How does a construction bond work?
If a contractor fails to fulfil their contractual requirements then the client or developer can face severe disruption or financial hardship, therefore it is common for developers to ask contractors to provide a contractual guarantee or promise in the form a bond or surety. Therefore a bond is a bit like an insurance policy that will pay the client if something goes wrong, for example if the contractor becomes insolvent.
The need for a bond is normally set out by the developer within the contract, and the contractor is expected to purchase the bond, with the developer or client being the beneficiary of any payment.
There are a range of different bonds available but the two most commonly requested are Performance Bonds and Advance Payment Bonds:
- Performance Bonds
These have become a regular requirement in recent times as developers are unwilling to risk being left in a situation where the contractor fails to perform their contractual requirement. A frequent concern is that the contractor might become insolvent before the contract is completed. Performance bonds are commonly set at a figure of around 10% of the total contract price, which is usually considered sufficient to cover the cost of disruption in rectifying any failure in the performance of the contract.
- Advance Payment Bonds
Contractors will often request the developer or client gives them an advance payment or down payment to cover the cost of materials or equipment at the start of a contract. A concern for the client in such a situation is that they might pay a large sum up front but the contractor fails to fulfil the contract or goes insolvent. In this case a bond would compensate the client for the lost advance payment.
Bonds generally come in one of two types, either ‘on demand’ or ‘conditional’:
- If a contractor purchases an ‘on demand’ bond then the employer or client can call upon this bond to be paid at any time, even if the contractor is not in breach of contract. There have even been cases where the bond has been called upon when the developer actually owes the contractor money.
- A ‘conditional’ bond on the other hand can only be called upon if the developer or client can demonstrate that the contractor has failed to comply with the contract and the beneficiary has suffered a loss.
Bonds are generally obtained either from a bank or from a bondsman or surety, generally via a broker such as Sutcliffe & Co. Banks will usually issue ‘on demand’ bonds and may well tie up the value of the bond, which restricts the finances of the contractor. A bondsman or surety will more often issue a ‘conditional’ bond and will not tie up any of the contractor‘s finances. As such, most contractors find bonds offered by their bank too restrictive.