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What is a 'Construction Bond'

Construction bond is a type of surety bond used by investors in construction projects to protect against disruptions or financial loss due to a contractor's failure to complete the project or to meet contract specifications.

A construction bond is also called a construction surety bond or a contract bond.

BREAKING DOWN 'Construction Bond'

When a contractor vies for a construction job, he is usually required to put up a contract bond or construction bond. The construction bond provides assurance to the project owner that the contractor will perform according to the terms stated in the agreement. On larger projects, construction bonds may come in two parts - one to protect against overall job incompletion and another to protect against nonpayment of materials from suppliers and labor from subcontractors. 

There are generally three parties involved in a construction bond –the investor/project owners, the party or parties building the project, and the surety company that backs the bond. The project owner or investor, also known as the obligee, is typically a government agency that lists a contractual job that it wants done. To reduce the likelihood of a financial loss, the obligee requires that all contractors put up a bond. The contractor selected for the job is usually the one with the lowest bid price since investors want to pay the lowest amount possible for any contract.

By submitting a construction bond, a principal, that is the party managing the construction work, is stating that he can complete the job according to the contractual policy. The principal provides financial and quality assurance to the obligee that not only does he have the financial means to manage the project but that the construction will be carried out to the highest quality specified. The contractor purchases a construction bond from a surety which runs extensive background and financial checks on a contractor before approving a bond.

Sureties and Construction Bond Types

A surety is the financial guarantor of a construction bond, guaranteeing the obligee that the contractor will act in accordance with the terms established by the bond. Surety companies will evaluate the financial merits of the principal builder and charge a premium according to their calculated likelihood that an adverse event will occur. A surety can assist a contractor having cash flow problems and may also replace a contractor who abandons a project. There are three main types of construction bond provided by a surety:

  1. Bid bond: This bond is necessary to the competitive process bidding. Each contending contractor has to submit a bid bond along with their bids to protect the project owner in the event that a contractor backs out of the contract after winning the bid or fails to provide a performance bid, which is required to start working on the project.
  2. Performance bond: A bid bond is replaced by a performance bond when a contractor accepts a bid and proceeds to work on the project. The performance bond protects the owner from financial loss if the contractor’s work is subpar, defective, and not in accordance with the terms and conditions laid out in the agreed contract.
  3. Payment bond: This bond, also called a labor and material payment bond, is a guarantee that the winning contractor has the financial means to compensate his or her workers, subcontractors, and suppliers of materials.

When a contractor fails to abide by any of the conditions of the contract, the surety and contractor are both held liable. The owner can make a claim against the construction bond to compensate it for any financial loss that ensues if the principal fails to deliver on the project as agreed or for costs due to damaged or defective work done by the principal. In cases where the contractor defaults or declares bankruptcy, the surety is held responsible for compensating the project owner for any financial loss. A surety that takes on the liability of a claim can sue the contractor for the amount paid to the owner if the terms of the construction bond permits it.

Many things can go wrong in a large construction project. Because of this, construction bonds are almost a mandatory prerequisite of any project beyond a certain size, and for most (if not all) government and public works projects.

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