Private Performance Bonds & Payment Bonds – What are they?
Before we discuss private performance bonds in particular, let’s first look at what a surety bond is in general. A surety bond is, in its simplest form, a consumer protection product. It promises to pay for covered financial harm caused when your business breaks a rule or violates a contract provision. A private performance bond is one that protects a private entity such as a developer or bank from contractor default.
For example: A general contractor enters into a contract with a developer. The GC then posts a performance bond as a guarantee that the project will be completed according to the contract. Now let’s assume the company defaults on the contract. What happens now? The surety company is obligated to remedy the default in accordance with the contract and bond form. The remedy can include replacing the GC, paying the damages owed according to the contract, or supporting the GC so it can finish the job.
Why should a bank require a Private Performance Bond & Payment Bond?
The better question is why shouldn’t a bank require performance bonds on private projects? They’re lending money to a developer in order to construct a building, subdivision, or some other structure. The money is loaned based on the financial strength of the developer and, ultimately, the underlying asset. But, as we saw in the most recent recession, even the strongest developers and contractors can fail. When failure occurs and the contractor has no bond, the lender may find itself paying out of pocket to complete the project.
In the paragraph above, we mentioned that a bank may be responsible for paying out of pocket to complete the project. But why? There are two main obligations met through performance and payment surety bonds. The first was discussed previously and results when a contractor fails to perform the contract (i.e. defaults). The second obligation involves payment of the contractor’s subs and suppliers. A payment bond can help ensure that payment is made by the contractor to the subs and suppliers working for them. Banks assume a large risk when it comes to payment. This is because the developer can submit for a draw when a portion of the contract is completed. However, that doesn’t ensure that the contractor has paid its subs and suppliers up to that point. In most cases, banks only become aware of payment issues when mechanics liens are issued on the project.
The trickle down effect of contractor default on unbonded projects
At this point, you may be thinking that the negative impact to a bank from contractor default can be isolated to the GC and/or developer. Unfortunately, that’s not the case. When a GC defaults on a job, subcontractors and suppliers are often left unpaid in addition to the uncompleted project. When subs and suppliers are left unpaid, those companies may default on other contracts which may leave their employees unpaid and out of work. Those subs and suppliers and their employees may also be customers of the bank who provided funding to the GC’s project. Now the bank not only has a partially completed project with outstanding liens but also subcontractors unable to pay for their loans and business lines of credit. Additionally, they may be left with personal lines customers who worked for the GC, subcontractors, and suppliers who are now unable to make their mortgage payment.
How can a bank protect itself from contractor default?
The description above holds especially true for local and regional banks with smaller lending portfolios. One big mistake can result in dire straights for the institution. So how can they protect themselves? The most obvious answer is to utilize private performance and payment bonds once a contract exceeds a certain amount. You’re probably thinking to yourself that banks can’t benefit from the GC’s bond because it runs to the developer. However, this is untrue. Banks can require what’s called a dual obligee rider to the performance and payment bond. The rider allows the bank to make claims on the bond and, in most cases, gives them the same rights as the developer to make a claim. This is especially important if the developer also owns the GC performing the work.
How do I learn more about private performance bonds?
Please contact us if you’re a bank looking for more information on how to stop losses from occurring. This article is only meant to give broad points regarding how contractor default can harm your company. Each bank has their own lending guidelines and will need to tailor those practices to their organization.