Basic Construction Bond Definition
A Surety Bond is a Contract by which one party agrees to make good the default or debt of another. Actually, three parties are involved: the principal, who has primary responsibility to perform the obligation (after which the bond becomes void); the surety, the individual with the secondary responsibility of performing the obligation if the principal fails to perform. (After the surety performs, recourse is against the principal for reimbursement of expenses incurred by the surety in the performance of the obligation, known as surety's right of exoneration); and the obligees, to whom the right of performance (obligation) is owed.
Construction Bonds Law & Legal Definition
Construction bids are an offer to provide construction services at a certain price. Many government projects are required to solicit bids so that contracts are awarded on a fair and competitive basis. Using a bidding process can lessen the charges of discrimination or conflicts of interest in the awarding of public contracts. The bid submitted must conform to the applicable requirements of content, form, and timeliness in order to be considered.
Construction Surety Bonds
Most construction contractors are familiar with the process of obtaining surety bonds, but they may not be aware of the legal relationships bonds establish the relationships among the principal (the contractor), the obligee (usually the owner) and the surety. Contractors' lawyers, on the other hand, are aware of the rights and the obligations of the principal, obligee, and surety, but they may lack practical knowledge about the process of obtaining bonds.
A surety bond is not an insurance policy. A surety bond is a guarantee, in which the surety guarantees that the contractor, called the "principal" in the bond, will perform the "obligation" stated in 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; and the "obligation" in a payment bond is that the principal will properly pay subcontractors and suppliers. Bonds frequently state, as a "condition," that if the principal fully performs the stated obligation, then the bond is void; otherwise the bond remains in full force and effect.
If the principal fails to perform the obligation stated in the bond, both the principal and the surety are liable on the bond, and their liability is "joint and several." That is, either the principal or surety or both may be sued on the bond, and the entire liability may be collected from either the principal or the surety. The amount in which a bond is issued is the "penal sum," or the "penalty amount," of the bond. Except in a very limited set of circumstances, the penal sum or penalty amount is the upward limit of liability on the bond.
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. Where 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.
SURETY BOND REQUIREMENTS ON FEDERAL PROJECTS
This article is an abridged version of Federal Publications' February 1996 CONSTRUCTION BRIEFINGS entitled Surety Bond Basics, copyright 1996 by Federal Publications, Incorporated, written by Messrs. Donohue and Thomas.
MILLER ACT AND FAR REQUIREMENTS
The Miller Act, 40 U.S.C. §§ 270a-270f, provides that all federal construction contracts performed in the United States must require the contractor to furnish a performance bond in an amount satisfactory to the contracting officer; a payment bond in a penal sum of up to $2.5 million, and other surety bonds as well. In the Federal Acquisition Streamlining Act of 1994, Congress made the Miller Act inapplicable to contracts under $100,000, and directed agencies to develop alternatives to surety bonds for contracts between $25,000 and $100,000. These statutory requirements are implemented in FAR part 28, bonds and insurance.
A Bid Bond is a bid guarantee required on federal projects whenever a performance bond and/or a payment bond is mandated. Bid guarantees usually are in the form of bid bonds, but on federal projects they may also be submitted as a postal money order, certified check, cashier's check or an irrevocable letter of credit. A bid guarantee must be in an amount equal to at least twenty percent of the bid price; the maximum amount is $3 million. The standard solicitation provision requiring bid guarantees says that if the contractor awarded the contract fails or refuses to execute all contractually required documents, the agency may terminate the contract for default. In such a case, the agency will make a demand on the bid bond or bid guarantee to offset the difference in price between that bid and the next lowest bid. Bid bonds and bid guarantees are returned to unsuccessful bidders after bids are opened; bid guarantees are returned to the successful bidder after all contractually required documents and bonds are executed.
Federal surety bond requirements may be met in three ways: surety bonds issued by an approved corporate surety; surety bonds issued by an individual surety who pledges certain defined types of assets; or by the contractor pledging assets directly. The third option is uncommon.
Individuals may act as sureties to satisfy bonding requirements on federal projects if they have certain acceptable assets in the required amounts to support the bonds. Although federal agencies probably would prefer to deal only with approved corporate sureties, allowance for individual sureties may enhance competition by allowing awards to contractors that might not otherwise qualify to obtain bonds from an approved corporate surety.
To support bonds issued by individual sureties, agencies may only accept cash, readily marketable assets, or irrevocable letters of credit from a federally insured financial institution. Acceptable assets include cash, certificates of deposit or other cash equivalents; U.S. agency securities (valued at current market value); stocks and bonds traded on the New York, American and certain other exchanges, valued at ninety percent of their current 52-week low price; real property owned outright in fee simple, valued at one hundred percent of its current tax assessment value; and irrevocable letters of credit issued by federally insured financial institutions. Examples of unacceptable assets are also listed in the regulations. Unacceptable assets are those that may be difficult to liquidate (e.g., a life estate in real property); are of uncertain or greatly fluctuating value (e.g., jewelry); property commonly exempt from attachment under state laws (e.g., the individual surety's home); or commonly pledged to others (e.g., plant and equipment). An individual surety is required to submit an affidavit, in which the surety identifies the assets, the market value of the assets, and all encumbrances on the assets. The affidavit must also identify all other bonds issued by the individual surety within the last three years.
When approving corporate sureties, Treasury makes a determination as to the financial strength of the surety, and sets an underwriting limit, commonly called a bonding limit. The bonding limit is also stated in Circular 570. When an approved surety offers a bond on a federal project, the contracting officer checks to make sure that the surety has not exceeded the surety's bonding limit. Because of these underwriting limits, surety bonds on very large construction projects, valued in the hundreds of millions of dollars, frequently are issued by several different approved surety companies, acting as co-sureties. The name of each co-surety will appear on the bond, along with its individual limit of liability.
Another way surety companies can stay within their approved surety underwriting limit, and spread their risk, is to obtain coinsurance or reinsurance, in which they essentially obtain a contract from another surety company to cover part of their risk on the bond they have issued. When a surety obtains reinsurance for part of its risk under a Miller Act bond, it must submit to the contracting officer a reinsurance agreement for a Miller Act performance bond and a reinsurance agreement for a Miller Act payment bond. The terms of both reinsurance agreements are stipulated in the regulations.
Statutes in all fifty states and the District of Columbia require performance and payment bonds for state government construction contracts. These state statutes often are called "Little Miller Acts" because many of them are modeled after the federal Miller Act. Each state licenses sureties to issue bonds..
There obviously is a great variation among private construction owners and projects throughout the United States. Performance bonds and payment bonds are required by owners for most large 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.
Premiums rise along with the penal sum of the bond, and the owner ultimately pays these costs in the contract price. Nonetheless, the owner has an interest in setting the bond penal sum high enough to provide the desired protection to the project. A fairly good guideline for setting penal sums is the FAR requirement discussed hereinabove. The penal sum for the performance bond should be one hundred percent of the original contract price, and the penal sum should be increased for each change order. The payment bond should be fifty percent of the contract price up to some fairly large maximum penal sum.
Popular form contracts for private construction projects, leave bonding requirements to the choice of the parties. Thus these forms do not provide much guidance in deciding the issues we have identified. Private construction contracts rarely require particular bond language. Rather, they usually require bonds in a specified amount with a surety acceptable to the owner, general contractor or other obligee.
The terminology of construction surety bonds is confusing and you may want to schedule an Appointment with one of our expert consultants. Surety bonds are required for most large construction projects in the United States and now more frequently they are required in other countries.
