WHAT YOU NEED TO KNOW ABOUT SURETY BONDS

When negotiating or bidding a construction contract, a major concern is whether or not the contractor is competent and capable of doing the work.

Does he have experience in the type and size work to be done? Is he financially strong enough to finance the work and to pay his sub-contractors and suppliers?

Where does the owner stand if problems arise — if the contractor is unable, for whatever reason, to complete the contract?

It is very difficult for an owner to properly check a contractor’s financial credentials. And even if he does, who is to say that the contractor will have anything left if the job “goes wrong?” An award for Breach of Contract isn’t much good if the contractor has no assets to satisfy a claim. So what’s the answer? What can the owner do to protect himself? The answer – A SURETY BOND! Or more precisely, Performance and Labor and Material Payment Bonds.

A Performance Bond is the promise by a third party (the Bonding Company) to pay – or sometimes perform – if the contractor fails to complete the contract. A Labor & Material Payment Bond can also help protect an owner from liens against the owner’s property if the contractor fails to pay workers, sub-contractors and suppliers. Maintenance Bonds are often required to guarantee the contractor’s performance of certain maintenance over a fixed period of time after completion of the work.

Bond is a three-way contract between:
“The principal” (Contractors) – “The Obliges” (Owner) – “The Surety” (Bonding Agent)

The Obliges, owner, benefits from the promise described in the bond. The Principal and Surety both sign the bond; the Obliges does not. Nevertheless, the Obliges also has obligations under the bond, such as paying the contractor. If the Obliges 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 two types of bonds of primary interest to our customers:

• Contract Bonds (bid, performance, labor & material payment bonds)
• License or permit bonds, which are required for many occupations, including contractors.

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 amount of the bond– of such things as the 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) Obliges 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.

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 frequently 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 some 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 has the necessary bonds and adequate insurance coverage, and to determine whether there are any claims pending against the bond. Insurance coverage should be confirmed through requirement of a current Certificate of Insurance.

LIMITATIONS OF BONDS

• 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 Obliges from valid claims by a contractor. If a contractor sues the Obliges, the Surety has no obligation to defend the Obliges. If a contractor prevails in a dispute with an Obliges, the bond will not pay for what the oblige owes to him or her.
• A surety is entitled to most of the same defenses that the Principal has. Thus, if the Obligor’s problem with a contractor is a legitimate dispute, the Obliges can expect the Surety to dispute the claim as well.
• A bond is liable only if the Obliges has performed all the Obligor’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 cost to complete or correct after the Obliges has spent what the Obliges 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 Obliges, up to the penal sum, for the Obligor’s excess cost.
• The Obliges must act reasonably to mitigate (minimize) any damages. An Obliges cannot, for example, let an uncompleted project simply sit so that weather damage increases the cost to complete. An Obliges may jeopardize bond recovery, too, by paying the contractor funds which have not been earned, or amounts in dispute, or amounts which an Obliges is entitled under contract to withhold for delay or for damage correction. Because an Obliges must at the same time be sure that failure to pay does not result in the Obliges 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 Obliges hires a new contractor to finish or fix the work, an Obliges must be sure that either (a) the new contract covers only the original work or (b) that the Obliges 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.

SUMMARY

BENEFICIARY:

• A person who is entitled – by law or bond language – to claim against a bond even though not specifically named as an Obliges.

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 Obliges 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 statue 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 service.

OBLIGES:

• The named person to whom, under a bond, the promises of the Principal and the Surety run. For a prime contract performance bond, the Obliges is usually the owner.

LICENSE BOND:

• A bond required of all licensed contractors in certain states for the benefit of specific persons designated by statue. 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 statue (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 obligation under a contract.
• PLEASE NOTE: this presentation is provided for informational purposes ONLY and should not be considered a substitute for obtaining legal or other professional advice.

LICENSE CLASSIFICATION

The CSLB issues licenses to contract in particular trades or fields of the construction profession. Each separate trade is recognized as a “classification.” You may add as many classifications to your license as you can qualify for. The CSLB issues licenses for the following classifications:

Class “A” — General Engineering Contractor. The principal business is in connection with fixed works requiring specialized engineering knowledge and skill.

Class “B” — General Building Contractor. The principal business is in connection with any structure built, being built, or to be built, requiring in its construction the use of at least two unrelated building trades or crafts; however, framing or carpentry projects may be performed without limitation. In some instances, a general building contractor may take a contract for projects involving one trade only if the general contractor holds the appropriate specialty license or subcontracts with an appropriately licensed specialty contractor to perform the work.

Class “C” — Specialty Contractor. There are 41 separate “C” license classifications for contractors whose construction work requires special skill and whose principal contracting business involves the use of specialized building trades or crafts. Manufacturers are considered to be contractors if engaged in on-site construction, alteration, or repair.

You may obtain a license in any of the specialty classifications listed below. For a detailed description of these classifications, see the CSLB Web site, or consult the CSLB Rules and Regulations in the California Contractors License Law .