Bonds are widely misunderstood by most developers. Here's a guide to what's true and what's a fairy tale.
Scenario: A multi-family developer feels good about the fact that it required the contractor to put up payment and performance bonds on the project, even though the bond costs were rolled into the construction contract. If anything goes wrong, just like the friendly helpful State Farm agent who magically appears after a loss, the surety issuing the bonds will do the same, checkbook in hand...right? Well....no. Bonds are widely misunderstood by most developers—at least by those who have not had to go through the hassle and expense of trying to get a surety to pay up.
In the first place, in private projects, requiring bonds is discretionary, but may be required by the bank financing the project. In most instances, the decision depends on two factors: (1) the size and "economics" of the project; and (2) the developer's faith and confidence in the financial stability of the contractor. Under all state laws, unpaid contractors, subcontractors and suppliers have the right (after jumping through some legal hoops) to file mechanic's liens against the real property, which has the result of placing the developer in default to his lender. There are many horror stories where developers have not required bonds; paid a contractor hundreds of thousands of dollars; the contractor abandons the project; files for bankruptcy; does not pay subcontractors/suppliers with the monies previously received from the developer; scores of liens are filed (preventing any sale); and in the end, the developer is required to pay "twice" to avoid foreclosure. While "legally" the contractor should reimburse the developer, best wishes and good luck in collecting if the contractor has gone "belly-up," filed for bankruptcy, or simply shut down the business (and then opened another company under a different name).
Payment Bonds: Developers of course require contractors to use the money paid to in turn pay "downstream" bills–to the subcontractors/laborers/suppliers that actually perform the work. A payment bond simply states that the surety guarantees this obligation and is responsible for paying the bills if the contractor fails to do so.
Performance Bonds: The surety guarantees to the developer faithful performance by the contractor on the contract. If the contractor does not perform, or abandons the project, the Surety should "step in," hire a replacement contractor, and finish the project for the remaining contract sum.
There are many myths associated with payment and performance bonds, and even those in the "industry," or those who have not gone through a claims process with a surety, do not fully understand the realities of such bonds. Two of these are as follows:
Myth: (1) obtaining both a payment and performance bond costs double; and (2) premiums are the same for every contractor. Reality: (1) it costs the same amount to obtain a payment bond as it does to obtain a performance bond; and (2) every surety has discounted/preferred rates for its most credit worthy contractors, and premiums can vary wildly. Developers need to ask tough questions when bids are received about the contractor's bond costs.
Myth: (1) Bonds are "guarantees" that a project will be completed on time, within budget and without any deficiencies. If anything goes wrong, the surety will respond in the gracious style of that "mythical insurance claim adjuster" who comes rushing to the scene of a disaster with a checkbook in hand; and (2) bonds avoid/prevent mechanic's lien claims.
Reality: (1) Bonds are not insurance. Frequently the surety is neither seen nor heard until the disaster has occurred. Forms have to be filled out, and if the developer fails to give timely and adequate notice, the surety will deny the claim on technical/legal grounds. If a claim is disputed, the contractor will instruct the surety not to pay the claim or perform any additional work. Sureties worry about interfering with the contractual relationship between the developer and contractor, and if a claim or lawsuit is filed, the surety will allow the contractor's lawyer to defend the contractor and surety. For performance bond claims, pretty much the only time a surety will hire a replacement contractor is when the original contractor completely abandons the project for financial reasons: it goes broke/bankrupt. Certainly, if at the end of a long and expensive arbitration/lawsuit, the owner prevails in its claims, the surety (assuming it has not failed/filed for bankruptcy—or asserts there is no coverage) will pay. Warning: payment bonds are not a legal replacement for liens, and do not prevent liens, but are another way for the unpaid companies to seek payment. It is an easier task for a company to collect against a bond versus a lien against property, which has a prior mortgage, but any good subcontractor lawyer knows it puts pressure on to assert lien rights. In some states, a developer can file the payment bond of record and legally "discharge" liens. If such laws do not exist, a developer must, especially if the bank is demanding a clean title, go out and obtain separate "lien bonds" in sometimes double the amount of the lien, which then puts the developer on the hook, and the sureties for those bonds also demand collateral.
In the end, the decision as to whether a multi-family developer should ask for and require payment and performance bonds from a proposed contractor should be carefully examined with the above comments in mind. Certainly it is NOT a good sign that a contractor reports that it cannot obtain a bond. Many times, even though the developer or bank may not in the end require a bond, it is a good tactic to ask if bonds can be obtained. If the answer is no, then the next step may be to carefully examine the proposed contract and try to put into place additional protections in the event of a meltdown or dispute.
David Taylor is a partner at the Nashville, Tenn., office of Bradley Arant Boult Cummings, LLP. He can be reached at firstname.lastname@example.org.