Article by Heather DeBlanc, Liebert Cassidy Whitmore
When embarking on campus construction or a significant renovation project, schools should certainly buy insurance (see full feature for more detail). But should your school require its contractors to have performance or payment bonds? The following may help you decide. Schools should always consult with their broker to determine the coverage appropriate for the project.
A performance bond is a three-party document that involves the school, contractor and a performance bond surety. It provides financial assurance that the contractor or its surety will complete the contract according to its terms, including within the agreed-upon time and price. If the school does not require a performance bond and the contractor defaults, the school’s only remedy is usually to proceed against the contractor. The performance bond protects against financial loss and contractual performance. Insurance coverage provided by the contractor does not protect against this kind of loss. Insurance coverage typically protects against injury to persons or property. Therefore, a performance bond gives the school a source of recovery (other than the contractor) for the contractor’s failure to perform.
In the event the contractor fails to perform the work in accordance with the contract documents and the school suffers a financial loss, the school would file a claim against the bond. The surety investigates and, if it determines the claim is valid, will pay out up to the amount of the bond. The surety then turns around and sues the contractor to recover. If the surety investigates the claim and determines the claim is not valid, the school would have to sue the contractor and surety by bringing an enforcement of performance bond (“breach of contract”) lawsuit.
The contractor typically will pass through the additional cost of a performance bond to the school under the construction contract. The additional cost to the school will depend on underwriting factors, i.e., the contractor’s credit, financial condition, etc. At the time of contracting, the contractor should be able to tell the school the additional cost associated with posting a performance bond. Performance bond rates typically are 1% for projects/performance bonds over $1 million.
Schools should weigh this increased cost against the potential risk of not having a bond, i.e., the contractor could file for bankruptcy, walk off the job, etc. Performance bonds should incorporate by reference the entire underlying contract documents, where the surety agrees to guarantee every contract term, not just the completion of the project.
A payment bond provides assurance to the school that the contractor’s subcontractors and suppliers will be paid. A payment bond provides subcontractors and suppliers an alternative to filing a mechanics lien against the school’s property. A payment bond is similar to a mechanic’s lien except instead of filing a lien against the school’s property, a claim is filed against the bond money. When the contractor fails to pay its subcontractors, they can collect from the surety under the payment bond (up to the penal sum of the bond). The payment bond provides a fund against which unpaid subcontractors, suppliers or laborers can make a claim.
If the surety rejects the claim, the subcontractor may file suit against the surety. Doing so will impact the general contractor’s future bonding capacity, so contractors typically do not want to become involved in a payment bond enforcement action by a subcontractor.
Having a payment bond on your project typically will not prohibit a subcontractor from filing a mechanic’s lien, but merely gives the claimant a different avenue to assert its claim.
Importantly, per the contract language, the contractor should be required to post a release bond with regard to any mechanic’s lien that is filed against the property, which effectively, would also give the subcontractors a potential avenue for recovery (instead of the school’s property).
For more on the roles of architects, construction managers, contractors and mechanics in campus construction, see “Foundations for Construction Success."
Schools usually will weigh the cost of requiring these bonds against the benefits on a project-by-project basis. The school should strongly consider requiring a performance bond if it is concerned the contractor may not perform pursuant to the contract or if the school wishes to protect itself from loss arising from breach of contract. As long as the contract language requires the contractor to post a release bond if a mechanic’s lien is filed, a payment bond may not necessary.
Each state likely has specific statutory provisions governing payment and performance bonds. For example, bonds may be required on certain projects, depending on the owner’s net worth, size of the project, ownership status of the land, or other factors. Schools should consult the laws in their state.
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