Q: Our 90-unit co-op in Morningside Heights is planning a masonry and roof repair project with an estimated budget of $400,000. We noticed a performance bond fee in our construction contract bids and have been told this is optional. What is a performance bond, and should we require that our contractor obtain one for this project?
A: Performance bonds are typically required on public construction projects, but since they’re not required by law in the private sector, it’s not surprising you haven’t heard of them before. Financial risk is always associated with construction projects, which often involve significant investment and a high level of coordination of several parties for successful completion. Bonds can provide a measure of financial protection to owners.
A performance bond is a third-party agreement involving the contractor, the owner (in this case, your co-op), and the bonding company that guarantees the completion of a construction project in accordance with the contract documents. If the contractor becomes financially distressed or insolvent and is unable or unwilling to complete the project, a bonding company can step in and have the project completed as specified. Thus, if your contractor is bonded and defaults during the course of the project, the bonding company will select a contractor to fulfill the contract and finish the work at the contracted price.
One clear advantage of a performance bond is that if you engaged your original contractor at a low price, the bond guarantees that this price will be honored to complete the project (excluding any change orders and/or scope changes). An added benefit is that contractors must be qualified by a bonding company before they can be issued a bond, assuring you that your contractor has been deemed financially stable and in good standing.
The cost and limits of the available bond are determined by a contractor’s standing with the bonding company and the total amount currently bonded on the contractor’s other projects. The more established, well-financed contractors can have bonding limits of $10 million or more, while smaller firms with little track record and a weak balance sheet may not even be able to find a bonding company willing to back them.
The only reason performance bonds are not standard on all projects is that the cost is passed on to the owner. As a cost-saving measure, they are commonly omitted. The fee charged to the owner is typically about 3% to 5% of the total contract cost, meaning a $500,000 project would have an added cost of $15,000 to $25,000.
Other than the cost, one downside of bonding is that it is up to the owner to prove the contractor has defaulted or that the work is inadequate. That can be difficult. Furthermore, while the bonded project is guaranteed to be completed, the owner has no say regarding which replacement contractor is brought in by the bonding company.
Typically issued with a performance bond, and included in the bonding fee, is a labor and material payment bond. This assures the owner that all labor, material, and subcontractor costs on the job will be paid if the contractor does not meet his payment obligations. Having this bond in place will help clear any liens placed against the property for lack of payment.
The case for obtaining this bond can be particularly strong when a down payment is involved. In such cases, the owner is vulnerable.
For example, if a $1 million heating plant upgrade project calls for a $150,000 (15%) down payment to cover equipment purchases, what happens if the contractor defaults and absconds with the down payment without installing or even delivering any equipment or paying his suppliers or subcontractors? The owner is now left $150,000 short while owing another $150,000 to the subcontractors and boiler suppliers or possibly facing a mechanic’s lien.
In this case, the payment bond would cover any sum owed to the subcontractors and suppliers, while the performance bond ensures that the project still gets completed for the original contract price. For this reason, on projects where a down payment is typical because significant equipment or materials (such as windows, elevators, boilers, chillers, and plumbing and electrical equipment) need to be purchased in advance and require a down payment by the owner, a payment bond can be especially valuable in mitigating the risk associated with paying up front.
Retain, Retain, Retain
If a project is not bonded, establishing a healthy retainage is the most effective way to provide at least some measure of financial protection for an owner against loss when faced with a defaulting contractor. Retainage is the practice of withholding a portion of the value of completed work from the contractor’s payments until work is complete. It is a nearly universal component of construction contracts and not only provides protection to the owner, but also gives the contractor a financial incentive to finish a project as quickly as possible.
Retainage can act as a reserve of money that an owner can draw upon if the contractor defaults. The amount can vary, but most commonly it’s set at 10 percent of the contract price, proportionately deducted from each progressive payment. While this does not provide the level of protection offered by a bond, it can still grant the owner some financial relief if a contractor defaults.
Although a bond sounds like insurance, it is not. Bonds do not provide owners with a legal defense or monetary funds in the event of a claim. If you have concerns about your contractor, or reason to believe the project may not be sufficiently completed for the quoted price, a performance bond might be the way to go.
For your co-op’s project, with a budget of less than $500,000 and no down payment required, bonding is probably not necessary. You could still ask your contractor to provide a quote for bonding the project to ensure that a bonding company finds them bondable. Then, based on the quote submitted, you can determine how to proceed with the bond. If you decide against having your contractor obtain one, make sure you stay well ahead on payments by carefully checking that claimed work is properly performed, and maintain a proper reserve of retainage throughout the course of the project.