Performance bonds mitigate risk on public projects

Contractors are prohibited from filing mechanic's liens on public projects like highways, schools or fire stations, as this would lead to public real estate foreclosure. Instead, they are offered alternative security in a performance bond as a guarantee against the failure of the other party to meet the contract obligations.

Why it matters: Understanding the prohibition of mechanic's liens on public projects and the role of performance bonds is important for contractors to secure their financial interests and ensure fulfillment of contractual obligations.

Payment Bond vs Performance Bond

Typically, a general contractor (GC) on a public project is required to provide a payment bond to ensure all subcontractors and suppliers are paid. The GC acts as the principal on the bond, with a third-party surety guaranteeing payment to eligible claimants.

A performance bond is often required for government construction projects to ensure the GC completes the work on time and on budget. It is typically provided by a bank or insurance company to guarantee the contractor finishes the designated projects.

"A performance bond was primarily meant to protect against the GC filing for bankruptcy and leaving public entities with no way to fulfill the obligation of the general contract," said Chris Ring of NACM's Secured Transaction Services (STS).

Pros of Performance Bonds

• Protects an obligee from additional costs if work is not completed.
• Reduces the risk for developers in construction and other large projects.

Cons of Performance Bonds

• Bond issuers may attempt to deny payment.
• If the obligee underestimates the cost of non-performance, they will have to absorb the extra costs on their own.
• Performance bonds add an additional cost to the contractor that may be passed on to the obligee.

Once one of the public entities calls upon the surety bond, then that company must find a contractor to finish the project. "Usually, the surety company gets involved by attempting to get compliance from the original contractor by the surety," said Beau Hays, partner at Hays & Potter, LLP (Peachtree Corners, GA). "So, if the bonded company and the owner dispute over project completion incentives, the bonding company prefers resolving it early without involving a third party. This also motivates the contractor to finish the job."

This was the case for Miami-based American Empire Builders, who wasn't able to fulfill the obligations of a general contract to complete bridges in Florida. On Jan. 19, the City issued a Notice of Default to the contractor, which "confirmed that the contractor has failed to complete the project on schedule and that the City will be sending the surety bond company a Demand for Performance," reads a Tampa Bay article.

Occasionally, the GC may not only fall short of fulfilling their responsibilities outlined in the general contract but may also face bankruptcy or cease operations altogether. Martin Smith, CCE, CICP, credit manager at Ash Grove Cement Company (Sumterville, FL) encountered this situation over a decade ago when his company took over a financially troubled concrete and cement supplier in Florida. "In this instance, many were adversely affected, including the bonding company," he said. "It's unfavorable when others must step in to complete the job, as they have to hire contractors who lost the initial bid. These contractors won't be doing anyone any favors, resulting in higher costs to finish the project."

The cost of a performance bond depends on a variety of factors, such as the project's size, the contractor's creditworthiness, their license history and the bonding party's financial strength. In general, the rate usually ranges between 1.5% and 3.5% of the total value of the performance bond.

Bonds are not required on every public project. Accordingly, contractors should make a practice of obtaining a copy of the bond on the project in their initial credit evaluation of the project and customer. "From a diligence standpoint, supplier of materials should confirm that there is a performance bond on that project and who that bonding company is," Ring said. "When they hear about a GC struggling financially, that's when they need a copy of the performance bond to make sure that there is a bonding company there to support the complete obligation of the general contract."

The government contracting officer may require performance and payment bonds for contracts even if not required by law. "Payment bond claimants should always check the bonding requirements with the owner or contracting officer, especially once payment problems exist," reads a Fullerton and Knowles article. "A payment bond may exist on unexpected projects."

The bottom line: Performance bonds are essential in public projects as they offer financial security to contractors, ensuring the fulfillment of contractual obligations and mitigating risks associated with non-completion or bankruptcy; however, understanding their pros and cons, along with diligent evaluation of bonding requirements for each project, is crucial.

-Jamilex Gotay, editorial associate