What Are Surety Bonds? And Why Are They Important in the Construction Industry?
Although called by names in many different languages, surety bonds have been used to reinforce contracts for centuries. In fact, the Surety Information Office (SIO) notes that “the first known record of contract suretyship was an etched clay tablet from the Mesopotamian region around 2750 BC.” The contracted farmer was unable to tend the client’s fields. Since this client happened to be a king, the farmer was in a serious predicament. After all, the criminal justice system wasn’t what it is today in the 28th century BC, and failing to appease a king would likely result in death!
Therefore, to ensure that the job was completed and contract fulfilled (and to escape certain death), the farmer then contracted another farmer, promising to split the payment equally. Reasonably, the second farmer was a little skeptical. The first farmer had already agreed to a contract that was beyond his abilities, so how could he be sure that this new contract would be any different? Would he honor his agreement? Would payment be delivered promptly upon the completion of the contract? To quell these concerns, a local merchant was brought in to serve as the surety, assuring that payment would be provided to the second farmer.
Suretyship was later documented in the Code of Hammurabi between 1792-1750 BC. This is considered the first written legal code, further evidencing the historic importance of sureties. The oldest surety guarantee in existence is a Babylonian contract from 670 BC; however, sureties as we know them today share their closest ties with the laws of surety developed by the Roman Empire around 150 AD.
Today, surety bonds continue to play an important role in the exchange of services for compensation. The construction industry is a prime example of this. When millions of dollars are on the line, surety bonds are solely responsible for keeping all parties honest. In this editorial, a Jacksonville construction lawyer from Cotney Attorneys & Consultants will discuss surety bonds and why they are important. If you need legal advice pertaining to your rights and obligations when dealing with surety bonds, consult our Jacksonville construction lawyers for assistance.
The Beginning of the Modern Surety Bond
In the 19th century, the first corporate surety bonds were utilized to protect deals between business owners and contractors. This resulted in the passing of the Heard Act in 1894, which required surety bonds for any contracts entered with the federal government. The Miller Act of 1935 was later instituted to update the Heard Act, requiring performance bonds for public contracts valued at more than $100,000 and payment bonds for contracts with a value over $25,000. Today, the Miller Act and the Little Miller Acts that oversee local jurisdictions continue to govern surety law in all 50 states, the District of Columbia, and Puerto Rico. Our Jacksonville construction attorneys can help contractors maintain compliance with all relevant laws dealing with surety bonds.
Related: What Is the Little Miller Act?
There’s some degree of financial risk involved with every contract you sign. Someone needs to be accountable for these risks, and it usually falls upon the shoulders of the party supplying the service. The reasoning for this is quite clear when you think about the low-bid system utilized by the government to award contracts. When every contractor is forthcoming about their abilities and doesn’t embellish their bids, this is a relatively foolproof system, but when the lowest bidder turns out to be undependable, it creates a major problem for the project financier and any contractors that should have been awarded the bid. This principle is consistent for both public and private projects, which leads to two very important questions:
- How can the government rely on the low-bid system for awarding public works contracts and ensure that the lowest bidder can satisfy the scope of work and deliver the project on time?
- How can business owners in the private sector manage the risk of a contractor who cannot meet the terms and conditions of their contract?
The answer to both of the questions is the surety bond. Surety bonds provide twofold financial security for owners, ensuring that work will be completed and subcontractors will be compensated according to the agreement.
Related: Surety Bond Misconceptions
Types of Bonds
According to SIO, a surety bond is best described as a “risk transfer mechanism where the surety company assures the project owner (obligee) that the contractor (principal) will perform a contract in accordance with the contract documents.” There are three types of contract surety bonds, including:
- Bid Bond: guarantees that a bid was submitted in good faith and locks the contractor in for the price established in the contract. It also guarantees that the contractor will provide the necessary performance and payment bonds.
- Performance Bond: protects the project owner from any financial loss that results from the contractor’s failure to meet the terms and conditions of the project. In other words, a guarantee that the owner can “perform” the requested job.
- Payment Bond: assures that the contractor will compensate all subcontractors, laborers, and materials suppliers for their work on the project.
Surety Bonds Shift Risk
It’s important to keep in mind that surety bonds are only required by law for public works projects, but private owners can still require their use if they want to reduce risk. Compared to other types of financial security (i.e., letters of credit, self-insurance, etc.) only surety bonds can provide 100 percent performance and payment protection. Surety bonds shift risk from the owner to the surety company, but in the end, the contractor is ultimately responsible for any mishaps that occur throughout the project. Therefore, it’s imperative that contractors only take on projects they are qualified for.
The first step in the surety bond process involves the owner specifying the exact bonding requirements for the contract in question. Then, it is the contractor’s responsibility to obtain the bonds and provide them to the owner. In some cases, subcontractors may also be asked to obtain surety bonds to spread risk across multiple parties. This is oftentimes the case in projects where subcontractors play a significant role or have a unique specialization that is difficult to replace.
Surety companies are typically subsidiaries or divisions of insurance companies. Since they offer both surety bonds and traditional insurance policies, it’s important to understand the difference between the two and how it affects you as a contractor. Traditional insurance is utilized to protect a party against the unexpected, which is why the policy premium is calculated from aggregate premiums and earned versus expected losses. Sureties work in a slightly different way. They are designed to prevent financial loss from occurring in the first place. To do so, they prequalify contractors based on the financial strength of their business and their overall experience and expertise. The prequalification process is nuanced. Among the criteria required for bond issuance are high-quality references, a positive reputation, the ability to meet obligations now and in the future, relevant experience, access to equipment, financial strength, and a sterling credit history. Additionally, your company should have an established relationship with a banking institution and possess a significant line of credit.
Only contractors who can prove that they control a well-managed, profitable, and ethical company can get prequalified for lucrative projects that require surety bonds. And only a Jacksonville contractor lawyer can help them navigate the legal pitfalls relating to surety bonds, contract fulfillment, and other related legal matters.
How Bonds Benefit Contractors
It might seem like bonds are a threat to contractors who are looking to reach the next tier of their career by taking on increasingly complex (and expensive) projects, but this isn’t necessarily the case. Surety bonds may help alleviate risk for owners, but they can also benefit contractors in a few important ways, including:
- Prequalification bares evidence of the contractor’s capabilities.
- Contractors are more likely to complete their projects when bonded, improving their reputation and decreasing the opportunity for an ill-fated decision.
- With a payment bond in place, subcontractors do not need to file a mechanic’s lien.
- Bonding capacity may lead to more project opportunities.
- The surety company overtakes fulfillment responsibilities in the event of contractor default.
Needless to say, surety bonds are an important component of the construction industry that keep contractors honest and help ensure projects are completed and paid for as originally planned. If you need assistance handling surety bonds, consult a Jacksonville construction lawyer.
If you would like to speak with a Jacksonville construction attorney, please contact us today.
Disclaimer: The information contained in this article is for general educational information only. This information does not constitute legal advice, is not intended to constitute legal advice, nor should it be relied upon as legal advice for your specific factual pattern or situation.