A performance bond is a bond that guarantees that the bonded contractor will perform its obligations under the contract in accordance with the contract’s terms and conditions. Performance bonds are typically in the amount of 50% of the contract amount, but can also be issued for 100% of the contract amount. It should be noted that a surety is never liable for more than the total amount of the bond.
Understanding Performance Bonds
Gives the Owner More Than Cash to Fix the Problem Created by a Default
A Letter of Credit (LOC) will provide an owner with money to fix the problems created by a default by the contractor, but it will not give them a completed project. A performance bond gives an owner peace of mind that despite a default by the contractor, the owner will still end up with a completed project in accordance with the terms and conditions of the original contract.
Responds from the First Dollar
A performance bond provides complete protection from the first dollar of loss. An owner does not have to assume responsibilities for deductibles or co-payments.
Provide Sufficient Protection
LOCs are typically called for in the amount of 10 to 25% of the contract amount which typically means a shortfall of funds (usually 40% of the contract price) which leaves the owner in a very difficult position that not only do they not have the funds to cover the shortfall, but the owner must now find another qualified contractor to pick up and complete the project.
An LOC or certified cheque tie up a contractor’s borrowing line or cash reserves and deny them access to their money especially in times of financial stress. Ironically, by calling for liquid security of this nature, an owner can inadvertently bring on the very problem it is seeking to protect itself against.
Sureties often receive requests from their clients to issue bonds for contracts that provide ongoing services such as waste collection, recycling, and snow removal which can extend for periods five years or more. A growing trend toward longer terms for such service and maintenance contracts prompted the surety industry to develop multi-year performance and payment bonds that would contain a renewable feature. Many governments and agencies across the country have adopted these new bond forms as their standard security requirement on long term service contracts.
Multi-year bonds aren’t only for long term service contracts. Construction contractors are often called upon to provide extended warranty protection against defective workmanship and materials and to furnish bonds which guarantee this obligation. To address this risk, the Surety Association of Canada has developed two versions of a multi-year renewable maintenance bond. One version is used in circumstances where the Principal has posted a performance bond on the project and the bond only responds to maintenance/warranty claims that do not fall under the performance bond’s umbrella. The second version is for stand-alone warranty obligations where no performance security has been issued.
The multi-year renewal bonds acknowledge the overall contract term, but also stipulate an ‘initial term’ period for the bond as well as the ‘renewal term’ periods. The initial term will typically run for a period of one to three years; following which the surety and principal have the option of extending the protection by a Continuation Certificate for a series of renewal terms, typically of one or two years in duration.
It should be noted that if the surety or contractor chooses not to extend the protection for the coming renewal term, this does not constitute a default that could trigger a claim under the bond.
Not a Source of Quick Cash
Performance bonds are not liquid instruments that provide cash on demand, but instead seek to provide owners with what they contracted for in the first place: a completed project.
Not a Dispute Resolution Tool
The bond is there to protect the owner’s financial interest should the contractor default on their contractual obligations. It cannot be used to resolve disputes that may arise between the owner and contractor during the course of construction. Disputes of this nature should be addressed by mechanisms and remedies that are provided within the contract.
Not a Magic Lamp
Having a performance bond in place can go a long way to solving complex problems, but it can’t provide a “miracle cure” or a quick fix. For example, should a messy default occur on a complex project, there will almost certainly be delays; possibly lengthy delays while the surety sorts through the issues and arranges for a completion contractor to take over the unfinished work. It’s important to remember that these issues will arise irrespective of a bond is in place or not. Owners are encouraged to work with the bonding company to bring the job to successful completion.
A formal claim under a performance bond can only be made if the contract is in default and the default has been declared. However, the owner does not need to wait for things to go south before calling the surety for assistance. As soon as the owner encounters performance issues that could lead to default, they should inform the bonding company. Sometimes, the surety can intervene and prevent default by:
- Providing informal assistance to solve performance problems;
- Convening a meeting or teleconference amongst the parties to address the problems; and
- Assisting in formalizing the solutions by helping to implement the remedy or amending the contract.
To make a claim under a standard performance bond, three conditions must be met:
- The owner (obligee) must formally (in writing) declare the bonded contractor (principal) in default under the contract’s terms and conditions.
- The contractor must actually be in default under the contract’s terms and conditions.
- The owner must have fulfilled their obligations under the contract.
If all three conditions are met, there are four options available to the surety:
The surety can take action to “fix” the situation that created the default and thereby convince the owner to rescind the declaration of default and allow the contractor to continue.
The surety can enter into a formal contract with the owner to complete the contractor’s obligations under the contract.
Arrange for Completion
The surety can arrange for a replacement contractor to complete the bonded contractor’s obligations. Under this approach, the surety would arrange for a completion contract to be executed between the owner and replacement contractor. If this method is chosen, the surety will absorb the additional cost above the original contract amount.
The surety will pay a sum of money to the owner which is the lesser of: a) the excess cost to complete or b) the amount of the bond.