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Friday, July 13, 2012

Contractor Bonding: Defined and Explained

Guest contributer: Danielle Rodabaugh
Construction professionals in the D.C. area are probably familiar with the district's various surety bond requirements. Unfortunately, most contractors have a limited knowledge of contractor bonding beyond the fact that they need it before working on certain construction projects. Contractors should fully understand the legal implications of bonds before they purchase them so they know what they're getting into — otherwise they might find themselves in court.

How do surety bonds work?

Although insurance companies typically underwrite contractor bonds, the protection they provide is very different from insurance policies. When underwriting insurance policies, companies assume a certain amount of risk is involved. This is not the case with surety bonds. Unlike insurance companies, surety providers intend to avoid any and all claims, which is why getting a surety bond is often much more difficult than getting an insurance policy. Furthermore, whereas insurance policies involve only the policy holder and the insurance company, surety bonds involve three entities.
  • The obligee, typically a government agency, requires the bond to regulate the market and protect against financial loss.
  • The principal, a construction professional, buys the bond as a legal guarantee of future work performance.
  • The surety financially backs the construction bond as a show of good faith in the principal's ability to complete the project.
No matter the specific bond type that's issued, every surety bond functions in the same basic way: as a legally enforceable contract. If contractors fail to fulfill the contractual terms of their bonds, they face legal action. To avoid the costly and troublesome claims process, contractors should be sure they fully understand the legal language of each surety bond they purchase.
How do contractors know when they need bonds? There are a number of different ways contractors can determine if they need one or more surety bonds.
  • Know federal bonding regulations because they always apply. For example, the Miller Act requires contractors to provide contract bonds on any publicly funded project that costs $100,000 or more.
  • Check with government agencies that issue contractors licenses. Many states require construction professionals to provide contractor license bonds. County and city bylaws might require additional bonds that vary by location.
  • When being contracted for a project, ask the project owner which surety bonds they require. Although surety bonds are not legally mandated for private projects, some owners choose to require them as a way to ensure they don't lose money on their projects.
Failing to purchase and maintain contract bonds according to law — even if done so unintentionally — can result in consequences that include penalty fines, license revocation and even legal action in court.
Is contractor bonding expensive?
Unfortunately, new contractors aren't always aware of the costs associated with surety bonds. Oftentimes contractor bonding is considered a hidden cost to starting a career in the construction industry. Most states require contractors to purchase a contractor license bond before they can even apply for their business license. Then contractors are usually expected to provide one or more surety bonds for each project they take on. An individual surety bond can cost thousands of dollars. The fees associated with bonding vary depending on the type of construction bond and the contractor's application. Financial credentials play a crucial role in determining a construction bond's cost. Generally speaking, the higher a contractor's credit score, the better the rate he'll receive. Conversely, contractors with low credit scores typically pay higher premiums to get the surety bonds they need. Some construction professionals aren't able to front the premium, which means they're limited to working on smaller projects that require less expensive surety bonds.
How does the claims process work? Fortunately, claims on surety bonds are relatively rare, primarily because surety providers are so thorough when reviewing contractors who apply for bonds. Government agencies and other project owners can only make claims on bonds when contractors violate the bond's contractual terms. Most surety providers only pay out claims if the project owner takes the matter to court and the contractor is found to be liable. If the claim is valid, the surety will pay retribution and then go after the contractor seeking full reimbursement (as discussed earlier). Contractors can avoid the surety claims process by fully understanding their bonds' contractual terms before purchasing them — and then, of course, by fulfilling them.
Danielle Rodabaugh is the chief editor of the Surety Bonds Insider, a publication that tracks developments within the surety industry. As a part of the publication's ongoing educational outreach program, Danielle writes informational articles that help construction professionals and their lawyers better understand surety bond regulations and their legal implications.