Eighty-eighth in a Series—Each issue of this newsletter discusses important terms found in typical construction documents. Contractual requirements for surety bonds receive Sylvia Gillis’ attention this month

We discussed contract requirements for surety bonds in our very first column, way back in June of 2000 (our fifth issue). Now, 87 issues later, we revisit that topic and address how the surety obligation works.

Types of Bonds

As noted previously, many construction contracts include a provision permitting an owner to request that a contractor provide bonds to cover the faithful performance of the construction contract. The plural form of “bonds” refers to the separate payment bonds and performance bonds that are available from surety companies. Surety companies can also issue bid bonds to cover those situations when bids are solicited for the specified work. A maintenance bond is another specific type of bond often associated with or specified as a requirement for a construction contract. The standard forms published by the American Institute of Architects include a bid bond, a performance bond, and a payment bond.

What Does a Bond Do?

The bond guarantees performance of contractual obligations and/or indemnifies the owner against damages and expenses incurred by the contractor’s (prinicipal’s) default. It involves three parties:

(1) the principal—the contractor;

(2) the obligee—the person or entity for which the principal is performing work, generally the owner; and

(3) the surety—the company ensuring that the principal will perform the contractual obligation for the obligee, or agreeing to be financially responsible if the principal fails to perform.

The bond is issued in the amount of the contract, referred to as the “penal sum.” In most cases, the surety’s liability will not exceed this amount. On public construction projects in Ohio, the Ohio Revised Code provides two statutory forms of bond:

(1) a combined bid guaranty and contract bond, which covers the required bid guaranty and both payment and performance obligations; and

(2) a contract bond to guarantee payment and performance but not the bid (because a different form of bid guaranty has been submitted with the bid, as permitted by the Code).

These are indemnity bonds and do not contain the many conditions and limitations found in other bond forms. In each case, the owner and the principal must carefully read the bond (RTFB – read the fabulous bond, as the terms of bonds differ greatly). For owners, we recommend the statutory form of bond.

Often a surety will include riders with the form of bond provided. These riders must be carefully examined, as they may supplement but not change the statutory bond provisions. A typical rider is a co-obligee rider, which may be attached when two or more parties are identified as owners in the contract documents.

Getting a Bond

How does a contractor secure a bond for a construction contract? The contractor must first establish a business relationship with a surety, usually working through the surety’s agent. The contractor provides financial information about its business and the personal assets of its principals and also provides guarantees for payment of any amounts expended by the surety should a claim be made against the bond.

These guarantees most often take the form of very broad indemnification agreements (a General Indemnity Agreement, known as a “GIA”) under which the principals of the contractor agree to indemnify and hold the surety harmless with respect to all claims and expenses arising from the bond. The GIA also will give the surety the right to settle and compromise claims made against the bond.

The costs and expenses incurred by the surety in investigating and settling or paying claims can be very substantial. Persons who sign as indemnitors under the GIA can find themselves liable for thousands and even millions of dollars. Beware of signing a GIA for a friend or relative or as a minority shareholder of the contractor-principal, unless you understand and are willing to accept the risk.

This process of building a relationship with a surety and obtaining a bond can take some time. The surety establishes a capacity for business for the contractor above which it will not issue bonds for work to be performed by the contractor. The surety grants powers of attorney to certain companies (the surety agents) to issue bonds to contractors that have been previously approved.

When the contractor needs a bid bond or contract bond, the contractor contacts an agent of its surety and requests the appropriate form of surety bond. The bond is either submitted with the contractor’s bid for competitively bid contracts or provided during the contract negotiation process. The cost of the bond is a cost of the work included in the contract sum or bid amount. It is important that the contract documents issued to bidders or to companies soliciting proposals for the cost of certain work specify that the contractor must provide a bond and the type of bond to be provided.

Ohio public owners are required by statute to provide written notice to the surety of the contractor who gets the contract. The public owner knows who that surety is if the contractor submitted a combined bid guaranty and contract bond form with its bid submittal for the work. The premium paid by the contractor to the surety is based upon the amount of the contract awarded (including the base bid amount and any add alternates included with the contract award). The rates for such premiums will vary with the surety’s evaluation of the contractor.

Benefits of a Bond

What is the surety’s obligation on a bid bond? On a public project in Ohio, if the contractor gets the job but refuses to enter into a contract, the surety agrees that it will pay the difference between the lowest bid and the next lowest bid or 10% of the amount of the bond, whichever is less. If the owner decides to rebid the work, the surety is liable for the costs to rebid or 10% of the amount of the bond, whichever is less.

A bid guaranty can also provide certain protection to the owner if the bidder withdraws its bid and the owner either awards to the next lowest bidder or rebids the work. It is important to remember that while the surety’s obligation is limited by statute in these situations, the principal’s obligation to the obligee is not.

Once the contract is signed, what does the performance bond provide the owner? If the contractor defaults and is unable to complete the work specified for its contract, the surety is obligated to indemnify the owner up to the penal sum of the bond. The bond provides assurance to the owner that the work will be completed. The total contract sum is the maximum amount available to complete the work. Here is an example:

  • Assume the contract sum is $1,500,000, and the contractor has been paid $1,250,000 but is unable to complete the work;
  • Assume the estimated cost to complete the work is $1,000,000;
  • Then there is a maximum amount of $1,500,000 available from the surety to complete the work. This amount can be exceeded if the surety undertakes to complete the work, unless otherwise provided in a takeover agreement.

The Surety’s Role in the Project

The surety attempts to manage its risk during construction by requesting periodic updates from the owner on the status of the contract. Owners may but are not required to complete these updates, with the help of their architects or construction managers, and return them to the surety. If there have been any problems with the contractor on the job, owners should seek advice from their attorneys.

The information requested typically includes what percentage of the work has been completed, how much has been paid to the contractor to date, the balance of the contract sum, and any changes to the original contract sum. The surety may also request information about the quality of the work performed and whether there are any issues related to the contractor’s performance.

Depending upon the form of the bond, the surety’s obligations do not arise until there is a default by the contractor. Nevertheless, it is important to keep the surety apprised of any issues relating to the contractor’s performance of its contractual obligations. The surety can be useful in securing performance of the contract before a claim is made or a default occurs. If the surety is made aware of any problems, it should investigate. If there is a proper claim under the bond, then the surety must promptly conduct an independent investigation in good faith.

If the contractor defaults, the surety may attempt to negotiate a takeover agreement with the owner to complete the remaining work. The takeover agreement, if properly negotiated, will permit the surety to complete the work at its risk and to control the cost of doing so.

Careful review of the proposed takeover agreement is important for the owner. Issues to consider include what contractor will perform the work (is the surety proposing to have the defaulting contractor complete the work?), what limitations may be requested for warranties and guarantees of the work being performed, and what amount will be paid to the surety from the balance of the contract.

Depending upon the terms of the bond, another option in the event of a default is for the owner to complete the work using another contractor, with the surety paying for completion of the work and correction of any nonconforming work, if necessary. In this instance the surety’s obligation will be limited to the penal sum of its bond.

In a Nutshell

Surety bonds look in many respects like insurance. Sureties will always contend, however, that they are not insurance. The bonds can be an important part of the owner’s ability to complete a construction project or to correct defective work discovered after completion. The owner should consider giving the surety notice as soon as there are problems on the project or as soon as defective or nonconforming work is identified after contract completion. For example, if defective or nonconforming work is discovered after completion of the contract, and the contractor is responsible for the work but is unable or unwilling to correct it, the bond may be a source of funds for the owner to correct the work.

Surety bonds are an important part of the owner’s ability to complete its project. They help the owner to manage risk associated with defective and nonconforming work or with a defaulting contractor.