Payment bonds are a subset of the broader category of Contract bonds that must be filed with the project owner or government agency for which a contractor has entered into a contract to perform work. Payment bonds are frequently paired with Performance bonds to provide project owner’s with security for both the performance of the work and payment of suppliers and subcontractors.
Payment bonds must be issued by insurance carriers admitted in the state where the project is to be completed. The insurance carrier issuing any surety bond, such as a payment bond, will also be referred to as the “surety company” or the “bond company”.
Payment bonds protect the project owner by transferring to a surety bond company the cost of ensuring the project owner is compensated for damages resulting from the contractor failing to pay subcontractors and material suppliers. The surety company provides the project owner a guarantee (the surety bond) that the project will not be encumbered by a lien from a subcontractor or supplier up to a limit specified in the bond (“penal sum” or “bond amount”). Ultimately, contractors are responsible for their actions and required by law to reimburse the surety company for any payments made under the bond. Payment bonds refer to the contractor as the Principal, the surety bond company as the Obligor and the project owner as the Obligee.
Payment bonds cost between 1% and 3% of the contract amount. Performance bond rates are determined by the size of the bond and the financial stability, experience and reputation of the contractor. For contractors that qualify for bond amounts up to $500,000, contract bonds cost 3% of the bond amount. For contractors needing larger bonds, the rates will be tiered based on the size of the bond. The tiered rate is essentially a volume discount for larger bond amounts. The most typical tiered rate is known as a 25/15/10 rate; translated to mean 2.5% of the first $100,000 of the bond amount, 1.5% for the next $400,000, and 1.0% for the rest.
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Credit checks are required for payment bonds. Credit analysis is an important component of payment bond underwriting and is reviewed in addition to business financial statements, personal financial statements, and work in progress schedules. Dependent on the bond amount, some sureties have express programs that allow contractors with excellent credit standing to qualify based on credit alone. Ultimately, the surety insurance company determines how it will underwrite and price a surety bond.
The bond form is a tri-party agreement which defines the rights and obligations of the project owner (obligee), surety company (obligor) and contractor (principal). While many bond forms use similar language, each bond form can be customized by the project owner requiring the specific bond and may contain provisions that increase potential costs for the surety company, which will ultimately be passed on to the contractor via higher bond premiums, stricter underwriting or collateral. The primary text to consider in a payment bond surrounds cancellation provisions and forfeiture clauses.
Most bonds contain a provision allowing for the surety company to cancel the bond (“Cancellation Provision”) by providing a notice to the contractor and project owner requiring the bond with the cancellation taking effect within a set period of time, usually 30 days (“Cancellation Period”). Cancellation provisions allow the surety company to cancel the bond for any reason, but most often due to the contractor failing to pay premiums due, claim payouts, or material changes in the contractor’s credit score. Payment bonds are non-cancellable by the Surety and the project will need to be completed or the contract will terminate ending in a claim upon the bond.
Surety bond claims are paid by surety companies to damaged parties to reimburse that party for the financial loss incurred up to the bond penalty amount. Certain bonds contain a clause which requires the surety company to pay the full bond penalty to the damaged party, regardless of the actual damages incurred (“Forfeiture Clause”). Payment bonds with forfeiture clauses will be more expensive than a bond with similar coverage that does not contain the clause.
The contract entered into by the project owner and the contractor is a legally binding agreement that sets forth the responsibilities of the parties. While many contracts contain similar language, each contract can be customized by the project owner and may contain provisions that increase potential costs for the surety company, which will ultimately be passed on to the contractor via higher bond premiums, stricter underwriting or collateral. The primary text to consider in a construction contract surrounds the following provisions or clauses:
These clauses allow the contractor to withhold payment to their subcontractors until they are paid by the project owner. This type of clause has rarely been enforced by courts and ultimately could result in a payment bond claim. This type of clause will likely have to be amended or removed prior to issuance of the bond for payment bond claim reasons.
Large Liquidated Damages Clause
Liquidated damages are common in contracts and are paid out when damages arise that cause a breach of contract; however, larger than usual daily penalties in the contract have the potential to create significant liability to the contractor when work is delayed.
Long Warranty Period
A warranty period is a common provision in a construction contract. However, when warranty periods extend for a lengthy period of time it becomes difficult to distinguish between faulty craftsmanship and normal wear and tear. Sureties typically deem warranty periods shorter than two years as acceptable and anything over the two year threshold as more hazardous.
Contractors do not make guarantees of how well their design or building will function. Ultimately contractors are required to perform the work specified in the contract. Any guarantees of how well something will perform when it is completed is outside of the scope of the contractor’s work and not the contractor’s responsibility.