When talking about big fields like construction and real estate development, the focus is on how projects are completed. Financial instruments are needed to ensure that such projects are completed on time. This is where performance bonds come into play. When you have a large project related to either field, you need to have a collateral property or investment as a backup. Performance bonds provide such a guarantee. Like all legal matters, there are specific details regarding the parties and procedures. If your company starts working on projects in municipalities, cities, or states, it will be beneficial to understand the mechanism behind performance bonds. In this guide, we will go over the basics of performance bonds to help you before you get one for your property.
What Are Performance Bonds?
Performance bonds are guarantees provided by financial institutions such as banks and insurance companies, which are called surety parties. They guarantee against any failure to meet the obligations of the contract. The financial experts from SwiftBonds.com state that the party providing the service, like contractors, should pay for the performance bonds based on the agreement. Such bonds are required in real estate and construction development, and they can also be used in certain transactions of commodities. In the latter case, the performance bond ensures the availability of the commodity for buyers. Generally, payment bonds and maintenance bonds are required with performance bonds. It is worth mentioning that performance bonds fall under surety bonds, as they involve the surety entity like banks.
Who Are The Parties Involved?
As mentioned before, a performance bond is paid to any entity involved in the project, such as laborers, suppliers, and contractors to ensure its completion. Performance bonds involve three main parties.
- The Obligee: This is the party that benefits from the performance bond. In other words, it is the customer, such as the individual, firm, or federal entity. It is whoever gains benefit from such bonds
- The Principal: It is often called the obligor, which is the party whose work will be monitored and guaranteed by the performance bond. Mainly, it is the contractor or firm that works on the project.
- The Surety: This is the financial entity issuing the performance bond.
What Is The Process of Performance Bonds?
For the main part, performance bonds are an integral requirement of government-relevant projects, such as road constructions, establishing public facilities, or building bridges. They can also benefit the private sector. Performance bonds are issued for the protection of the customers against the non-performance of the principals. If a principal fails to meet the terms of the contract, defaults in payment, or declares bankruptcy, the surety shall pay for compensation accordingly or look for an outside party to resume the contract. The contract must be clear about the task performed, expected results, and timetables. The payment should be received by the obligee i.e. the government or property owner.
What Are The Required Documents?
To be clear, performance bonds are only granted to stable financial parties. There are some important aspects to consider to get approved for bonding. For instance, surety entities use a method that relies on the percentage of project completion. This is applied to large projects that are worth more than 350 thousand dollars. While some contractors want a cash method, this is not a true estimation of the principal’s financial status. In the case of smaller ventures, the completed contract method is applied to keep track of the costs and revenues of a specific project in a given time period. While the surety companies’ methods vary, they agree on the necessity of documentation. Typically, insurance firms will require the following documents:
- A copy of the contract.
- An application sent to the surety company.
- Minimum of two years of financial statements reviewed or prepared by a certified public accountant (CPA)
- Collateral and liabilities.
Why Are They Needed?
According to the Miller Act, performance bonds are required by law in government contracts. Such bonds are essential when dealing with paramount public construction ventures. With private sectors, performance bonds are also required. However, they rely on what is mentioned in the contract in addition to the party that will commission the work.
Benefits and Drawbacks
Like most bonds, performance bonds involve delicate procedures to ensure that every party is satisfied. They provide several advantages and have some disadvantages. So, it helps to be aware of the two sides of the equation. On one hand, the owner is guaranteed the completion of the project regardless of the non-performance of the principal. Moreover, owners will not pay for additional funds for the work to be completed. On the other hand, the potential drawbacks can include the surety’s denial of compensation by claiming that the owner did not comply with the terms of the bond. The surety may also offer a lesser amount to redress the underperformance of the principal. Unfortunately, it is left to the owner to quantify the financial losses in case the contractor fails to meet the terms of the contract. If the owner does not do this correctly, they cannot recover any lost costs.
For property owners, time is money, especially for huge projects involving construction. Performance bonds regulate the relationship between owners, construction firms, and surety institutions. They ensure that the project is completed promptly regardless of the circumstances. With the help of this guide, you can make an informed decision before getting a performance bond for your project.