What Is a Performance Bond?

A performance bond is issued to one party of a contract as a guarantee against the failure of the other party to meet obligations specified in the contract. It is also referred to as a contract bond. A performance bond is usually provided by a bank or an insurance company to make sure a contractor completes designated projects.

Performance bonds are also used in commodity contracts.

Understanding Performance Bonds

The Miller Act instituted the requirement of placing performance bonds. The Act covers all public work contracts $100,000 and above. These bonds are also required for private sectors that necessitate the use of general contractors for their company's operations.

Jobs that require payment and performance bonds go through job or project bidding first. As soon as the job or project is awarded to the winning bidder, payment and performance bonds are provided as a guarantee for the completion of the project.

Performance bonds are common in construction and real estate development. In such situations, an owner or investor may require the developer to assure that contractors or project managers procure performance bonds, in order to guarantee that the value of the work will not be lost in the case of an unforeseen negative event.

Protecting Parties

Performance bonds are provided to protect parties from concerns such as contractors being insolvent before finishing the contract. When this happens, the compensation provided for the party that issued the performance bond may be able to overcome financial difficulties and other damages caused by the insolvency of the contractor.

A payment bond and a performance bond work hand in hand. A payment bond guarantees a party pays all entities, such as subcontractors, suppliers, and laborers, involved in a particular project when the project is completed. A performance bond ensures the completion of a project. Setting these two together provides the proper incentives for laborers to provide a quality finish for the client.

Commodity Contracts

Performance bonds are also used in commodity contracts, where a seller is asked to provide a bond to reassure the buyer that if the commodity being sold is not in fact delivered, the buyer will at least receive compensation for lost costs.

The issuance of a performance bond protects a party from monetary losses due to failed or incomplete projects. For example, a client issues a contractor a performance bond. If the contractor is not able to follow the agreed specifications in constructing the building, the client is given monetary compensation for the losses and damages the contractor may have caused.

Key Takeaways

  • A performance bond is issued to one party of a contract as a guarantee against the failure of the other party to meet the obligations of the contract.
  • A performance bond is usually issued by a bank or an insurance company.
  • Most often, a seller is asked to provide a performance bond to reassure the buyer if the commodity being sold is not delivered.

Special Considerations

Usually, performance bonds are provided in the real estate industry. These bonds are heavily used in real property construction and development. They protect real property owners and investors from low-quality work that may be caused by unfortunate events, such as bankruptcy or insolvency of the contractor.

Performance bonds are also useful in other industries. A seller of a commodity may ask a buyer to provide a performance bond. This protects the buyer from risks of the commodity, for any kind of reason, not being delivered. If the commodity is not delivered, the buyer receives compensation for losses and damages caused by the non-completion of the transaction.