To Bond or Not to Bond? The Pros and Cons of Bonds on Private Projects

October 18, 2016 Firm News

A Laurie & Brennan article featured in the Construction Law Corner Fall 2012 eNewsletter.

by Krista Hallberg Kapp

We were recently asked by an owner client whether or not the client should require that its general contractor obtain a bond for an upcoming, private construction project with an estimated budget of $1.5 million.   Given the size of the project, we questioned whether the client would want to incur that expense.   On the other hand, purchasing a bond would afford protection, eventually, from a contractor who fails to perform the work in accordance with the contract documents.   While that may be true in part, the surety’s performance under a bond is not automatic or guaranteed.

This article addresses the general pros and cons of performance bonds on private projects and can be used as a primer in your decision making process on whether or not your project should require the contractor to obtain a bond.

What is a bond?

Before we can discuss the pros and cons of obtaining a performance bond on private projects, it is important to know what a bond is.   A bond is not insurance.   It does not provide the owner with a defense or funds in the event of a claim.   A performance bond is a three party agreement that guarantees the completion of a construction project in accordance with the contract documents.   If the contractor fails to or cannot complete the project satisfactorily, an owner who has required its contractor to obtain a performance bond may call on the bonding company or surety to step into the shoes of the contractor and complete the project.

Parties to the Bond

There are three parties to the bond.   The “obligee” of the bond is typically the owner or developer of the construction project and is the entity to which an obligation under the bond is owed.   The “principal” on the bond is the general contractor, the party who is building the project for the obligee and, as discussed below, is required to participate in a vigorous prequalification process in order to obtain a bond.   The “surety” issues the bond and is the party who provides the guarantee to the obligee that the principal will complete the construction project and in the event the principal defaults or is unable to complete the project, will step into the shoes of the principal to complete the work.

Pros to Bonding

So, should you require that your contractor obtain a bond for your upcoming construction project?   The following list provides the primary “pros” to requiring a bond on a construction project.

  • Prequalification Process. Prior to obtaining a bond, the contractor must participate in the surety’s vigorous prequalification process which analyzes the contractor’s financial strength and construction expertise, among other things.   The surety requires this process because the surety must determine the likelihood of a contractor default.   The surety does not want to provide the owner with a guarantee of performance under the bond if the contractor fails the surety’s prequalification process indicating to the surety that the contractor may be prone to default under the contract.   Thus, a prequalified contractor is judged at least by the surety (an independent guarantor) as a contractor who is likely not going to commit a default on the project. The mere fact that a surety is ready, willing and able to issue a performance bond is assuring to an owner that it is hiring a financially stable general contractor.
  • Personal or Corporate Indemnity. Sureties require the contractor to indemnify the surety for all costs incurred by the surety in the event the bond company is called upon by the owner to cure a contractor default.   Contractors who are required to provide this indemnity are more than likely not to default under the contract as the consequence of performing under such an indemnity could be devastating to the contractor.
  • Surety’s Performance. The most important advantage of a bond is that in the event of a contractor default or inability to perform, the surety will fulfill the contract and complete the remaining contract work.

Cons to Bonding

While bonds may sound like a panacea for all ills on a construction project, they are not without drawbacks.   The following list provides some of the downsides to obtaining a bond.

  • Cost. Although the contractor is required to obtain the bond, the contractor will include the cost of the bond in the price charged to the owner.
  • Bond Performance May Result in Litigation. Even though the surety guarantees the contractor’s performance in the event of a default, the burden is on the owner to prove to the surety that the contractor defaulted.   This conflict between the surety and owner often ends up in litigation.
  • Surety’s Reluctance to Perform. Performing under the bond and stepping into the shoes of the contractor to complete the work is typically a costly endeavor for the surety.   As a result, the surety will attempt to find technicalities in the bond that the owner has not complied with in order to avoid responding under the bond. In addition, if the contractor has any available defenses to the owner’s assertion of a default, the surety will assert those same defenses to avoid exposure under the bond.   Finally, the surety runs the risk of being caught between the proverbial rock and a hard place if it performs, even though the contractor had valid defenses, then seeks reimbursement under the contractor’s indemnity; in that case, the contractor will contend that the surety should not have performed and therefore should not receive reimbursement from the contractor.
  • Owner Loses Control of Quality. In order to minimize costs, the surety, in responding to the bond, may implement the cheapest and least expensive remedy for the contractor default, which will likely compromise quality for the owner.
  • Owner’s Burden to Calculate Losses. In the event of a default, certain bonds may require the owner to quantify the losses that it would have suffered but for the surety’s guarantee of performance.   If the owner fails to adequately calculate its losses and the costs to complete for the surety, the owner will be unable to recoup the deficit from the surety.  

These pros and cons simply provide a general perspective on whether an owner should require the contractor to obtain a bond.   A cost benefit analysis based on these factors should be performed for each construction project to make a determination as to whether a bond is appropriate for a particular project.

After reviewing these pros and cons with our client, the client decided to require that the contractor provide a bond at the owner’s request, which meant that the contractor had to be in a position to provide the bond (and thus have passed surety’s prequalification process), but the owner could decide whether it would actually request such a bond and incur the associated costs.