Payment and Performance Bonds

Performance bonds provide a guarantee that a construction project will be satisfactorily completed and that a contractor will live up to all the terms specified in the bond to the satisfaction of the project owner. Having a contract performance bond in place is often a required step to securing a contract.

Government and private sector companies require performance bonds as protection against contractor noncompliance or failure of the contractor to complete a project. Federal construction projects often involve the building of bridges, roads and other structures where completion is important to public functioning — making performance bonds the assurance that the project will get done.

When the contracting company fails to live up to its obligations on the project and can't complete the work, the bonding company may be obligated to pay for the completion of the project or secure the services of an alternative contracting company.

Bonds include terms that the contractor must meet and that define what the project owner will consider is a completed project. If the contractor fails to meet any of these terms, the construction job owner could then make a claim against the bond to recover any losses that the owner might have incurred.

If having to pay a claim would bankrupt the contractor, that would leave the surety company as the sole party responsible for making up any losses to the project owner. And because a case like this can go to court, where the terms of the performance surety bond are subject to legal interpretation, the terms and the language used must be specific.

A payment bond and a performance bond are both contract surety bonds commonly used in construction projects, but they serve different purposes.

Generally, a contractor can anticipate that a surety company will impose a charge of roughly 1% of the total contract value as the cost of a bond itself.

There are special cases, however, such as when the value of a contract exceeds $1 million. In those situations, the cost of a performance surety bond might climb as high as 2%. In all cases though, the cost imposed on the purchase of a bond will be closely connected to the creditworthiness of the contractor.

Contractors who appear to be relatively unstable financially will be charged a higher amount for a bond than would a financially stable contractor with a good credit history. As another rule, the purchase of performance bonds is generally made in conjunction with the purchase of a payment bond, so that the terms of both can be included under one comprehensive coverage.

When terms are not entirely fulfilled by a contractor, the project owner is within their right to make a claim against the bond to recover any losses. Initially, the surety company is responsible for paying that amount to the project owner, assuming that the claim can be validated, either privately or through legal means.

After that, the bonding company can then pursue the contractor to recover that same amount of money, since it was the contractor's failure to comply that caused the claim to be made. Whether a bonding company has the option to pursue the defaulting contractor will depend on the language that is included in the bond.

When the performance surety bond clearly states that the contractor must repay the amount of a claim, the contractor is legally obligated to do so. If paying that claim would push the contractor into bankruptcy, the bond-issuing company would then have no recourse for being compensated for its financial losses. For this reason, surety companies make a point of thoroughly screening applications from contractors who are interested in purchasing this kind of bond.