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Surety bonds, commonly referred to simply as ‘bonds’, have been around for centuries. The first known record of a contract suretyship was an etched clay tablet from the Mesopotamian region dating to around 2750 BC. According to the clay contract, a farmer who had been drafted into the service of the king was suddenly unable to tend his fields. To resolve this issue, the farmer contracted with another farmer to tend them under the condition that they split the proceeds of the crops equally. A local merchant served as the surety and guaranteed the second farmer’s compliance. Suretyship was also addressed in the first known written legal code, the Code of Hammurabi, around 1792-1750 BC. and a Babylonian contract of financial guarantee from 670 BC is the oldest surviving written surety contract known. In fact, tThe Roman Empire developed laws of surety around 150 AD that still exist in the principles of suretyship today.
It is important to undertsand that a surety bond is not an insurance policy. A surety bond is a guarantee, in which the surety (a third party providing financial idemnification) guarantees that the contractor, called the “principal”, will perform the “obligation” stated and outlined in the bond.
If the principal fails to perform the obligation stated in the bond, both the principal and the surety are liable, and their liability is “joint and several.” That is to say that either the principal and/or surety may be sued, and the entire liability may be collected from either one. The amount in which a bond is issued is the “penal sum,” or the “penalty amount,” of the bond. Except in a few very limited circumstances, the ‘penal sum’ or ‘penalty amount’ is the limit of liability on the bond.
For example, the “obligation” stated in a ‘bid bond’ is that the principal will honor its bid; the “obligation” in a ‘performance bond’ is that the principal will complete the project or perform as specificed in the bond contract; and the “obligation” in a ‘payment bond’ is that the principal will properly pay its subcontractors and/or suppliers. Also, bonds frequently state that as a “condition,” that if the principal fully performs the stated obligation, then the bond is null and void; otherwise the bond remains in full force and effect.
The person or firm to whom the principal and surety owe their obligation is called the “obligee.” On bid bonds, performance bonds, and payment bonds, the obligee is usually the owner of the property or project. When a subcontractor furnishes a bond, however, the obligee may be the owner or the general contractor, or both. The people or firms who are entitled to sue on a bond, sometimes called “beneficiaries” of the bond, are usually defined in the language of the bond or in those state and federal statutes that require bonds on public projects.
Generally speaking, there are four types of bonds that investors and contractors normally have need for.
’Permit Bonds’, which are often inexpensive and easily issued, guarantee that the person or entity licensed by a city, county, or state agency will perform activities for which the bond was granted, according to the regulations governing the license. These are situations where a project is going to include or require modification of a public easment, right-of-way, or similar issue. Such situations might include pouring a new driveway which touches a public street, cutting a curb, installing or modifying electrical or plumbing work, and son on.
A ‘bid bond’ guarantees the owner that the principal will honor its bid amount and will sign all contract documents if awarded the contract. The owner of the project or property is the obligee and may sue the principal and the surety to enforce the bond. If the principal refuses to honor its bid, the principal and surety are liable on the bond for any additional costs the owner incurs in reletting the contract. This usually is the difference in dollar amount between the low bid and the second low bid. The penal sum of a bid bond often is ten to twenty percent of the bid amount. In order to obtain a bid bond, principals must provide detailed financial information such as as profit and loss statements, bank account records, and other information. The prinicpal must also have acceptable perosnal or business credit as well.
A ‘performance bond’ guarantees the owner that the principal will complete the contract according to its terms including price and time. The owner is the obligee of a performance bond, and may sue the principal and the surety on the bond. If the principal defaults, or is terminated for default by the owner, the owner may call upon the surety to complete the contract. Many performance bonds give the surety three choices: completing the contract itself through a completion contractor (taking up the contract); selecting a new contractor to contract directly with the owner; or allowing the owner to complete the work with the surety paying the costs. The penal sum of the performance bond usually is the amount of the prime construction contract, and often is increased when change orders are issued. The penal sum in the bond usually is the upward limit of liability on a performance bond. However, if the surety chooses to complete the work itself through a completing contractor to take up the contract then the penal sum in the bond may not be the limit of its liability. The surety may take the same risk as a contractor in performing the contract.
A ‘payment bond’ guarantees the owner that subcontractors and suppliers will be paid the monies that they are due from the principal. The owner is the obligee; the “beneficiaries” of the bond are the subcontractors and suppliers. Both the obligee and the beneficiaries may sue on the bond. An owner benefits indirectly from a payment bond in that the subcontractors and suppliers are assured of payment and will continue performance. On a private project, the owner may also benefit by providing subcontractors and suppliers a substitute to mechanics’ liens. If the principal fails to pay the subcontractors or suppliers, they may collect from the principal or surety under the payment bond, up to the penal sum of the bond. Payments under the bond will deplete the penal sum. The penal sum in a payment bond is often less than the total amount of the prime contract, and is intended to cover anticipated subcontractor and supplier costs.
SURETY BOND REQUIREMENTS IN PRIVATE CONSTRUCTION PROJECTS
Performance bonds protect the owner from contractor default and delays, and these are important for commercial properties with fixed tenant availability dates. Payment bonds protect the property from mechanics’ liens, which might otherwise interfere with sale or refinancing of the property. Bid bonds, which generally address only the price-spread between the low and next to lowest bid price, serve a much narrower purpose. However, because of the expectations and requirements of the bid package, corporate sureties generally will issue bid bonds only to contractors who qualify for performance and payments bonds. Thus a requirement for a bid bond may help narrow the field of bidders to only those firms who can actually satisfy performance and payment bond requirements.
If you need to satisfy bonding requirements, please contact us at (512) 501-4010 or (800) 299-8994 to discuss your project and learn exactly what type of bond(s) you may need.