1. A surety bond is an instrument under which one party guarantees to another that a third will perform a contract. Surety bonds used in construction are called
contract bonds.
2. There are three types of bonds used in construction. The bid bond protects the owner by guaranteeing that the contractor will enter into the contract at the determined price. The performance bond guarantees the
performance of the work on schedule and according to the plans and specifications. The payment bond guarantees that certain workers, subcontractors, and suppliers will be paid.
3. Construction is a very risky business. More than 80,000 contractors failed from 1990- 1997 leaving a trail of unfinished private and pubic construction projects with liabilities exceeding $21 billion. (SOURCE: Dun
& Bradstreet Business Failure Record).
4. Federal law (the Miller Act) mandates surety bonds for all public works contracts in excess of $100,000. Federal procurement officials may, at their own discretion, require bonds on projects below that amount. All
states have laws requiring bonds on public works too (known as Little Miller Acts). Owners of private construction projects are recognizing the wisdom of requiring surety bonds to protect their company and shareholders
from the enormous costs of contractor failure.
5. Although surety bonding is considered a line of insurance, it has many characteristics of bank credit. The surety does not lend the contractor money, but it does allow the surety's financial resources to be used to
back the commitment of the contractor, thus enabling the contractor to acquire a contract with an owner. The owner receives guarantees from a financially responsible surety company licensed to transact surety bonds.
6. Surety bonds, through the surety companies' rigorous
pre-qualification of contractors, protect the owner and offer assurance to the lender, architect, and
everyone else involved with the project that the contractor is able to translate the project's plans into a finished project. Before issuing a bond the surety needs to be fully satisfied, among other criteria, that the
contractor:
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is of good character;
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has experience matching the requirements of the contract;
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has or can obtain the equipment necessary to do the work;
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has the financial strength to support the desired work program;
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has an excellent credit history;
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and has established a banking relationship and a line of credit.
7. Contract surety bonds:
guarantee the project will be completed;
guarantee that the laborers, suppliers, and subcontractors will be paid;
relieve the owner from the risk of financial loss arising from liens filed by unpaid laborers, suppliers, and subcontractors;
smooth the transition from construction to permanent financing by eliminating liens;
reduce the possibility of a contractor diverting funds from the project; and
lower the cost of construction in some cases by facilitating the use of competitive bids.
8. With a surety bond, the owner can be satisfied that a risk transfer mechanism is in place. The risks of construction are shifted away from the owner to the
surety. If the contractor defaults, the surety may pay for a replacement contractor, finance the existing contractor, or provide technical and/or financial assistance.
9. The costs for bonds vary, but generally are one to three percent of the contract amount. On very large projects, the cost may be less than one
percent.
10. To bond a project, the owner merely includes the bonding requirement in the plans and specifications for the project. Obtaining bonds and delivering them
to the owner is the responsibility of the contractor who will consult with an independent bonding agency.
An owner wants to be satisfied the contractor runs a well-managed, profitable enterprise, keeps promises, deals fairly, and performs obligations in a timely manner.
The surety bonding company's prequalification of the contractor provides these assurances to the owner.
SURETY BONDS: Financial Security * Construction Assurance
Re-printed from the pamphlet "10 Things You Should Know About Surety Bonding" issued by Surety Information Office
