What Are Bond Requirements?
Bonding Requirements may not be something that you’ve heard of, but you’ve probably come across a business like "ABC Construction Company" and then seen "ABC Construction Company (Bonded)" on their truck or website. Many of these construction companies advertise that they are licensed and bonded, but it doesn’t mean the same thing.
Bonding requirements for construction companies are basically a form of protection for consumers of construction contracts. Construction companies who aren’t bonded are usually not required to be licensed and therefore not subject to those licensing requirements which the state requires in order to be a licensed contractor. "Licensed and Bonded" is a misrepresentation of the bonding requirements by most construction companies.
"Bonding" requirements for construction companies is just a fancy name for an assurance that if you give a deposit or make a payment, the construction company can be held liable for any money you spend on it. It’s also an assurance that the construction company has financial integrity and won’t close up shop as the project gets started. It’s also the assurance that they have the financial resources to properly finish a project.
A bond is really no more than an insurance policy which provides for repayment of any funds paid out by the bonding company or insurers . As an example, if I’m a construction company and I require that I be paid $20,000 before starting a construction project, there are two very good reasons for my requiring this payment before allowing a contract to be formed between us. First, under an insurance bond, the bonding company has to pay you the cost to have the project completed even if I don’t do the work (up to the limit of the bond of course). Second, the bonding company does their own due diligence before issuing a bond. This means they require that I submit to them my profits and loss statements for the last year and proofs of sufficient credit to perform the work at the cost I am charging. By requiring me to submit my P&L and credit history to them, I have a much lesser chance of closing up before the project is complete.
Most consumers who hire contractors are never going to know the difference unless the contractor screws up. If there is a problem with the contractor, the bonding company must pay if they are bonded. If the contractor is merely licensed, then you as the consumer have no recourse if the contractor decides to run off with your money. Therefore, the bonding requirement is to ensure that the contractor has the financial strength to be able to afford the cost of the project and that they are willing to stand behind their business.
Bonding requirements are a strong hint to the consumer that the contractor is reliable enough to hire. A contractor who is bonded is less likely to rip off the consumer. A licensed contractor who is not bonded may try to steal your money.
Types of Construction Bonds
There are three types of on most public works and some private work projects that require one type or another of bonding. Most public entities desire them, as they provide a level of assurance to the project owner that the project will be completed under the law and to the satisfaction of the owner. General Contractors, architects, engineers and other design professionals and construction industry subs have learned that it is often advisable to acquire a bond from the subcontractor(s) that they use on the project.
Bid Bonds. When any project owner issues a request for bids (or any type of proposal), it can also require that each person who bids on the project submit a "bid bond" along with the bid. The bid bond assures the project owner that the person bidding will enter into a contract and furnish all required performance and/or payment bonds if the contract is awarded. If for some reason the bidder refuses to execute the contract, the project owner can hold the bond issuer responsible for pay in the amount of the bond. For example, if the successful bidder is for a $500,000 public works project, the project owner may have requested a bid bond in the amount of say $50,000. If the successful bidder refuses to enter into the agreement, then the project owner may recover $50,000 from the bond issuer.
Payment Bonds. When any project owner is desirous of protecting the suppliers that it has contracted with (such as plumbers, sheet metal workers, or drywall workers), the project owner can require that the general contractor on the project obtain a "payment bond" to guarantee such contingent compensation. A payment bond guarantees the payment of all just claims for labor and materials furnished for the project (under the terms and conditions of the public works contract). Since not all materials are included in the deposit made by the general contractor, as materials may be ordered and delivered directly to the jobsite, the payment bond insures that the project owner will pay the subcontractors and their suppliers, whether or not paid.
Performance Bonds. Some owners may require that the Contractor provide, or some subs may also be forced to provide a "performance bond". This bond guarantees the faithful performance of every portion of the contract, and also guarantees the correction of any defective work discovered during the period of the bond (usually one year). If the Contractor fails to perform properly, the project owner may demand money or substitute a new contractor to correct the defective work.
License & Permit Bonds. Depending on the jurisdiction and funding source of a public works project, different permits may be required. The project owner, architect, or governmental authority may require a "license bond to cover such permits as business licenses, encroachment permits, excavation permits, etc. The bond assures the project owner that all work will be done according to local ordinances and laws. The payment of the premium for such bonds is typically the obligation of the contractor.
Qualifying For a Construction Bond
To qualify for a bonding, a contractor must pass the Department’s financial criteria, and have been in business for at least one fiscal year. Further, the bonding line they are requesting, must be reasonably commensurate to their annual work volume within the past three years. For example, if your company does $500,000 worth of work on an average year – you should request an aggregate bond for a minimum of $500,000 and no more than $750,000. The primary bonding underwriting criterion is construction experience.
When a contractor first qualifies with a Surety Company and requests a bonding line, the contractor must offer his financial statements for the latest fiscal year, contact references from his banker, and all proper registrations, classifications and licenses. Although most bonding decisions are based on the financial statements, Sureties also consider the contractor’s experience, organization, production capabilities, bank references, contingent liabilities and personal credit history.
If you apply for a bond and the bond is issued, that is an indication that you have sufficient financial resources.
Remember that a Surety Company will not issue a bond if your financial statements do not accurately reflect the true financial condition of your organization.
Common Bonding Challenges
Construction companies may experience bonding challenges for several reasons. If the construction firm has inadequate credit or has insufficient time to obtain the required documentation for the bonding company, bonding can become increasingly difficult. In addition, if the bonding company takes too long to provide the bond, the contractor may miss out on a job opportunity. The only way to alleviate these specific bonding issues is to develop a strong working relationship with a bonding company.
Other bonding challenges for contractors include poor management of surety bonds, changes in laws and regulations, poor liquidity, lack of necessary documentation, such as financial statements, and missing detailed scopes of work. Failure to disclose material changes, including the delayed submission of warranty, maintenance contracts and subcontracts can hinder a contractor from obtaining bonding. When an entity fails to disclose material changes, such as management changes, significant increases in losses, financial changes such as bankruptcy, a surety company may halt or refuse to continue bonding that entity. Finding ways to remediate poor management and disclosure issues can be the difference between premature bonding and increased bonding.
Benefits of Bond-Compliance
Licensing requirements help ensure that a contractor has the minimum amount of technical experience before being given the go-ahead to start performing work on projects. Bonding goes a bit deeper: it ensures that there are legal and financial repercussions for a contractor that doesn’t perform up to the terms of its contract. In the case that a contractor doesn’t complete its project, a third party can replace the contractor, and the bonding company has to foot the bill. Because of this responsibility on the bonding company to make things right with the client, the bonding company has strict guidelines for assessing a contractor’s eligibility for bonding.
For contractors that do meet the eligibility requirements, the benefits that bonding affords extend well beyond the scope of any particular project. The fact that a contractor has met a bonding company’s vetting criteria (generally revolving around past performance , financial strength, and technical competence) builds trust in that contractor for clients. That trust is worth quite a bit: a client gets the assurance of knowing that a reliable contractor is performing the work—one that is accountable to both clients and the bonding company, and has the financial backing of that bonding company.
Those same benefits translate directly to the client if there is any dispute over the project requirements. If the bonding company marketed your skills—your financial strength, technical competence and track record in completing similar projects—it will know that you performed up to the standard advertised, and stand by you if you’re ever accused of subpar performance. So bonding can mean more trust, lower rates, and more projects simply because you met certain requirements. These benefits can roll up quite a few savings.
How to Get a Bond
Once you have a clear understanding of the bonding requirements for your project, you can work on the process to obtain a bond. The following steps simplify the process. If you do not, or cannot, understand all of the requirements, consult with a construction attorney.
Step 1
Select a bonding company. Bonding companies often require that you use surety agents that are approved by the bonding company you select. Insufficient credit or financial backing can result in significant restrictions being placed on your bonding capacity. A bonding company will limit your bonding capacity based on your industry and business credit ratings. For example, only the highest credit rating may qualify a contractor for an unlimited amount of bond coverage for a project. A contractor with a less than favorable credit rating may obtain a bond for a specific amount or category of work as determined by the bonding company. Your bonding company will review both your short and long term performance history. Performance history is considered from the first moment of contact with a surety up to the time that your final billing has been submitted and paid. Performance history can be positive or negative. The bonding company will consider your credit history and other risks that could negatively affect your business or leads to the inaccurate representation of your financial ability to handle bonds. For example, a bonding company may refuse you coverage if: Failures to meet these obligations can make it difficult to obtain bonding from a surety. The bonding company you ultimately select for a particular project will conduct a thorough review of your business. You may have to sign a Release of Information Form that allows your current bonding company to provide information about your business to the prospective bonding company.
Step 2
Complete your surety application. Your surety application should contain the latest updates about your project, including estimated costs, workers compensation coverage and worker’s compensation experience, and business ownership information. Costs are often provided in chart format by category, or in more detail if necessary. The surety company will also consider your business ownership when determining your bonding eligibility. Your surety application should contain the latest updates about your project, including estimated costs, workers compensation coverage and worker’s compensation experience, and business ownership information. Costs are often provided in chart format by category, or in more detail if necessary. The following items should be verified by the bonding company as part of your surety application:
Step 3
Submit the surety application and any other requested documentation to the bonding company. Once an application is submitted, you will receive an underwriter’s response. A bonding company’s response can be in the form of an Expectancy, which means a bond will be issued for the project once a contract is signed; or a Prequalification, which requires that the contract be reviewed before the bond can be released. Your contract will be covered from the date of bonds or goods are placed, however, your bonding company may require that you submit certified invoices on a monthly basis. The bonding company will set the requirements for monthly reporting. Such reporting may be informal, formal or a combination of both informal and formal reports. For example, the bonding company may require that you prepare a progress report each month for the underwriter while submitting invoices via e-mail.
The Effect of Bonding on Project Success
A construction company’s bond obligations can be the most important factor in affecting the success of a project. The Underlying Contract and subdivision construction work (including water main installation, sewer installation, site work and roadway construction) typically require the General Contractor to provide a Performance and Payment Bond in favor of the Owner and/or an HOA for the benefit of subcontractors and suppliers. These bonds are referred to as "Subdivision Bonds" and help ensure the property owner and/or HOA gets a project completed according to the plans and specifications. Here are some areas where bonding can affect the success of a project:
Project Completion
The obvious reason a Contractor obtains a Performance and Payment Bond is the bond ensures the principal (the Contractor) performs the contract in accordance with its terms. Performance Bond proceeds can be used to pay other Contractors and Suppliers if the principal fails to complete the Project. A properly tackled Performance Bond claim usually results in the surety paying a contractor/subcontractor directly or in providing a subcontractor with a payment bond so the subcontractor gets paid for all work performed. Without a performance bond, Subcontractors are often left without a remedy when the general contractor fails to perform the contract.
Risk Management
Performance Bonds are designed to protect the owner/HOA from downside risk. Sureties will insist on being involved with a project anytime a Contractor may increase its liabilities. This includes payment obligations to Vendors. An HOA materially impacted by construction defects needs to be especially aware of the Subcontractor’s ability to meet all payments to the General Contractor. A Subcontractor ensures its ability to pay its Vendors (for which it will need a second bond) will reduce the HOA’s risk of delay or having to pay twice for the same work (i.e. the General Contractor failing to pay its Vendors for work the General Contractor had to get performed again to finally correct the deficiency).
Risk Mitigation
A well-drafted Surety Indemnity agreement is essential for a Surety when selling bonds. In addition, it will mitigate risk for an Owner/HOA. For a Surety, the purpose of an Indemnity Agreement is to obtain the right to be paid for any sums paid to settle or resolve a claim. For an Owner/HOA, a Surety’s Indemnity Agreement is always in favor of the HOA and allows the HOA to step into the shoes of the Surety to recover amounts it must pay to remedy construction defects.
Bonding Requirements Affecting Legislation
Federal legislation governing public works projects, such as the Miller Act, generally requires contractors working on federal construction contracts to obtain performance and payment bonds. Likewise, many more restrictive state laws differ and sometimes require contractors to obtain bonds for specific types of work. While many state laws mirror federal requirements, some states have modified the requirements for performance and payment bonds. To be in compliance with the Federal Miller Act, public work contracts exceeding $100,000 require a performance bond and a payment bond from appropriate surety companies. The Miller Act applies to both prime contractors and subcontractors at any level who are performing federal work. Similarly, the Davis-Bacon Act requires contractors working on federally funded public works projects to pay their workers the federally established prevailing wages.
On the state level, laws often require that contractors doing public work obtain a payment and performance bond . These laws differ significantly and even more so with regard to how they apply to subcontractors at any level. Some states allow for relief from a requirement to obtain these bonds, while others will not. These differences mandate that contractors investigate the bonding and bonding exemption requirements for each project, even if in the same state. For example, in Wisconsin, 779.14(1), provides an exemption for obtaining a bond. However, in North Carolina, at G.S. 143-129(a)(1), bonds are required to exceed $100,000.00, while in Wyoming, W.S. 16-6-105(b) exemption bonds may be obtained. Many states have similar statutory provisions that provide that the surety must be licensed by the state to do business there. Therefore, it is critical that contractors know the bonding requirements for each state where they conduct business. This is particularly important when dealing with subcontractors, as some laws require the subcontractors, rather than the prime contractor, to obtain the bond.