Important Role of Surety Bonds Within the Construction Industry
Construction companies face significant risks, especially when they perform work on projects spanning several years. Issues like economic downturns, inflationary pressures, material shortages, equipment breakdowns, and others can threaten the ability of contractors to perform under their contracts. When these types of problems are insurmountable, construction contractors might be forced to delay or abandon their projects.
Construction project owners need to get some type of assurance that their projects will be completed by the contractors they hire regardless of what might occur. Surety bonds help transfer the risk you might face as a project owner to the contractors and help ensure that your project will be completed as agreed and budgeted. Construction contractors might also be required to purchase license bonds as a condition of being licensed, and subcontractors and suppliers might be likelier to agree to perform work on projects when the contractors also have payment bonds to guarantee payment.
What Is a Surety Bond?
Contrary to popular misconceptions, a construction bond is not a type of insurance. They are instead enforceable agreements between the following three parties:
• Principal – Contractor required to purchase a bond as a license or project requirement
• Obligee – Party requiring the bond, which can be the government or a project owner
• Surety – Bond company that guarantees the principal’s legal compliance and performance and issues the bond
When you apply for a surety bond, you are applying for a type of credit. Your application will be sent to underwriters to determine your degree of risk. If the surety company approves your bond application, you will have to pay a percentage of the maximum bond amount as a premium up front. The surety will also require you to sign an indemnity agreement through which you will be legally obligated to repay any amounts the surety might pay out on valid claims against your bond.
Surety bonds protect the local or state government and consumers instead of the parties that hold them. If you fail to meet your obligations under your contracts or violate the regulations governing the construction industry, claims can be filed against your bond. While the surety company will pay valid claims, you will have to reimburse the company. If you don’t, the bond company can file a lawsuit against you and recover damages through the court process.
How Surety Bonds Work in the Construction Industry
Contractors are required to get license bonds in most states to perform work on projects worth more than a certain amount. Contractors that want to bid on federal projects worth more than $150,000 are also required to purchase performance and bid bonds before they can compete for contracts.
Under the Miller Act, federal contractors that want to perform work on public buildings in projects worth more than $100,000 are also required to purchase payment bonds guaranteeing that their suppliers and subcontractors will be paid for their work on the projects. Most states also have their own laws called “Little Miller Acts” that require construction companies to purchase bonds for public projects worth more than a threshold amount.
The four main types of construction bonds that are often required in the construction industry include the following:
• Contractor license bonds – Bonds required by state agencies as a condition of licensing
• Bid bonds – Bonds required before contractors can bid on public projects that guarantee the contractors have the means to perform the work on which the bid has been submitted
• Performance bonds – Bonds that guarantee the contractor’s performance under the contract and within the agreed-on budget
• Payment bonds – Bonds that guarantee the contractor will pay its suppliers and subcontractors for their materials and work
Why Are Construction Bonds Important?
Construction bonds are important to contractors, subcontractors, project owners, and the government for several reasons. In most states, contractors need to secure surety bonds if they intend to perform work on projects exceeding certain thresholds as a condition of licensure. This means that to legally perform work as a construction contractor in those states, you will need to purchase a surety bond and apply for a contractor’s license through the relevant state agency.
Contractors also can benefit from being licensed and bonded because many savvy consumers and project owners will only agree to hire companies that are licensed, bonded, and insured. Having the relevant license and bonds in place might help you expand your prospective customer base and grow your business.
Surety bonds are also important to suppliers and subcontractors. Suppliers and subcontractors run the risk of not being paid for their work if something goes awry with the projects on which they work. Making sure the general contractor has a payment bond can help alleviate those types of concerns because the subcontractors and suppliers can file bond claims if they are not paid timely for their completed work.
Project owners are protected by requiring the construction companies they hire to be bonded in several ways. Making sure a contractor has a performance bond helps guarantee the contractor will perform its work as agreed under its contract and within the budget. A payment bond helps guarantee the contractor will pay its suppliers and subcontractors so that the project owner will not have to worry about mechanic’s liens filed against the property by subcontractors that have not been paid for their work.
Local, state, and federal governments also benefit from requiring surety bonds as a condition of licensing. These types of bond requirements help ensure construction companies will comply with the regulations and laws that govern the industry and help weed out bad actors through bond claims and license revocations.
Whether you are a contractor, subcontractor, project owner, or supplier, surety bonds play a critical role in ensuring that your business runs smoothly. If you are required to purchase surety bonds as a contractor, you should make sure that you comply with the law and perform as promised so that you can avoid potential claims against your bond.