Risk is More Than Just a Board Game: A Guide to Performance Bonds

By: Brian L. Lynch


Although other forms of security are possible to secure performance of a construction contract, corporate surety performance bonds remain the construction contract guarantee of choice for owners in both public and private projects. 

The performance bond is generally meant to protect the named obligee (i.e., the owner) against the contractor's default. As such, the surety's performance obligation is usually offered in various expressions that specifically protect owners, such as the performance of the contract; payment for labor and materials furnished in furtherance of the contract; indemnification of the owner against loss caused by the contractor's failure to perform; or completion of the contract unconditionally. There are, however, a few different types of bonds that are commonly referred to under the heading of “performance bonds,” which may limit sureties to only one or a few of these different remedies upon the bond being triggered. This has important risk-allocation implications, and it is important that all of the contracting parties know and understand all different types of performance bonds.

The four types of bonds commonly lumped together under the heading of “performance bond” include:

  1. Traditional performance bonds, such as the AIA A312 performance bond
  2. Indemnity bonds, such as the Federal Standard Form 25 performance bond
  3. Completion bonds
  4. Manuscript bonds

Traditional Performance Bonds/AIA A312 Performance Bond

The A312 Performance Bond is one of the clearest, most definitive and most widely used type of traditional common law “performance bonds” in private construction. This type of bond gives sureties a wide array of options following the triggering of its liability, including 1) arranging for the contractor to continue to perform the contract, 2) taking over and completing the contract itself, 3) tendering to the owner a substitute contractor, 4) buying back the bond for the amount the surety may be liable to the owner or 5) denying liability. The A312 Performance Bond also contains an important risk-mitigation provision for contractors and sureties in that it limits, to the extent allowed by law, the duration of the bond to two years after the contractor completes its work at the applicable project.

Indemnity Bond/Federal Standard Form 25 Performance Bond

Under an indemnity bond, the surety's performance obligation is limited to reimbursing the owner (up to the penal sum of the bond) for any cost of completing the bonded contract in excess of contract funds that remain unpaid at the time the contract is terminated. An indemnity bond exposes the surety to increased risk, since the surety has no control over the owner's completion of the contract and incurrence of completion costs. Contrary to the A312 Performance Bond, the Federal Standard Form 25 Performance Bond is a type of statutory indemnity bond that simply provides for “payment” as the only performance option. Although written as a pure indemnity bond for “payment of the penal sum,” the surety's options upon default on a Form 25 Bond are whatever the government agrees to accept.

Completion Bond

Under a completion bond, the surety's performance obligation is limited to a single option: to take over the work and complete the contract at the sole expense of the surety. While this type of bond is preferred by lenders who finance private construction, such an unconditional completion bond is rarely accepted by sureties without significant qualification to require the owner and its lenders to continue funding completion with funds remaining unpaid under the bonded contract. The completion bond typically names the owner as obligee and its construction lender as a “co-obligee,” thus giving both the owner and construction lender equal rights to enforce the bond.

Manuscript Bond

Last, but not least, is the tailored manuscript combined obligations bond that frequently is prepared by large owners intent on shifting as much risk as possible to the surety and contractor. This type of bond is written by lawyers employing a “belt and suspenders” approach that combines performance, indemnity, completion and lien-free property obligations in a single instrument tailored to apply to specific risks. Because these types of bonds shift risk in drastic ways, they are rarely used in either the public or private sector.

Conclusion

Overall, these different performance bonds — especially manuscript bonds — can have a drastic effect on risk allocation and remedies available to the surety upon triggering of their obligations. As a result, it is important that all contracting parties understand what kind of performance bond is required under the contract and how it may be used to ensure contractor performance.

For a comprehensive discussion of corporate surety performance bonds, see Sections 12:14 to 12:21 of Bruner & O’Connor on Construction Law.

 

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