As published in the Nashville Business Journal.
The use of payment and performance bonds on private commercial construction projects (bonds are required on public projects) is widespread - but largely misunderstood. Owners pay for such bonds (passed through on a contractor's bid), and whether or not bonds are "required" is discretionary.
In most instances, the decision depends in large part on two factors: the size and economics of the deal; and the owner's faith and confidence in the financial stability of the contractor. Under Tennessee law, 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 owner in default to his lender.
There are many horror stories where owners haven't required bonds; paid a contractor hundreds of thousands of dollars; the contractor abandons the project; files for bankruptcy; doesn't pay subcontractors/suppliers with the money previously received from the owner; liens are filed; and in the end, the owner pays "twice."
While legally the contractor should reimburse the owner, good luck 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).
A look at bonds
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Payment bonds: Owners require contractors to use their money to pay "downstream" bills, particularly to subcontractors, laborers and suppliers who could otherwise file liens. A payment bond simply states that the company (the surety) guarantees this obligation, and is responsible for paying the bills if the contractor fails to do so.
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Performance bonds: The surety guarantees to the owner faithful performance by the contractor on the underlying contract between the owner and contractor. If the contractor doesn't perform, or abandons the project, the surety will 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 that haven't gone through a claims process with a surety, do not fully understand the realities of such bonds. Here are some common myths:
Myth No. 1: Obtaining both a payment and performance bond costs double.
Myth No. 2: Premiums are the same for every contractor.
Reality No. 1: It costs the same amount to obtain a payment bond as it does to obtain a performance bond.
Realty No. 2: Every surety has discounted/preferred rates for its most credit worthy contractors, and premiums can vary wildly. Owners need to ask tough questions when bids are received about the contractor's bond costs.
Myth No. 3: 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 everyone sees on television that comes rushing to the scene of a disaster with a checkbook in hand.
Myth No. 4: Bonds avoid/prevent mechanic's lien claims.
Reality No. 3: 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 owner fails to give timely and adequate notice, the surety will deny the claim on technical 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 owner 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.
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.
Reality No. 4: Bonds do not prevent the filing of mechanic's liens, but give a claimant another legal avenue for collection. However, having a payment bond is helpful in the owner's relationship with its bank because under Tennessee law, all an owner has to do (or a contractor if it is a subcontractor/supplier lien) is file the bond in the Register's office where the project is located, and this filing legally "transfers" the lien to the bond and clears the title.
The decision as to whether or not a commercial developer/owner should ask for and require payment or performance bonds should be carefully examined, with the above comments uppermost in mind.
Certainly, it's good sign that a contractor may not be financially viable if it reports that he cannot obtain a bond. That, in and of itself, should raise serious concerns for any owner, especially on a large, complex project.