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How Bonds Work in Construction

How Bonds Work in Construction

October 16, 2019

When payment disputes arise in construction, the mechanics lien is the go-to weapon to settle outstanding debts. Unfortunately, however, a mechanics lien can be attached only to private properties. Public utilities may not be seized or sold in an auction, therefore aggrieved construction parties are not allowed to recover payment in a public works project via a mechanics lien.

This is why construction bonds play a crucial role in government projects. Contractors, subcontractors, and material suppliers handle all the work for the government, and different types of construction bonds ensure that all stakeholders are protected.

What is a construction bond?

Construction bonds, also known as surety bonds, are a form of guarantee that one party will get compensation in the event that another party fails to honor or fulfill its obligations in a federal project.

There are typically three main players involved in a construction bond: the guarantor (e.g. the bond company), the obligee (e.g. the government office), and the principal (e.g. the general contractor). If the principal or the general contractor fails to complete a project, the bond company that the contractor hired will step in and pay the government.

Construction bond parties

What is the purpose of a construction bond?

Different types of construction bonds have different purposes. In general, however, a construction bond ensures that all parties get to honor their responsibilities and obligations based on an earlier agreement or contract.

Government construction projects tend to be large-scale, and they also last over long stretches of time. There are multiple contractors, subcontractors, and material suppliers involved in a government project and they all work under different interrelated contracts. In an ideal world, everything will run smoothly – all parties will get paid on time and they will all do their work and honor their contractual obligations.

In reality, however, varying issues and disputes may arise during a project. A contractor may default due to financial mismanagement, for instance, which could leave the government with an unfinished building and which could also cause payment delinquency towards subcontractors and other lower-tier parties.

Since, in this case, a mechanics lien is not an option to recover payment from delinquent clients, the construction bonds on a property serve as an alternative remedy not just for the unpaid construction parties but also for the government itself.

Construction bonds

How construction bonds differ from mechanics liens

The primary difference lies in the type of project to which these two methods apply: construction bonds are used on public projects, while mechanics liens are used on private projects. Keep in mind, however, that construction bonds may still be used on private projects, but mechanics liens may not be used in public projects.

Mechanics liens are attached to a property’s records, so they are highly effective in forcing property owners to settle outstanding debts. Potential buyers and financiers can see if a private property has debts attached to it, which in effect freezes the market value of a property. This cannot happen in publicly owned properties – government buildings, bridges, and roads are not sold like private real estate.

Another difference lies in who can file a mechanics lien claim versus who can file a bond claim. General contractors are typically the ones who furnish a construction bond to the government. They are, therefore, not allowed to file a claim against their own bonds. Only lower-tier parties may seek compensation from a delinquent general contractor via a bond claim.

By contrast, mechanics liens may be filed by most construction parties, including general contractors.

Different types of construction bonds

Bid Bonds

Bid bonds ensure that a winning contractor will enter into a contract with the government if they get awarded the contract.

Contractors secure a government project via a bidding process. Once the bidding process is over and the job was awarded to a contractor, the contractor is expected to accept the contract for which they submitted a bid. Sometimes, however, a contractor may find a better job or pursue a different offer.

If a bid bond has been furnished by the bidding contractor, the government may recover payment from the contractor if they fail to accept the offer and sign the contract that was awarded to them.

Maintenance Bonds

Maintenance bonds are furnished by a contractor to the government to assure them that there are faults and defects in their work. A maintenance bond is effective only for a certain period of time after the project completion.

This bond is similar to how a product warranty works. If a maintenance bond covers one full year after the project completion date and one part of the construction was determined to be defective during that time frame, the government can recover payment for the damages via a maintenance bond claim.

Payment Bonds

Payment bonds are some of the most common construction bonds as they directly relate to settling outstanding debts to lower-tier construction participants. This type of bond is the most similar to a mechanics lien.

Think of a payment bond as a pool of money from which subcontractors and material suppliers can recover payment, in the unfortunate event that a general contractor defaults on a project. All general contractors working for the government are required to purchase a payment bond under the Miller Act.

Performance Bonds

Performance bonds are also required from all government general contractors under the Miller Act. If the payment bond concerns potential nonpayment issues with subcontractors and material suppliers, the performance bond is more about the quality of the work of the general contractor.

If, for instance, a general contractor lags behind the schedule and does not perform quality work on a project, the government may tap the performance bond to have their money reimbursed.

Site Improvement Bonds

Site improvement bonds are like performance bonds but they are more specific to construction work that is performed on an already existing facility or utility.

Like a performance bond, the obligee of a project may have their money reimbursed if a contractor fails to deliver the quality of work that is described in the contract.

Labor and Material Bonds

Labor and material bonds protect laborers and material suppliers from cases of nonpayment. A government entity or a private property owner may require this bond from their general contractors before signing a contract.

Like a mechanics lien, this bond is also a remedy for settling outstanding payment disputes.

Bad Credit Bonds

Bad credit bonds are specific to contractors who have bad credit ratings. Some employers may require them to furnish a bad credit bond first, mainly because contractors with bad credit scores are considered high-risk hires.

This type of bond essentially protects all stakeholders working with a party that has a poor credit score. If the party defaults on a project and gets embroiled in a financial mess, other parties will be able to secure their payment by making a claim against the bond.

Bonds required under the Miller Act

Two bonds are required under the Miller Act: the payment bond and the performance bond. Both bonds must be purchased by a general contractor and must be furnished to the government entity before a project begins.

These two bonds protect the stakeholders working with a general contractor. Subcontractors and material suppliers who are contractually tied to the general contractor may file a payment bond claim in the event that they do not get compensated for the work that they have been doing.

Construction bonds under the Miller Act

The government entity that hired the general contractor may also recover payment from the performance bond in case the contractor does not deliver quality work in a project. A contractor may engage in illegal activities, for instance, or they may also cause major delays in the implementation of a project.

If these cases occur, the government entity can receive payment through a bond claim.

Construction bond requirements per state

In all states, general contractors working in government projects are required to have at least two surety bonds: the performance bond and the payment bond. This requirement is imposed based on the Miller Act.

Each state also has its own so-called Little Miller Acts, which are specific modifications to the bigger federal law. There are many variations in these Little Miller Acts. Some of the similarities and differences concern the amount of the bond that must be purchased, and there are also different requirements for how one can make a bond claim.

You are highly encouraged to look into the Little Miller Act that governs your state.

 Further reading