Bond Basics
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. A complimentary copy of the CONSTRUCTION BRIEFINGS may be obtained by contacting our firm. Subscriptions to CONSTRUCTION BRIEFINGS are available from Federal Publications, Incorporated, 1120 20th Street, N.W., Washington, D.C. 20036. You may call Federal Publications at (202) 337-7000 or (800) 922-4330.
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. This article is directed to both contractors and their lawyers. It explains in plain English just when construction surety bonds are required on federal, state, and private projects, and the bonding requirements contained in widely used contract forms, including federal government contracts, AIA contract forms, and the AGC subcontract form.
Some Surety Bond Basics
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.
Types of Surety Bonds
Bid Bonds
A bid bond guarantees the owner that the principal will honor its bid and will sign all contract documents if awarded the contract. The owner is the obligee and may sue the principal and the surety to enforce the bond. If the principal refuses to honor its bid, the principal and surety are liable on the bond for any additional costs the owner incurs in reletting the contract. This usually is the difference in dollar amount between the low bid and the second low bid. The penal sum of a bid bond often is ten to twenty percent of the bid amount.
Performance Bonds
A performance bond guarantees the owner that the principal will complete the contract according to its terms including price and time. The owner is the obligee of a performance bond, and may sue the principal and the surety on the bond. If the principal defaults, or is terminated for default by the owner, the owner may call upon the surety to complete the contract. Many performance bonds give the surety three choices: completing the contract itself through a completion contractor (taking up the contract); selecting a new contractor to contract directly with the owner; or allowing the owner to complete the work with the surety paying the costs. The penal sum of the performance bond usually is the amount of the prime construction contract, and often is increased when change orders are issued. The penal sum in the bond usually is the upward limit of liability on a performance bond. However, if the surety chooses to complete the work itself through a completing contractor to take up the contract then the penal sum in the bond may not be the limit of its liability. The surety may take the same risk as a contractor in performing the contract.
Payment Bonds
A payment bond guarantees the owner that subcontractors and suppliers will be paid the monies that they are due from the principal. The owner is the obligee; the “beneficiaries” of the bond are the subcontractors and suppliers. Both the obligee and the beneficiaries may sue on the bond. An owner benefits indirectly from a payment bond in that the subcontractors and suppliers are assured of payment and will continue performance. On a private project, the owner may also benefit by providing subcontractors and suppliers a substitute to mechanics’ liens. If the principal fails to pay the subcontractors or suppliers, they may collect from the principal or surety under the payment bond, up to the penal sum of the bond. Payments under the bond will deplete the penal sum. The penal sum in a payment bond is often less than the total amount of the prime contract, and is intended to cover anticipated subcontractor and supplier costs.
Surety Bond Requirments on Federal Projects
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. You can get a good introduction to the language and purposes of surety bonds simply by reading FAR part 28.
Bid Bonds
A bid guarantee is 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.
Performance Bonds
As amended by the FASA, the Miller Act requires payment bonds and performance bonds for all federal contracts over $100,000. The penal amount of the performance bond is generally one hundred percent of the contract amount, and the penal sum is generally increased for each change order. The surety is entitled to receive information from the contracting officer concerning the progress of the work, payments, and estimated percentages of completion whenever it so requests in writing. The form of the Miller Act performance bond is set out at FAR 53.301-25.
Payment Bonds
Payment bonds are now required for all federal construction contracts over $100,000. The penal amount of the payment bond is required to be a maximum of $2.5 million where the contract price is more than $5 million; for contracts less than $5 million, the penal sum of the payment bond is to be forty to fifty percent of the contract price. Each solicitation must state that a payment bond and performance bond are required, the penal amount required for the bonds, and the deadline by which bonds must be submitted after contract award. The form for a Miller Act payment bond is at FAR 53.301-25-A. The bond form does not set out any time limitations for claims against the bond. However, the Miller Act provides that suits against a payment bond must be brought within one year after the date on which the last of the labor was performed or material was supplied. In addition, the Miller Act requires that second-tier subcontractors and others who do not have a direct contract with the prime contractor submit a written notice of their claim to the prime contractor with ninety days of the last date of their work on the project.
Requirements for Qualified Sureties
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.
Requirements for Individual Sureties
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. 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 accept cash, bank trust receipts, safekeeping receipts, readily marketable assets, 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.
Conclusion
If the terminology of construction surety bonds is confusing at first, you may want to keep this guide as a reference. Surety bonds are required for most large construction projects in the United States and now more frequently they are required in other countries. Our next article will review the process of obtaining surety bonds, the choices contractors have among surety companies, and the agreements typically entered into between contractors and sureties when construction surety bonds are issued.