Understanding Bonds and Risk Allocation for Construction Projects
On any construction project, bonds should be considered as part of the owner’s or general contractor’s strategy for risk management or risk allocation. Bonds are separate and apart from the types of insurance generally found on construction projects (builder’s risk insurance, commercial general liability, workers compensation/employer’s liability, and umbrella coverage), but none-the-less they can be equally as important to the success or failure of any project.
There are a wide variety of bonds available for constructions projects. Whether or not a particular type of bond is applicable for the construction project is often driven by either statutory requirements, in the case of public construction projects, or the owner’s requirements in the case of private construction projects. Below is a brief description of the types of bonds available in the market place and generally found on a construction project.
On some projects, a bid bond may be requested by either the owner or the general contractor. The entity requesting the bid bond is referred to as the “obligee” and the bid bond runs to the obligee’s favor. The purpose of the bid bond is to ensure that the general contractor or the subcontractor will honor its bid and perform the work contemplated in the construction contract once the contract is awarded. Should the contractor or the subcontractor refuse to honor its bid, then the obligee can make a claim against the surety for the sum of the bond or difference between the contractor/subcontractor’s bid and the next highest bid on the project (whichever is less).
Payment bonds are meant to ensure that subcontractors and suppliers are paid on the construction project. The general contractor or a subcontractor may be required to post a payment bond on the project. In general, most public construction contracts require payment bonds. Many private construction project owners will require payment bonds to help ensure that payments are being made to subcontractors and suppliers.
Performance bonds are meant to ensure that the contractor or subcontractors complete the project in accordance with the plans and specifications outlined in the contract documents. If the contractor fails to complete the project in such a manner, then the “obligee” (often the owner) can make a claim against the surety, up to the amount of the bond, to complete the project. These too are often required in public construction projects.
Construction contracts generally always have some type of warranty provisions. The length of the warranty provisions can vary by contract but there are bonds available to protect owners from a contractor’s failure to honor its warranties. These bonds are called maintenance bonds. A maintenance bond offers some level of protection (depending on the amount of the bond) that the contractor will honor its warranties and ensure that the project is functioning as intended.
One other type of bond typically encountered on the construction project is a retention bond. The purpose of a retention bond is to allow for the removal of retainage requirements in the construction contract or the release of retainage on the construction project to contractors and/or subcontractors in return for the retention bond. Should the contractor or subcontractor fail to complete the project in accordance with the contract or fail to pay its suppliers, then the obligee can make a claim against the retention bond.
These are few of the commonly found bonds on a construction project. Whether these types of bonds are appropriate for your project is driven in part by cost, risk tolerance, and whether the project is a public or private. A take away from this post is that bonds should not be considered as a stand alone product and must be incorporated into every owner and contractor’s strategy for risk management. In upcoming posts we will explore how and when to make a bond claim, which can be just as important as purchasing bond coverage in the first place. In addition, we will also explore Idaho's Mechanic's Lien Release Bonds.