Performance bonds and payment bonds are fundamental requirements for most government construction contracts and many private projects. While they're often required together and may even be written on the same form, they serve entirely different purposes and protect different parties. Understanding these differences is essential for every construction contractor.
What Is a Performance Bond?
A performance bond is a surety bond that guarantees the contractor will complete the project according to the contract terms. If the contractor fails to perform, the surety company must either:
- Finance another contractor to complete the work
- Complete the project themselves
- Pay the owner the bond amount (less common)
Who Performance Bonds Protect
Performance bonds protect the project owner (the obligee). They ensure that:
- The project will be completed as specified
- Work will meet quality standards
- Schedule commitments will be honored
- Contract requirements will be fulfilled
Key Performance Bond Terms
- Principal: The contractor who must perform
- Obligee: The owner who is protected
- Surety: The bond company providing the guarantee
- Penal sum: The maximum bond amount (usually 100% of contract value)
What Is a Payment Bond?
A payment bond guarantees that the contractor will pay all subcontractors, suppliers, and laborers who contribute to the project. If the contractor fails to pay, these parties can make claims against the bond.
Who Payment Bonds Protect
Payment bonds protect subcontractors, suppliers, and workers—not the owner. They ensure that:
- Subcontractors receive payment for their work
- Material suppliers get paid for delivered goods
- Workers receive their wages
- Lower-tier parties are protected
Why Payment Bonds Exist
On public projects, mechanics liens are typically not available because government property cannot be liened. Payment bonds provide an alternative remedy for unpaid parties.
Side-by-Side Comparison
| Aspect | Performance Bond | Payment Bond | |--------|------------------|--------------| | Protects | Project owner | Subs, suppliers, workers | | Guarantees | Project completion | Payment to project participants | | Triggered by | Contractor default on performance | Contractor failure to pay | | Claimants | Owner only | Unpaid subs, suppliers, workers | | Amount | Usually 100% of contract | Usually 100% of contract | | Replaces | Owner's completion risk | Mechanics lien rights |
The Miller Act: Federal Bond Requirements
The Miller Act (1935) requires performance and payment bonds on all federal construction contracts exceeding $150,000:
- Performance bond: 100% of contract amount
- Payment bond: 100% of contract amount for contracts over $5 million; lesser amounts for smaller contracts
States have enacted "Little Miller Acts" with similar requirements for state and local public works projects.
When Bonds Are Required
Federal Projects
All construction contracts over $150,000 require both bonds. The Federal Acquisition Regulation (FAR) specifies requirements and procedures.
State and Local Projects
Requirements vary by jurisdiction:
- Most states require bonds on contracts over $25,000-$150,000
- Specific thresholds differ by state
- Some allow alternative security forms
Private Projects
Owners may require bonds at their discretion:
- Common on larger commercial projects
- Lenders often require bonds
- More negotiable than public projects
Making a Claim on a Performance Bond
When to File a Performance Bond Claim
Owners typically file claims when:
- Contractor abandons the project
- Contractor is terminated for default
- Work is substantially deficient
- Schedule delays are unrecoverable
The Claims Process
- Notice of default: Owner notifies contractor and surety
- Investigation: Surety investigates the claim
- Decision: Surety chooses how to respond
- Resolution: Completion, payment, or dispute
Surety Options
When a valid performance claim is made, the surety typically:
- Finances completion: Provides funds for the original or replacement contractor
- Re-lets the contract: Hires a new contractor directly
- Takes over: The surety completes work through its own resources
- Tenders the bond: Pays the penal sum (rare, usually disadvantageous)
Timeline
Performance bond claims can take months to resolve:
- Investigation: 30-90 days
- Contractor replacement: 30-60 days
- Completion: Varies by remaining scope
Making a Claim on a Payment Bond
Who Can File Payment Bond Claims
The Miller Act and most state laws allow claims from:
- First-tier claimants: Direct subcontractors and suppliers to the prime contractor
- Second-tier claimants: Suppliers to first-tier subcontractors (with notice requirements)
- Workers: Unpaid laborers
Notice Requirements
Requirements vary by jurisdiction and claimant tier:
Federal (Miller Act):
- First-tier: No preliminary notice required
- Second-tier: Must give written notice to prime contractor within 90 days of last furnishing
State Requirements:
- Vary significantly
- May require preliminary notices
- Specific deadlines apply
Filing Deadlines
Strict deadlines apply—missing them can forfeit claim rights:
- Miller Act: Claim must be filed within 1 year of last furnishing labor/materials
- State acts: Typically 90 days to 1 year, varies by state
The Payment Bond Claim Process
- Provide required notices (if applicable)
- Make written demand to the contractor
- File formal claim with the surety
- Document the amount owed with supporting evidence
- Negotiate resolution or pursue legal action
Bond Costs and Pricing
How Bonds Are Priced
Bond premiums are calculated as a percentage of the contract amount:
- Standard range: 1-3% of contract value
- Excellent credit/financials: 0.5-1.5%
- Higher risk contractors: 2-4%+
Factors Affecting Premium Rates
- Contractor's financial strength
- Credit history
- Experience and track record
- Work on hand vs. capacity
- Project type and complexity
- Contract terms
Sample Bond Cost
For a $1,000,000 contract at 2% rate:
- Performance bond: ~$10,000
- Payment bond: ~$10,000
- Combined: ~$20,000 (often discounted when purchased together)
Qualifying for Bonds
What Sureties Look For
The "Three Cs" of bonding:
- Character: Reputation, integrity, experience
- Capacity: Equipment, personnel, management capability
- Capital: Financial strength, working capital, credit
Documentation Required
- Personal financial statements of owners
- Business financial statements (CPA-reviewed or audited)
- Work-in-progress schedules
- Bank references
- Equipment lists
- Key personnel resumes
- Contract backlog reports
Building Bonding Capacity
New contractors can build capacity by:
- Starting with smaller bonded projects
- Maintaining clean financial records
- Completing projects successfully
- Building relationships with surety agents
- Keeping personal credit strong
Common Bond Issues for Contractors
Performance Bond Concerns
- Wrongful termination: Surety may dispute owner's right to terminate
- Completion costs: Surety may argue actual costs were reasonable
- Scope disputes: What work was actually required?
- Owner-caused delays: May excuse contractor performance
Payment Bond Concerns
- Disputed amounts: Surety investigates before paying claims
- Notice failures: Claimants may lose rights through procedural errors
- Bond exhaustion: Multiple claims can exceed bond amount
- Subrogation: Surety can pursue recovery from contractor
Best Practices for Contractors
Maintaining Good Standing with Your Surety
- Submit financial statements timely
- Communicate about large projects early
- Report problems before they escalate
- Maintain open dialogue with your agent
Avoiding Performance Bond Claims
- Complete projects as contracted
- Address owner concerns promptly
- Document everything
- Communicate about delays early
- Finish punch lists quickly
Avoiding Payment Bond Claims Against You
- Pay subcontractors and suppliers promptly
- Verify lien waivers before making payments
- Track payment status across all tiers
- Address payment disputes quickly
- Maintain cash flow discipline
As a Potential Claimant
If you're owed money on a bonded project:
- Know your notice requirements
- Track deadlines carefully
- Document amounts owed thoroughly
- Consider the bond as a payment source
- Act promptly—don't wait
Bonds and Subcontractors
Subcontractor Bonds
GCs may require subcontractors to provide their own bonds:
- Guarantees subcontractor performance
- Protects GC from sub default
- May be required on larger subcontracts
Flow-Down Requirements
Subcontracts should address:
- Bond requirements for sub's work
- Claims procedures
- Notice requirements
- Cooperation with surety
Alternatives to Traditional Bonds
Subcontractor Default Insurance (SDI)
GCs may use SDI instead of requiring sub bonds:
- Covers sub default losses
- GC manages the program
- Can be more cost-effective
- May have different terms
Letters of Credit
Some owners accept letters of credit:
- Bank guarantee of payment
- Less common than surety bonds
- Higher cash requirement
- Different risk profile
Conclusion
Performance bonds and payment bonds serve essential but distinct functions in construction contracting. Performance bonds protect owners from contractor failure to complete projects, while payment bonds protect subcontractors, suppliers, and workers from non-payment.
For contractors, understanding these bonds means:
- Knowing what you're guaranteeing
- Maintaining strong surety relationships
- Protecting your bonding capacity
- Managing projects to avoid claims
For subcontractors and suppliers, understanding payment bonds means:
- Knowing your rights on bonded projects
- Following notice requirements precisely
- Acting within filing deadlines
- Having recourse when payments are withheld
Whether you're the principal on a bond or a potential claimant, these financial instruments are fundamental to how the construction industry manages risk and ensures project completion and payment.
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