Performance bonds are used in a variety of industries to guarantee that a contract’s obligations are met. They are issued by banks, insurance companies and surety companies and are common in construction, real estate development and import/export contracts. In commodities markets they are called margins, where good faith money is deposited as collateral to secure futures contracts. Here is what you need to know about performance bonds. Consider working with a financial advisor if you’re involved in creating or obtaining a performance bond.
Understanding Performance Bonds
Performance bonds are financial instruments that help guarantee that large projects are completed according to the terms of the contract. In the construction and real estate development industries, a performance bond is used to guarantee a construction agreement. It is \collateral that assures that a contractor who has bid for and won the contract for a project will complete the project according to the terms of the contract.
If the contractor defaults on the contract, the performance bond kicks in and provides compensation to the property owner. Then, that money could be used to complete the project.
Performance bonds are most often used for public works construction projects. The Miller Act, enacted in 1935, requires that any federal government construction project over $100,000 have both a payment bond and a performance bond in place. The payment bond guarantees that all parties will be paid and that there are no title claims against the company. It also protects the property from title claims. The states usually have similar requirements for performance bonds.
Private projects seldom require performance bonds, but large commercial projects often do. Payment and performance bonds work together to protect the parties involved in the contract.
Types of and Parties to Performance Bonds
There are two classes of performance bonds, the contract bond and the commercial bond. The contract bond, and there are several types, is used in the construction industry. The performance bond, a type of contract bond, is used to guarantee the work will be completed. The bid bond can be used by the client to lock in bids on a project. The payment bond guarantees payment to all parties. The ancillary bond covers miscellaneous issues that could possibly come up. The commercial bond is not related to construction work. Instead, this type of bond is used in various legal proceedings.
There are three parties involved in a performance bond:
- Principal – The principal is the contractor or person who will be doing the work.
- Obligee – The obligee is the federal government unit, city, state, private company or individual who is the customer. The customer is the party who may need the performance bond to guarantee the terms of the contract.
- Surety – The surety is the financial institution, like a bank or insurance company that issues the performance bonds.
Getting Performance Bonds
Performance bonds can be obtained at banks and insurance companies and are usually only available to creditworthy customers. There are also surety companies from which you can obtain performance bonds. If you need a performance bond, try to get one from either a financial institution or a surety company with some experience in the kind of project you are undertaking.
The U.S. Treasury Department has a list of certified surety companies that may be helpful to you. Other resources are the National Association of Surety Bond Producers and the Surety and Fidelity Association of America.
When you apply for a performance bond, you will need to submit the following to the surety company:
- An application with the surety company
- A copy of the contract between principal and obligee
- Several years of audited financial statements for the principal
- The collateral that is tied to the contractor
A performance bond usually covers the full value of the contract. Often, obtaining the bond costs about 1% of the value of the contract. The cost may vary depending on the creditworthiness of the issuer of the bond.
Remember that performance bonds are not insurance. The contractor still should have all necessary liability insurance and other types of insurance that are usual and necessary.
Pros and Cons of Performance Bonds
There are several strengths and weaknesses of performance. Which ones matter most will depend on the specific type of contract being undertaken.
- The obligee or client can be assured that the project will be completed regardless of the status of the principal.
- It will not cost the obligee anything if the work has to be completed by another contractor.
- The obligee has to account for the financial losses they have sustained at the hands of the principal based on the bond contract.
- If the obligee accepts a bid on a project that is too low and the contractor has to go over budget, they probably can’t recover that cost.
- A surety might try to avoid paying the cost of the performance bond by claiming negligence on the part of the obligee.
Performance Bond Claims
Problems can arise in any large development project. If a contractor runs into a problem, they should contact the surety company. The contractor should try to find help so they can finish the contract completely and in a timely fashion. If the contractor slips into bankruptcy, then the surety company may take one of the following actions:
- Payment – The surety company will pay the lower of the cost of the performance bond and the cost of completing the contract. The surety company may even finance the completion of the work for the contractor if the project is close to completion.
- Project Completion – The surety company and the obligee or client will make arrangements to finish the contract through a replacement contractor chosen by one or both of them.
In the commodities markets, performance bonds are often called margin and represent a guarantee from the seller to the buyer of a commodity that if the commodity they sold is not delivered (if they want delivery), they will be compensated for lost costs. Margin is basically a good faith deposit.
The Bottom Line
Performance bonds are, in general, a step for an obligee to take to protect their investment in a variety of types of projects. If a contractor does not fulfill their contractual obligations, at least the client will recover some or all of the costs. It’s important to remember that to get a performance bond, the contractor has to put up real estate, equipment or something else of value as collateral. A performance bond is not insurance and the contractor must hold the necessary liability insurance policies.
Tips for Financial Planning
- Performance bonds are not investment vehicles. They are for purposes of ensuring that projects, mostly real estate, are completed. NB: The term performance bond also refers to margin in the commodities market.
- Do you need to tune up your investment strategy? Maybe you need to update your estate plan. If you would like the assistance of a financial advisor, check out SmartAsset’s financial advisor tool and find someone local you like. It only takes a few minutes to be connected with advisors in your area. If you’re ready, get started now.
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