By nature, most contractors are risk takers.  To a contractor, calculated risk can be fortune’s accomplice.  Failure to recognize, calculate and properly manage the risk inherent in any construction project can, however, lead to financial disaster for any one or all of the participants in a construction project.  Once project risks are recognized, carefully drafted contract documents can help to allocate project risks between or among the various contracting parties.  For example, common strategies for allocating project risks include the use of contractual indemnification provisions, requirements for builder’s risk and commercial general liability insurance policies, and requirements for performance bonds and payment bonds.  Requiring performance and payment bonds on a project can provide significant protection against the downside risk of a failure to perform the work or failure to pay subcontractors and suppliers.

It is important to understand two types of bonds that you are likely to encounter on a construction project—performance and payment bonds—and to understand the relationship among the parties.  There are three parties in the construction surety bond relationship: the surety, the principal and the obligee.  The principal is the party obtaining the bond, typically the contractor or subcontractor.  The obligee is the party to whom an obligation is owed under the bond, typically the owner or contractor.  The surety is the party issuing the bond.  The surety is bound to perform in accordance with the contract and the terms of the surety bond if the principal fails to perform.  Performance bonds are obtained to ensure the contractor’s faithful performance of its contract with the owner or to ensure the subcontractor’s faithful performance of its subcontract with the contractor.  Payment bonds are obtained to ensure payment to third party “claimants” who furnish labor, material or equipment on a project.

A performance bond is a project specific contractual agreement between a contractor and a surety by which the surety guarantees to arrange for the completion of a contract if the contractor runs into trouble and fails to complete the project.  A performance bond is intended for the protection of the owner (or of the contractor, if dealing with a performance bond provided by a subcontractor).  A performance bond is different from a payment bond in that a performance bond is not intended to protect unpaid subcontractors or suppliers.

A payment bond is a project specific contractual agreement between a contractor and a surety by which the surety guarantees payment for the labor and materials contracted for and used by the contractor on the project.  It is a guarantee of payment that is intended to benefit and protect subcontractors and suppliers if the contractor (bond principal) fails to pay for the labor or materials furnished on the project.  A payment bond differs from a performance bond in that the payment bond does not directly protect the owner.  While the owner may make a claim against a prime contractor’s performance bond, an owner does not typically furnish labor, material or equipment on a project with the expectation of payment under the prime contract and thus would not be a claimant under the prime contractor’s payment bond.

Given the important protection provided by a payment bond, subcontractors and suppliers who may be potential claimants under a payment bond should request and obtain a copy of the payment bond at the outset of the project—well before there are payment problems.  Potential claimants should carefully review and become familiar with the terms of the payment bond and the requirements for asserting a claim against the bond if it becomes necessary.

You should be aware that both performance and payment bonds involve various notice and timing requirements relating to asserting claims and initiating mediation, arbitration or litigation.  It is critical to identify all timing and notice requirements and to then strictly follow these requirements.  Failure to comply with notice and timing requirements may bar an otherwise valid claim.

You should familiarize yourself with any state and federal bond statutes that are applicable to your project and determine whether the applicable state or federal statute requires posting of a performance and payment bond.  Importantly, the applicable state or federal statute involved, together with court decisions interpreting the respective statutes, will dictate which project participants may recover under the bonds and what procedures must be followed to perfect your claim against the bond.  It may be helpful to seek the advice of competent construction law counsel at the outset of a project and, certainly, upon the first hint of trouble on the project.

This article was originally published in the Construction Connection Newsletter.