The owner of a building under construction must know that the contractor doing the work will be able to finish the work on time and within budget.

Although no one can predict such things with certainty, contract bonds issued to the contractor by a corporate surety help to ease the mind of the building owner.

When issuing a bond, the bonding company is counting on the contractor to be able to finish the job. Bond underwriters look at the “three Cs” for any contractor — character, capacity, and credit. A successful contractor must have all three.

• Character: The contractor must be honest and possess a high degree of integrity.
• Capacity: The contractor must have the experience and knowledge to complete the job.
• Capital: The contractor must have access to appropriate amounts of capital in order to fully fund the project.

Here is a look at the five most common bonds used to secure construction projects.

1. Bid or Proposal Bonds: A contractor submits a bid bond along with the bid on a particular job. The bond guarantees that, if awarded the job, the contractor will sign the contract. It also guarantees that the contractor will furnish all necessary performance and payment bonds.

If the contractor defaults, the surety must pay the difference between this contractor’s bid and the next higher one. The surety’s liability is limited to the bond penalty (analogous to a limit of liability on an insurance policy). The bond sets a six-month time limit for suits against the surety.

An alternative to the bid bond is the bid letter. Sometimes required on public (government) projects, this is a letter signed by the surety. In the letter, the surety agrees to execute the bidder’s obligation in an amount equal to the amount upon which the project award was based. Because no penalty is specified, there is no limit on what the surety may end up paying.

2. Performance Bonds: A performance bond guarantees that a project will be completed according to contract specifications and lien-free, if the principal pays the contractor.

The owner, therefore, must advance enough money to complete the project. The owner must also contest any liens on the project and determine the amount of loss before turning to the surety.

3. Payment Bonds: A payment bond is for the benefit of those supplying labor and materials to a construction project. It agrees to indemnify the owner for any loss sustained because the principal does not pay the suppliers.

The provisions of a payment bond are usually included in the performance bond. If a payment bond is written separately from a performance bond, there is no charge for the payment bond.

4. Maintenance Bonds: Often a contractor must agree to fix any defects in the workmanship for a period of time after the project is complete. A maintenance bond guarantees to the project owner that the contractor will meet this maintenance obligation.

5. Completion Bonds: When a contractor receives a loan to complete a construction project, the lender often requires a completion bond. Such a bond guarantees to the lender that the project will be completed without any liens against the property.

Although the same surety may provide the contractor’s performance bond and the completion bond, such a procedure is usually not recommended.

Editor’s note: This information is excerpted from the FC&S Online article “Contract Bonds.”