • Pay for New Contractor: The owner will hire a new contractor acceptable to surety, and the surety will pay the difference between amount left in the prior contract and new contract price;
  • Pay Cash: The surety will offer the owner a sum of money to simply settle the claim. The owner can then finish the project as it sees fit; or
  • Deny Liability: Refuse to acknowledge or pay the claim.

In any of these instances where the surety acknowledges a valid claim, it is the surety's responsibility to complete the project at the original cost. For example, if a contractor defaults on a $1 million project having completed approximately half of the work, it is highly likely that the cost to complete the project with a replacement contractor will exceed the $500,000 remaining in the original contract. In circumstances such as this, the surety will pay for any costs exceeding the original $1 million contract price. Without the benefit of a performance bond, however, the owner is burdened with the increased costs to complete the project.

Payment Bonds. Unpaid subcontractors and material suppliers can, and will, leave a project if they do not believe they will be paid for their work, thus grinding the project to a halt. If the contractor on a private project fails to make payments to subcontractors and material suppliers, these entities may have security in the form of statutory lien rights against the owner's property. There are no lien rights, however, on public projects in New Hampshire. Thus, a payment bond is often a crucial and, in many cases, required component of any public project.

A payment bond guarantees that payment will be made to the contractor's subcontractors and material suppliers. Usually a payment bond "covers" all labor, rental equipment, specially fabricated materials and supplies directly incorporated into the project. If the subcontractors or material suppliers are not paid within a designated time after submitting their invoices, they may make a claim against the payment bond. The payment bond is distinct from bid and performance bonds in that direct beneficiaries of the bond are the subcontractors and suppliers, not the owner. The owner, however, still benefits from the bond in that subcontractors and suppliers will continue working through problems with the general contractor knowing that they are assured of payment.

Importantly, payment bonds are statutorily required on federal projects and, per N.H. RSA 447:16-18, on any public project exceeding $35,000. Unfortunately, many municipalities overlook this statute (and do not require bonds on smaller projects) either because they are unaware of the statute, do not believe the scope of the project requires payment bonds or are persuaded not to require bonds by contractors who claim that it will "add expense" to the project.

These reasons are not justifiable. There is no excuse for not following the letter of the law. Furthermore, the minimal increase in cost to owner (again, 1 to 3 percent depending on the size of the project) provides a significant value to the owner when compared to the potentially disastrous consequences of a troubled project.

Traps for the Unwary Owner
Read the bond AND contract. Bonds are contracts. A contract, by its nature, will establish the responsibilities of the parties. In surety bonding, it is essential that the owner carefully review and comply with the terms of the bond and the underlying construction contract.

Maintain project documentation. A well-documented project file provides immeasurable assistance in resolving potential bond claims. Ultimately, a well-maintained project file will greatly assist the resolution of claims and will help substantiate an owner's claim of contractor default and, most importantly, keep the project on schedule.

Beware of surety defenses. The owner and contractor's actions leading up to a bond claim may provide a surety with a defense to making any payment on the bond. For example, an owner's failure to comply with bond requirements (e.g., notice of the claim to the surety) or the express terms of the construction contract (wrongful termination of contractor, etc.) may provide the surety with an absolute defense to payment. Thus, it is imperative that owners carefully review the bonds and construction contracts to guard against surety defenses and note all time limits and notice provisions. An owner should consult with legal counsel if necessary.

Conclusion
Given the recent economic downturn, owners must be mindful of the potential for a contractor being unable, or unwilling, to complete its contract work. To guard against this risk, the town (and all owners) should strongly consider requiring bid, payment and performance bonds on all of its construction projects. The bonding process provides an initial level of screening, assists with the selection of the most qualified contractors, can assure project completion on time and on budget, and can guard against legal claims by unpaid subcontractors and material suppliers.

Daniel M. Deschenes is an attorney with Hinkley, Allen & Snyder LLP, Attorneys at Law. Local officials in NHMA-member municipalities may contact LGC's legal services attorneys for more information on this and other topics of interest Monday through Friday, 8:30 a.m. to 4:30 p.m., by calling 800.852.3358, ext. 384. School officials should contact the New Hampshire School Boards Association attorney at 800.272.0653.