How Contractor Bonds Protect Construction Projects

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How Contractor Bonds Protect Construction Projects

10 Oct 2019

Sometimes construction projects fail for one reason or the other. Most times the failure of these construction projects is in part is due to the construction company’s inability to fulfill its obligations. A situation that is normally out of the hands of those who gave out the contract.  A special type of contractor bond known as the surety bond serves to protect the interest of the project owner should the contractor fail to deliver on the project.

Contractor bonds or surety bonds exist to ensure that the contractor fulfills his entire obligation to the project at hand. The bond reduces the risk to the barest minimum by ensuring that all upfront costs of the project are protected by a surety. These kinds of bonds are also called risk transfer bonds because since you are hoping to eliminate or reduces all or a part of the risk involved in contracting a project to an external party.

Take for example, your office or business place is due for renovation or face lifting. You need to hire an external contractor for the job which will most likely involve buying expensive materials and depositing huge sums of money upfront. If you want to guarantee or protect your investments, ensure that you mandate the contractor company to post a bond with a credible surety such as an insurance company.

The contractor bond or surety will act on behalf of the construction company to ensure that they fulfill their entire obligation to the project. If the hired company fails to fulfill all of their obligations to the project then the surety can act on behalf of the company to compensate you with the money required to complete the project.

Three parties are involved in this; the first one is the obligee, which is you, since you are requiring that the construction company post a surety.  In this case, the hired construction company acts as the principal to the bond since they are the ones posting the bond.  The surety is the financial institution or insurance company that acts to provide a line of credit to the obligee should the principal fail.

The Obligee: any individual or group that requires that a construction company be financially bonded to the contract. Most times, the government is usually the obligee that seeks to reduce financial loss associated with most projects.

The principal: The individual or contractor company that is required to post a bond with a hiring client/obligee to guarantee the performance of the project.

Surety: Surety is the financial institution that acts to provide financial coverage for the bond ensuring that the principal’s obligation to the project is met.  Insurance companies are usually used as surety in construction projects. They serve to offer a line of credit to the obligee should the contracting firm fail on its obligations.

There are three types of construction bonds; these are bid bonds, performance bonds and payment bonds.

Bid Bonds: Bid bond protects the project’s owner in the eventuality that the bid is not honored by the principal or constructing firm. The owner reserves the right to sue or file a lawsuit against the construction company and the surety to enforce the bond. If the principal, surety or bank issuer refuses to honor the bid they will be liable for additional cost.

Performance Bonds: The performance bond is used by the principal to guarantee that they will deliver on the project.  If for some reasons the principal defaults the project owner can call on the surety to complete the job.

Payment Bonds: Payment bonds are used to ensure that all payments due to subcontractors from the principal get to them. Therefore the main beneficiaries of payment bonds are suppliers and subcontractors.  This bond proves a substitute for mechanic’s liens as it remedies non-payment by the principal.

Who requires these bonds?

1.) Public Sectors – The Government

The main beneficiary of contractor bonds in the public sector is the Government. The federal government ensures that taxpayer’s money is protected by making sure that hired contraction firms complete construction projects.

2.) Private Sectors

Private contract owners and lending institutions need contractor bonds. The surety ensures that capable hands and qualified contractors are hired, provide expertise, assistance and years of experience to ensure that the job is completed in time. General contractors and can also benefit from this bond to their subcontractors.

Eligibility of Construction bonds

Eligibility for construction bonds is mainly determined by the surety. Of course they won’t enter into an agreement when there is a huge chance that the construction company might fail on the job.  They employ varying standard criteria like skill level, availability of the resources needed to complete the job, and the applicant’s financial statements. They also investigate the principal’s working history and credit rating. In the end only the best hands capable of completing a project will qualify for a surety.

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