When entering into a construction contract, often times the primary concern is whether or not the contractor is competent and capable of doing the work. However, one may not think about the contractor's financial strength and, indeed, probably has no easy way of checking it. If problems arise, however, it is important to know that one can collect any damages to which one is entitled. An award for breach of contract does little good if the contractor has no assets to satisfy the claim. A bond can provide financial assurance.

A bond is a promise by a third party (the Surety) to pay - or sometimes perform - if the contractor fails to complete the contract. A bond can also help protect an owner from liens against the owner's property if the contractor fails to pay workers or suppliers.

A bond is a three-way contract. The Surety is almost always a company licensed by the Insurance Commissioner to write bonds, although a private person can on some occasions act as Surety. The contractor is called the Principal because the contract is his or her primary responsibility. The Surety and Principal promise, in the bond, that the contract will be performed according to its terms. Essentially, the Surety promises that if the contract is not performed, it will pay damages if the Principal cannot. 

The Obligee or Beneficiary benefits from the promise described in the bond. The Principal and Surety both sign the bond; the Obligee does not. Nevertheless, the Obligee also has obligations under the bond. If the Obligee does not perform his or her own obligations under the contract, neither the Principal nor the Surety is bound. The bond is not an insurance policy. It merely provides an extra level of financial resource behind the contractor, a place to turn if the contractor cannot meet contractual obligations through his or her own assets. 

TYPES OF SURETY BONDS

There are four types of bonds of primary interest to our customers: (1) License or permit bonds, which are required for many occupations, including all contractors in some states like Washington, Oregon, Alaska, California and Arizona; (2) Miscellaneous bonds comprising many different types of obligations; (3) Contract bonds (bid, performance and/or payment bonds) designed to cover a particular contract; and (4) bonds required under some funding programs (e.g., some housing rehabilitation programs or energy conservation remodel programs) to protect customers of the programs. 1. License and Permit Bonds License and permit bonds are those required by state law, municipal ordinance, or by regulation and in some instances by the federal government or its agencies. To be licensed, a contractor must have a bond and, in many states, a certain amount of insurance coverage. The bond may either be one written by a Surety company or, in many states, a cash deposit made with the State. In practice, the terms "license" and "permit" are used interchangeably. The purpose of a license or permit bond is usually to safeguard the public health, welfare, morals, or assure the public's safety. These bonds are usually for the benefit of laborers, suppliers, and taxing authorities, as well as most persons having contracts with the contractor. The amount of the bond (the "penal sum") is the total limit of the Surety's liability to all claimants combined. Thus, where a contractor has several claims lodged against its bond, the protection for any individual may be much less than the full amount of the bond. A license or permit bond may thus provide someone with only minimal protection. Before entering into a construction contract it is wise for an owner to call the licensing agency to be sure that the contractor is in good standing with bonding, and where specified by law, insurance coverage, and to determine whether there are any claims pending against the bond. Please note that all contractors should have general liability insurance, but one may only check on the status of such insurance with state agencies in those states that require the insurance for licensing. 2. Miscellaneous Bonds Miscellaneous bonds comprise many types of obligations including fiduciary, financial, license and permit, miscellaneous indemnity, etc. By nature, they do not clearly fall within the scope of other types of surety bond classifications. Some such bonds are required by law and must contain provisions spelled out by statute, ordinance or regulation. Others may be purely voluntary bonds or undertakings with conditions prescribed by or acceptable to the Obligee. Common types of miscellaneous bonds include Employer's, Interstate Commerce Commission (ICC), Fuel Tax, Airlines Reporting Corporation (ARC), Street Obstruction, Motor Vehicle Dealer, Vessel Dealer, Side Sewer, and Lease bonds. 3. Contract Bonds There are three types of contract bonds: bid bonds, performance bonds and payment bonds. A bid bond is an obligation undertaken by a bidder promising that the bidder will, if awarded the contract, enter into the contract and furnish the prescribed performance and payment bond(s) within a specified period of time. A performance and/or payment bond is specifically intended to cover a particular contract. A performance bond covers the contractor's actual performance of the contract. It guarantees payment -- up to the penal sum -- of such things as cost of completion or cost to correct deficiencies which are the responsibility of the contractor. A payment bond is intended to pay laborers, suppliers and other contract-related costs which the contractor owes to third parties. The benefit to a private (as opposed to public, i.e., governmental) Obligee is that it provides a source of funds for those who might otherwise be able to enforce a lien against an owner's property. Performance and payment bonds may be two separate documents, each with its own penal sum, or they may be combined in one document with a single penal sum. The penal sum is usually the contract amount at the time the bond is executed. The penal sum usually does not increase when items are added that change the contract price. It is wise to be sure that the payment bond's language explicitly gives such persons a direct right to claim against the bond. Otherwise the bond may be interpreted to be an Indemnity bond. An Indemnity bond reimburses only the Obligee for loss sustained by the Obligee due either to the contractor's failure to perform the contract or failure to pay persons with lien rights. Since a supplier or laborer cannot claim directly against an indemnity bond, an Obligee runs a greater chance of the inconvenience of a lien foreclosure suit. A payment bond lessens this chance, although an owner can never force a lien claimant to look to the bond instead of the owner's property. Some things to keep in mind:  (a) The Obligee is expected to pay the premium for performance/payment bonds. Thus, Principals will include the cost of the bond in their bids. The premium is an amount in most cases ranging anywhere from 1% to 3% of the contract price. (b) One cannot expect a contractor to provide a performance or payment bond unless it is made a requirement of the contract. In fact, one may be in breach of contract by refusing to let the contractor proceed without a bond when none was required in the contract. Decide ahead of time what sort of protection is wanted from a bond. Specify the type of bond(s) in the contract, and require a bond in a form acceptable to the person drafting the contract. (c) The original must be delivered to the Obligee before protection is effective. The Obligee should read the bond carefully to be sure it does what the Obligee wants and note carefully any notice requirements, time limits, and special conditions. If an Obligee does not comply with the bond's terms, its protection may be lost. (d) It may be impractical to require a bond for a small contract, since the contractor may not be able to find a Surety willing to write a small bond. Similarly, if a contract is imprecise or legally deficient, it may not be bondable. In addition, a Surety is often reluctant to bond contracts where the work has already begun. If for any reason a contractor cannot produce a required bond, one who has required the bond should consult an attorney before attempting to use this failure as a reason to terminate the contract.  4. Loan or Grant Program Bonds If a construction project is being funded or administered through a public utility or agency, the contractor may have to be bonded as a requirement of being an "approved" contractor. There are a wide variety of such programs and bonds. The beneficiaries of this type of bond would usually be the customers of the contractor who are part of the particular loan or grant program. Thus, there could be multiple claims against such a bond, but the pool of potential claimants is smaller than those benefited by the statutory bond. If there is a claim against the contractor, one may or may not be able to claim directly against the bond. It depends upon the conditions of the bond. One must check with the person administering a particular program to find out what needs to be done. The bonds cover only work done under the particular program in question. Side contracts with the contractor to do work outside the program's scope or approval will not be covered.  ------------------------------------------------------------------------  CLAIMING ON A BOND It is wise to consult an attorney if one contemplates claiming on a bond. For license and permit bonds, the method of claiming is usually set forth in the statutes. It is important to note that a pending claim is not necessarily a reflection on a contractor's abilities or financial strength; it may be the result of a legitimate dispute or may be a nuisance suit. It is, however, something that warrants further investigation. Performance/payment bonds and loan program bonds often have notice requirements and time limits which must be adhered to. A lawsuit may or may not be needed. Sometimes one will be required to sue and attempt to collect from the contractor before the Surety is required to pay. For private bonds (including the loan program bonds) one should notify the Surety in writing as soon as it is known there is a legitimate dispute or problem. Be aware, however, that putting a bond "in claim" for frivolous reasons may expose one to a claim by the contractor that you have injured his or her business.  ------------------------------------------------------------------------  LIMITATIONS OF BONDS Some important limitations of surety bonds to keep in mind are:  •A bond is not an insurance policy. It is not a substitute for adequate insurance coverage, either for liability or property damage. A bond will not be liable for personal injuries or for property damage that results from a contractor's negligence. •A bond will not protect the Obligee from valid claims by a contractor. If a contractor sues the Obligee, the Surety has no obligation to defend the Obligee. If a contractor prevails in a dispute with an Obligee, the bond will not pay for what the obligee owes to him or her. •A Surety is entitled to most of the same defenses that the Principal has. Thus, if the Obligee's problem with a contractor is a legitimate dispute, the Obligee can expect the Surety to dispute the claim as well. •A bond is liable only if the Obligee has performed all the Obligee's own obligations. This includes the obligation to pay the agreed price (including agreed extras) for the work. The bond is responsible only for excess costs to complete or correct after the Obligee has spent what the Obligee agreed to pay the Principal to do the work. •The Surety's basic obligation is to pay money. In some circumstances the Surety may agree to obtain bids for completion or correction and/or to take over the contract and see that it is completed. The Surety may do this when it believes that it is the least expensive way for it to meet its obligations. In other circumstances the Surety will simply reimburse the Obligee, up to the penal sum, for the Obligee's excess costs. •The Obligee must act reasonably to mitigate (minimize) any damages. An Obligee cannot, for example, let an uncompleted project simply sit so that weather damage increases the cost to complete. An Obligee may jeopardize bond recovery, too, by paying the contractor funds which have not been earned, or amounts in dispute, or amounts which an Obligee is entitled under contract to withhold for delay or for damage correction. Because an Obligee must at the same time be sure that failure to pay does not result in the Obligee breaching the contract, it is important to consult an attorney whenever an important dispute arises. •A performance bond covers only completion or correction costs within the scope of the original contract. Thus, if an Obligee hires a new contractor to finish or fix the work, an Obligee must be sure that either: (a) the new contract covers only the original work or (b) that the Obligee can segregate and prove what costs went toward finishing the original contract work. Extras added with the new contractor will not be covered by the bond.   CONCLUSION Most construction contracts have small problems that arise during the progress of the work and most small problems can be resolved between the Obligee and the Principal without the need to involve anyone else, attorney or Surety. As with any human endeavor, a reasonable attitude and willingness to keep communication open will do the most to assure successful completion of the project. On the other hand, no one should be so accommodating as to waive one's rights under either the contract or any bond one is relying upon. One must use common sense to determine when a problem is getting out of hand. A clear understanding of the contract, including any bond for it, is the best protection.    GLOSSARY OF TERMS  BENEFICIARY: A person who is entitled -- by law or bond language -- to claim against a bond even though not specifically named as an Obligee. BID BOND: An obligation undertaken by a bidder promising that the bidder will, if awarded the contract within the time stipulated, enter into the contract and furnish the prescribed performance and payment bond(s). BOND: An obligation undertaken by a third party promising to pay if a contractor does not fulfill its valid obligations under a contract. Some bonds may also promise that the Surety will perform if the contractor fails to. INDEMNITY BOND: A bond which promises to reimburse an Obligee for loss incurred when a Principal fails to perform its contract or (in some cases) fails to pay for material, services or labor used in prosecution of the contract. MECHANIC'S OR SUPPLIER'S LIEN: A right given by statute to certain persons - typically suppliers, laborers, architects, etc. - who perform services improving real property. If they are unpaid, they may file a claim against the property and force the owner to pay even if the owner has already paid a prime contractor for their goods or services. OBLIGEE: The named person to whom, under a bond, the promises of the Principal and the Surety run. For a prime contract performance bond, the Obligee is usually the owner. LICENSE BOND: A bond required of all licensed contractors in certain states for the benefit of specific persons designated by statute. Some of these states allow a cash deposit with the state in lieu of a bond. PAYMENT BOND: A bond which promises to pay some or all of the persons who provide materials, labor, or services for prosecution of a contract. PERFORMANCE BOND: A bond which promises that the terms of a contract, or some of them, will be performed by the Principal. PENAL SUM: The limit of the Surety's liability under its bond. The amount may be fixed by statute (for license and permit bonds), by the initial contract amount (for performance/payment bonds), or by some other means. PRINCIPAL: The bonded contractor, who has the primary responsibility for completing the obligations of a contract. SURETY: The third party (usually an insurance company) who promises to pay if the Principal fails to fulfill its obligations under a contract.