What Is a Performance Bond and How Does It Work?

What Is a Performance Bond?

A performance bond is a financial guarantee to one party in a contract against the failure of the other party to meet its obligations. It is also referred to as a contract bond. A performance bond is usually provided by a bank or an insurance company to make sure a contractor completes designated projects.

Understanding Performance Bonds

A performance bond is a financial guarantee that the terms of a contract will be honored. If one party to a contract cannot complete their obligations, the bond is paid out to the other party to compensate for their damages or costs.

The Miller Act instituted the requirement of placing performance bonds. The Act covers all public work contracts $100,000 and above. These bonds are also required for private sectors that necessitate the use of general contractors for their company's operations.

Jobs that require payment and performance bonds go through job or project bidding first. As soon as the job or project is awarded to the winning bidder, payment and performance bonds are provided as a guarantee for the completion of the project.

Performance bonds are common in construction and real estate development. In such situations, an owner or investor may require the developer to assure that contractors or project managers procure performance bonds, in order to guarantee that the value of the work will not be lost in the case of an unforeseen negative event.

Parties to a Performance Bond

A performance bond is an agreement between three parties, as explained below.

• The principal (usually a contractor), is the person or company who is providing a service.
• The obligee is the party that is paying the principal to perform certain work.
• The surety is the party that provides a performance bond to guarantee that the principal will complete their work. In the event of a partial or total failure by the principal. the surety will pay any additional costs for completion, up to the limits of the performance bond.

Protecting Parties

Performance bonds are provided to protect parties from concerns such as contractors being insolvent before finishing the contract. When this happens, the compensation provided for the party that issued the performance bond may be able to overcome financial difficulties and other damages caused by the insolvency of the contractor.

A payment bond and a performance bond work hand in hand. A payment bond guarantees a party pays all entities, such as subcontractors, suppliers, and laborers, involved in a particular project when the project is completed. A performance bond ensures the completion of a project. Setting these two together provides the proper incentives for laborers to provide a quality finish for the client.

Commodity Contracts

Performance bonds are also used in commodity contracts, where a seller is asked to provide a bond to reassure the buyer that if the commodity being sold is not in fact delivered, the buyer will at least receive compensation for lost costs.

The issuance of a performance bond protects a party from monetary losses due to failed or incomplete projects. For example, a client issues a contractor a performance bond. If the contractor is not able to follow the agreed specifications in constructing the building, the client is given monetary compensation for the losses and damages the contractor may have caused.

Advantages and Disadvantages of a Performance Bond

Performance bonds protect the contracting party in the event that their contractor may become insolvent or otherwise unable to meet the terms of a contract. If the costs of completing the project overrun their projections, the obligee will not be responsible for the additional expenses. This reduces the risk for developers or other companies when they engage in large-scale construction projects.

However, there are some risks to consider. The surety may attempt to argue that the obligee did not comply with all the requirements of the bond in order to deny payment. Or, they may try to get the obligee to settle on a lesser amount.

Moreover, it is up to the obligee to calculate the financial cost of a failure by the contractor. If the obligee underestimates the cost of non-performance, they will have to absorb those extra costs on their own.

How to Get a Performance Bond

In order to get a performance bond, contractors need to apply to a surety for a letter of bondability. This non-binding letter states the monetary limits that the surety would be willing to provide to bond the contractor, based on factors like the contractor's experience and creditworthiness, and the size of the proposed project(s).

The bondability letter also confirms that the surety is registered and licensed in the state where the work will be performed, and provides contact information. Although this letter is not legally binding, it is a useful way of demonstrating a contractor's qualifications before they have to spend any money.

In order to become fully bonded, the contractor must provide certain financial information to the surety in order to underwrite the bond. This will depend on the amount being bonded: Smaller projects might require only good credit and a clean license history, while larger projects may require financial statements, balance sheets, and several years of tax returns. The contractor will also pay the company to provide surety, usually a small percentage of the bond amount.

Example of a Performance Bond

Suppose a hypothetical developer is looking for a contractor to construct a new apartment building. Because of the size of the project, they will require their contractor to be bonded. This provides the developer with protection if the contractor fails to meet the requirements of their contract.

The contractor will engage with a bond provider, or surety, to provide a performance bond for that project. In order to get a performance bond, the contractor agrees to pay the surety a small percentage of the total bond amount, usually between 1% and 4%. In exchange, the surety promises to pay up to the agreed bond amount if the contractor fails to deliver on its obligations.

If the contractor does fail to deliver, the developer can file a claim with the surety for damages equal to their losses, up to the value of the performance bond. The surety then investigates to determine the extent of the losses.

Industries That Use Performance Bonds

Usually, performance bonds are provided in the real estate industry. These bonds are heavily used in real property construction and development. They protect real property owners and investors from low-quality work that may be caused by unfortunate events, such as bankruptcy or insolvency of the contractor.

Performance bonds are also useful in other industries. The buyer of a commodity may ask a seller to provide a performance bond. This protects the buyer from any risk that the seller is unable to deliver the commodity, for any kind of reason. If the commodity is not delivered, the buyer receives compensation for losses and damages caused by the non-completion of the transaction.

The Bottom Line

Performance bonds are used to ensure satisfactory completion of contracted work. If a contractor is unable to deliver on their obligations, a performance bond allows the paying party to cover any additional costs due to their failure to deliver. These bonds are usually used for large construction or government projects that might take a long time to complete.