Q: I’m confused over the all the different types of bonds and insurance. Can you explain bonds in layman’s terms?
A: Everyone gets confused over this, but I will try to explain in non-legal speak. There are three basic types of surety bonds. Insurance and bonds are two very different things, so I will tackle the bonds this week and insurance later.
1.) Bid Bonds
A bid bond guarantees the building owner that the principal of the bidding company will honor its bid and will sign all contract documents if awarded the contract. The owner is the holder of the bond and therefore could sue the principal and the surety company used to enforce the bond. Basically, if the principal refuses to honor its bid, the principal and surety are liable on the bond for any additional costs the owner incurs in re-bidding a portion of the project. This usually is the difference in dollar amount between the low bid and the second lowest bid. The amount pledged (penal sum) of a bid bond is typically 10 percent of the bid amount.
2.) Performance Bonds
A performance bond guarantees the owner that the company will complete the contract according to its terms, including price and timelines. Basically, if the company defaults, or is terminated for default by the owner, the owner may call upon the surety to complete the contract. Many performance bonds give the surety company three choices: completing the contract itself through a completion contractor (taking up the contract); selecting a new contractor to contract directly with the owner; or allowing the owner to complete the work with the surety paying the costs. The penal sum of the performance bond usually is the amount of the contract and may be increased when change orders are added. The surety bond is usually 1-2.5% of the contract value based on financial strength and history of the company.
3.) Payment Bonds
A payment bond guarantees the building owner that the subcontractors and suppliers will be paid what is due from the prime contractor. The owner is the bond holder but, in this case, the “beneficiaries” of the bond are the subcontractors and suppliers. Both the owner and the subs and vendors may sue on the bond. An owner benefits indirectly from a payment bond in that the subcontractors and suppliers are assured of payment and will continue performance. On a private project, the owner may also benefit by providing subcontractors and suppliers a substitute to a mechanics lien. If the contractor fails to pay the subs or suppliers, the owner may collect from the contractor to pay them directly. Payments under the bond will reduce as the progress payments are made. Generally, the penal sum in a payment bond is less than the total amount of the prime contract as long as partial payments have been made during the project.