Contractors who are awarded a contract are frequently required to obtain several surety bonds before they can begin the project. One of these bonds is the performance surety bond.

A performance bond basically guarantees a contractor's performance under a contract. Yet, there are a number of important details that contractors need to know about performance bonds when they are required to obtain one.

What are performance bonds?

Performance bonds are a type of financial security agreement commonly required for federal and state construction projects. There are three parties to the performance bond agreement:

• the party that requires the bond - the bond obligee;
• the party that obtains the bond - the bond principal; and
• the party that issues and backs the bond - the surety company.

The purpose of this agreement is to guarantee the performance of the bonded contractor in accordance with the conditions of the contract they have been awarded. If the bonded contractor violates the contract, i.e. does not perform as agreed, the project owner can file a claim against the bond to receive compensation in some form.

Who needs a performance bond?

Initially, under the federal Miller Act, a performance and payment bond needed to be presented by contractors on federal projects above $100,000. Yet, under the Federal Acquisition Regulation (FAR) Part 28 this amount was raised to $150,000 for federal projects.

States also have their equivalent of the Miller Act, the so-called "Little Miller Acts." These specify the contract amount above which a performance bond must be furnished by contractors. These amounts vary from state to state but are typically lower than the amount of the federal Miller Act.

Contractors who perform on private construction projects are also frequently required to get a performance bond. Whether such contractors need a bond or not is up to the project owner.

Why are performance bonds required?

Performance bonds work as a form of protection to the bond obligee. Given the importance of quality construction work, and the high amounts of contracts, bonds are required to guarantee that contract conditions are complied with.

If a contractor defaults on their obligations, the surety bond allows contract owners to file a claim against the bond. Under a bond claim, the surety must investigate the cause of the claim and take appropriate action to remedy any losses or damages suffered by the bond obligee.

An additional advantage of performance bonds in construction is that contractors who are bonded are usually vetted quite carefully by sureties. This provides contractors with the necessary legitimacy to perform construction work. Moreover, those contractors who are repeatedly bonded and perform on projects successfully can use this as proof of the quality of their work when competing for new contracts.

What happens when a bond claim is filed?

A claim is typically filed against a performance bond when the contractor defaults on their obligations. There are various reasons a contractor might default - financial issues, performance issues and overextension are common.

If a project owner claims a contractor has defaulted, the surety that backs the bond will investigate the issue to verify the claim. Sometimes a contractor has not defaulted, even though an owner may say so. If the surety does find that the contractor has defaulted, there are various ways it might proceed.
Common solutions to contractor default and the ensuing performance bond claim include:

• the surety taking over and completing the project;
• the surety tendering a new contractor to finish the project;
• the surety assisting the original contractor in finishing the project; or
• the surety handing over the project to the owner to find a new contractor to finish it.

In any of these cases, the surety will provide the finances necessary to complete the project, though not more than the full amount of the bond. Once a claim has been handled, and if the surety has extended compensation, the bonded contractor must repay the surety in full.

A better option is for a contractor to try to avoid the claim and resolve it with the owner in an alternative manner.

How much does a performance bond cost?

The cost of a performance bond is determined by the surety when a contractor applies to get bonded. The cost depends on the total amount of the bond required as well as on the financial health and stability of the applicant. The most important factor that determines the cost of the bond is an applicant's personal credit score. Other important factors are the personal and business financial statements of the applicant, the applicant's work record and more.

Typically, applicants for bigger bonds with a high credit score can expect a cost between 1-2% of the total amount, whereas for lower bond amounts the premium may be higher - around 3%. All of this is determined on a case-by-case basis, of course, and depends on the particular project and applicant.