Lack of bonding capability can prevent contractors from landing big projects in construction, energy, information technology and other fields. While traditional performance bonds aim to protect municipalities and project owners from loss, they also inflate costs to the owner and reduce competition among subcontractors and service providers. Performance bond alternatives may be an ideal balance to minimize owner risk while providing opportunity to all qualified contractors.
Performance Bond Overview
With a traditional performance bond, the project contract specifies the bond amount and terms. The contractor chosen to complete the project must contact a surety company and arrange for bonding. The surety agent evaluates the contractor's creditworthiness and ability to perform the job according to the contract terms. If the surety agent believes the contractor is qualified, he issues a performance bond that guarantees he will take responsibility for completing the job if the contractor fails to perform. This may involve hiring another company to complete the work or paying damages to the owner to cover losses associated with contractor failure.
Performance Bond Problems
From a contractor's perspective, performance bonds pose several problems. They can be tough to obtain, especially for newer or smaller firms. Quality contractors could be prevented from bidding on jobs, which also reduces competition for the project. For the owner, reduced competition could mean higher prices or less value. Requiring performance bonds also increases cost to the owner, as the cost of the bond is passed to the owner through higher bids. The Surety Information Office reports that the average performance bond costs 0.5 to 1 percent of the project price, a substantial fee for large projects.
Various types of collateral can serve as viable alternatives to traditional performance bonds. The owner may simply require the contractor to put up a cash bond representing a specified percentage of the bid price. This cash may be forfeited to complete the project if the contractor fails to perform. In lieu of cash, the contractor may be permitted to provide a property deed, a certificate of deposit, a cashier's check or some other asset to guarantee the project.
Subcontractor Default Insurance
A general contractor on a project may opt to take out a subcontractor default insurance policy to eliminate the need for performance bonds. This allows the contractor to choose subcontractors who may not qualify for bonds but are otherwise qualified to perform the job. With this type of insurance, the general contractor is covered for any costs incurred if his subcontractors fail to complete the project as specified. This performance bond alternative is best suited for larger companies and projects, according to the Higdon Compton Agency.
Letter of Credit
A bank can issue a letter of credit to the project owner, generally in an amount equal to 10 to 15 percent of the project cost. If the owner claims the contractor has defaulted on the project, the bank will pay based on the letter of credit to help cover the owner's losses or to help him get the project completed. "Construction Executive" magazine calls these "pay now, argue later" arrangements. The owner faces little risk, as he receives his payment quickly with relatively little evidence required. These letters are typically considered irrevocable unless otherwise specified. This means that the letter can't be canceled without the beneficiary's permission during the time specified in the letter.
If a general contractor or owner wishes to hire a subcontractor who can't get a performance bond, a joint venture agreement is another option: The owner or general contractor provides indemnity for the bond in exchange for a larger share of the project profits or a reduced price from the subcontractor.
- Surety Information Office: Surety Bonds Versus Bank Letters of Credit
- Construction Executive: Viable Alternatives to Payment and Performance Bonds
- Higdon Compton Agency: Surety Bond Alternatives for the Construction Industry
- King and Spalding: Performance Security -- Protections Available to Mitigate the Risks of Contractor Default During Construction of a Large Energy Project
Emily Beach works in the commercial construction industry in Maryland. She received her LEED accreditation from the U.S. Green Building Council in 2008 and is in the process of working towards an Architectural Hardware Consultant certification from the Door and Hardware Institute. She received a bachelor's degree in economics and management from Goucher College in Towson, Maryland.