When a contractor defaults on a building project, there are no winners. The contractor, of course, has lost his livelihood, the project owner suddenly finds an often substantial investment in dire risk, construction laborers are abruptly out of work and likely missing last week’s pay check, and the shock waves reverberate down the line.

But by its nature, construction is a risky business. According to the Associated General Contractors Association, one-half of all the construction firms in business today will be out of business six years from now. Dun & Bradstreet’s Business Failure Record reports that 80,000 construction firms failed between the years of 1990 and 1997, piling up a total liability of almost $21.7 billion. Indeed, it’s entirely likely that if you’ve been in the building industry for any length of time, you may know someone or some company who has first-hand experience with contractor default — whether it be giving or receiving.

Surety Institutions With so much volatility, it’s no wonder that bonding companies exist. Certainly, no astute and responsible business person is going to take a gamble on a contractor going belly up in the middle of his project. There is simply too much at risk.

Bonding companies, sometimes called surety companies, offer what is commonly known as surety bonding. The surety bond provides financial security and insurance to the owner on building construction projects by assuring the owners that the contractor(s) will perform their work and pay their workers, sub-contractors and suppliers according to contract.

The surety bond simply gives the owner something to fall back on should a default take place. The surety company allows its financial resources to be used to back up the commitment the contractor has made to the owner. If the contractor defaults, the surety company steps in to finish the job and sort out the mess. Of course, for this service, the contractor (and eventually the owner, through accepting the contractor’s bid) pays the surety company a fee not unlike paying an insurance premium.

Types of Bonds

Contractors use three general types of bonds:

• Bid bond
• Performance bond
• Payment bond.

The bid bond is financial insurance to the owner that the bid has been submitted in good faith and the bidding contractor intends to enter into the contract at the price quoted at the time of the bond submission. The bid bond also insures that the bidder will provide the owner with performance and payment bonds (assuming they’re required) in a timely fashion if an agreement is sealed. The performance bond protects the project owner from financial loss should the contractor fail for any reason to perform the work as set forth in the contract documents.

For private construction projects, the decision on whether or not to require bonding of the contractor is purely discretionary. If an owner has worked for many years (and many projects) with a particular contractor, he may feel confident and comfortable enough to forego the bonding requirement. Of course, this does leave the owner open to default by the contractor, so it becomes purely a matter of trust. And cost. Remember, these bonds do cost money — sometimes lots of money — and that cost is almost always passed along to the owner as a line item on the contractor’s bid. So by eliminating the bond, the owner saves himself some money.

The option to bond or not to bond isn’t the case, however, in federal public work. The Miller Act of 1935 requires performance and payment bonds on all public works projects that are in excess of $100,000. In addition, there may be, and often are, state and/or local mandates that require bonding for their own public projects. To know whether bonding is required, you can often check Division 1 “General Requirements” of the specification manual that accompanies many blueprints, or of course, you can contact the owner or architect.

Obtaining A Bond

First, check around through contractor acquaintances or associations for the names of good bonding companies. Then select one (or more) that you like and schedule an appointment. At this point, the surety company will likely begin to pre-qualify you. This process involves an in-depth investigation into items such as your work history, financial status, credit experience, and more. It is a thorough process, and before a bond will be issued, the surety must be completely satisfied that you:

• are responsible and reliable.
• have a real, proven experience in performing the type of work for which he’ll be bidding.
• have (or are able to obtain) the necessary equipment to perform the work in question.
• have the financial strength to support the work desired.
• have an excellent credit history and payment record.
• have an established line of credit and solid relationship with a reputable banking institution.

It’s certainly no cakewalk. Often the young or inexperienced contractor may find himself facing considerable odds to acquire bonding — odds that can affect his business by limiting the amount of jobs he’s able to bid. Caught in the proverbial Catch-22, this contractor will often ask in frustration, “How am I suppose to get the sterling experience and credit history required by the surety company when I’m not able to bid on more than half the jobs that are out there?” Well, the answer isn’t easy, and likely involves more residential work, less-glamorous light-commercial work, plus a lot of ingenuity and struggle.

It’s a cold, clinical system, but of course, it’s only accomplishing exactly what it was intended to do — be a checks and balances tool for the owner to protect himself against inexperienced or unscrupulous contractors.

There are alternative forms of financial security for the owner such as letters of credit (from the contractor’s bank), self-insurance, a thorough pre-screening process of the bidding contractors, and so on. Of course, the ultimate alternative to bonding is just plain trust, but lamentably, we no longer live in a world that affords us such an optimistic take on contractual relationships. So for now, the only solid assurance that the project will be completed according to contract is through the bonding process, thereby allowing the owner to enjoy a little (at least) peace of mind.