Introduction to Surety Bonding | Wednesday December 31st, 2003 | |
What are contract surety bonds? When do I need to get one? Who issues contract surety bonds?
A contract surety bond is basically a guarantee from a surety company that a contractor will complete a project as outlined in a project. Whenever you are planning a construction project requiring a contractor, you should also obtain a surety bond for that contractor.
A surety bond is a three-party agreement between a surety company, an owner (obligee) and a principle (contractor). In this type of bond, the surety company insures the obligee that the principle will fulfill a contract. When a surety bond is used in the construction industry, it is called a contract surety bond. Business owners acquire surety bonds because they want to be sure that a contract is going to manage his enterprise well, deal fairly, perform obligations in a timely manner and keep promises. Business owners also pursue surety bonds because they provide protection in case the contractor defaults on the contract.
Surety bonding is considered a part of the insurance industry, but it shares some characteristics with the bank credit industry. However, the surety company’s primary duty is not to lend the contractor money. Instead, the surety company uses its financial resources to stand behind, or back, the contractor’s commitment and ability to complete a contract. The surety bond is advantageous for the business owner because it assures that the contracted work will be completed, and protection will be provided if it is not. Surety bond companies charge a premium for prequalifying or underwriting the contractor. Unlike insurance companies, surety companies do not charge deductibles based on the probability of loss, because surety companies do not expect a loss to occur.
Surety bonding companies do extensive research on the contractors that they bond. They request a list of good references from the contractor, as well as proof that the contractor has experience fulfilling the requirements of contracts. Surety bond companies will also evaluate a contractor’s ability to obtain equipment necessary to carry out work, the contractor’s financial ability to hire necessary employees, the contractor’s credit history and the contractor’s current bank relationships and lines of credit. Having this information will allows you, as a business owner, to make a good decision in hiring a contractor. A surety bond will also help convince architects, lenders and other principles on the project that the chosen contractor will complete the duties and contracts as assigned.
Three primary types of contract surety bonds exist: the bid bond, the performance bond and the payment bond. The bid bond assures that the contractor’s bid has been submitted in “good faith,” and that the contractor is prepared to and will agree to complete the contract at the quoted price. The performance bond provides protection for a business owner in case the contractor fails to complete the contract in accordance to its terms and conditions. The payment bond assures that the contractor will pay suppliers, subcontractors and employees.
What happens if the contractor does not fulfill his obligations? If a contractor defaults on a project, the owner declares the contractor in default and informs the surety company of the default. The surety company will be responsible for investigating the incompletion or breach of contract. A surety company is careful to conduct an impartial investigation in order to assure that the contractor accused of being in default is given appropriate legal recourse in case the business owner has falsely declared him or her in default of contract.
In case of an actual default, the conditions under which the contract will be completed are generally included in the surety company’s bond. Options may include the original contractor’s right to re-bid for the job, the right to assist the replacement contractor, the right to bring a replacement contractor on board, or the right to pay the penal sum of the bond.
In short, business owners interested in hiring contractors to complete contracts should always attain a surety bond for the contractor before entering any type of contract or agreement. Again, a surety bond assures that the contract will be completed satisfactorily. It also assures that a private owner will not be liable for liens filed by employees, subcontractors and suppliers in the case that the bonded contractor does not pay them. Elimination of liens also eases a company or organization’s ability to move from financing construction to financing permanent operations.
In addition, surety bonds may also decrease the cost of construction by encouraging bid competition between qualified contractors. Having the assurance that your contractor is qualified, and that you are protected if your contractor defaults, ease of mind and the ability to focus on other necessary aspects of business.
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