New Jersey Law Journal, April 2021
By Jacqueline Greenberg Vogt
Private project owners have become increasingly interested in taking advantage of the same protections that public owners historically have had, by requiring surety bonds. While the cost can be a deterrent, when compared to the price of project failure, the cost of the bonds is relatively minor.
A failed contractor means a failed project and a financial disaster. With every contractor failure looms the potential for abandoned and delayed projects, increased financing costs, capital calls, lender issues, lost buyers or tenants, litigation, clouds on title and foreclosure. Surety bonds reduce the risk of these common problems.
Public construction projects almost always require surety bonds to protect the government if the contractor is unable to complete the project or absconds with the funds. Indeed, bonding has been required by the U.S. Government on federal public works projects since the late 1890’s. Currently, there is a trend toward private development projects requiring these bonds as well. One reason is because obtaining financing without having a majority of the project bonded is becoming more and more difficult. Moreover, private project owners have become increasingly interested in taking advantage of the same protections as public owners historically have had for the benefit of their projects, stakeholders, investors, lenders, and principals.
In addition, specifying bonds reduces the likelihood of default, increases the likelihood of successful completion, and, with a surety bond in place, ensures that the owner has the peace of mind that a sound risk transfer mechanism is in place to shift the burden of construction risk from the owner to the surety company.
What Are Surety Bonds?
A surety bond is a written agreement to guarantee compliance, performance or payment. All construction surety bonds are three-party agreements among the surety, the contractor and the project owner. Not only do surety bonds guarantee that the project will get done, they also guarantee that the project will get done correctly, according to the plans and specifications.
There are several types of surety bonds, but the two most important to a construction project are the performance bond and the payment bond. The performance bond ensures that the project will be finished. The payment bond guarantees that the subcontractors, vendors and suppliers on a project get paid by the general contractor. The payment bond protects the owner from subcontractors walking off the job, liens and delays, or refusals to deliver materials to the job site.
How Do Surety Bonds Work?
The surety’s obligations are triggered when a contractor defaults. Upon a declaration of default, and notice to the surety in accordance with the terms of the bond, the surety will conduct an impartial investigation of the circumstances surrounding the default, and make a determination if the default was proper. If the default is proper, the surety will step into the project as outlined in the bond. If the surety determines that the default is improper, it may refuse to honor the bond. The surety’s declaration also preserves the contractor’s ability to challenge the default.
If there is no default and the contractor completes the project, the bond becomes void. If the contractor does not perform, the bond remains in full force and effect. In this event, both the contractor and the surety are liable on the bond to the project owner, and are jointly and severally liable to the owner under the bond. That is, the project owner can sue either one or both of them and the entire amount can be recovered from one or the other.
The Performance Bond
Simply, a performance bond assures that the contract is performed. If a contractor becomes unable to perform or is properly terminated by the owner, the owner calls upon the contractor’s surety to complete the work under the performance bond. The performance bond typically states that the surety’s obligation under the bond arises when, 1) the owner notifies the contractor and the surety that the owner is considering declaring the contractor in default; 2) the owner has actually declared the contractor in default and formally terminated the contractor; and 3) the owner has agreed to pay the balance of the contract price to the surety. Performance bonds also protect the project owner against workmanship defects, building code violations and contractor bankruptcy.
Once the surety’s obligation under the bond is triggered, the performance bond provides for the surety to step in to help complete the contractor’s performance. Sometimes, this means that the surety merely provides funding to assist the contractor with cash flow that is impacting performance. In other situations, the surety may provide construction management assistance to assist the contractor in staying on track, and sometimes the surety hires a replacement contractor to complete the work. There are also circumstances where the surety instead pays over the penal sum of the bond (the amount of the contract, plus any change orders) to the project owner.
The Payment Bond
A payment bond guarantees that the contractor will pay its subcontractors, vendors and suppliers. This protects not only those parties, but also the project owner from financial responsibility rising out of the contractor’s failure to pay them. In the case of nonpayment, the subcontractors, vendors and suppliers can file a claim on the payment bond. The surety investigates the claim to ensure that the work or materials were in fact, used for the bonded project and not paid for by the contractor, and the surety then pays the claimant.
A payment bond may be triggered by the filing of a mechanic’s lien. In the event of a lien, the bonded contractor would contact the surety to bond the lien with a discharge of lien bond. The discharge of lien bond would stand in place of the lien and relieve the project owner of potential defaults under its lease or financing. The subcontractors, vendors and suppliers would then be able to sue the surety directly for payment.
Pros and Cons of Bonding
The existence of bonds on a project, at least in theory, ensures that liens will not be filed by the subcontractors, vendors and suppliers. Mechanics liens violate mortgage agreements, prevent owners from receiving additional draws under their construction loans, and in certain circumstances prevent new contractors from being retained for a project.
The bond does not release the contractor from its obligations, but rather, it guarantees that the project owner will not be responsible for the contractor’s default. The bond itself is not a risk transfer from the contractor to the surety, but an extension of credit for which the contractor is liable. These qualities make bonding an attractive requirement for the project owner to impose on the contractor.
In addition to the above benefits, private project owners also prefer bonds because the existence of the bond guarantees that the contractor has met the surety’s criteria for solid financials, good credit and performance history and reputation. Contractors also see an upside from bonding in that they can capitalize each prior success into better premium rates, and larger bonding capacity being available to it after each successful project. This can help a contractor grow its business. In addition, if the contractor does run into problems, the surety lends support to the contractor in situations that otherwise might lead to defaults and claims.
Finally, contractors are more likely to complete a bonded project than a non-bonded one. This is because the surety typically requires a personal guarantee from the contractor.
One downside of requiring surety bonds, however, is the cost. The bond amount is equal to the contract value, and the bond premium is generally anywhere from 1% to 3% of the bond amount. The cost of the bond is generally passed through by the contractor to the owner, making the project cost higher. While the bond is an additional cost, having it can save a fortune in the long run especially when the project begins to have problems.
As the requirement for surety bonds becomes more prevalent among private projects, project owners and contractors are well advised to understand the process, cost, benefits and detriments of surety bonds. While the cost of surety bonds for a project can be a deterrent, when compared to the cost of project failure, the cost of the bonds is relatively minor, and they may provide just what is needed to assure project success.
Jacqueline Greenberg Vogt is a member of Mandelbaum Barrett PC, in Roseland, focusing her practice on construction contracting and litigation. She assists clients throughout the entire construction lifecycle, from initial conception to project delivery, and has significant experience resolving a wide array of construction disputes.
"Reprinted with permission from the April 22, 2021 issue of the New Jersey Law Journal. © 2021 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved."