There are many different types of bonds involved in the construction industry, including those when dealing with government-funded projects. Our newest Construction Insider podcast explains all the ins and outs of surety bonds with special guest Cornelius “Con” Riordan, an attorney with Robbins, Salomon & Patt, an expert in the construction industry. He represents contractors, surety bonds, and lenders in litigation cases and appeals in both state and federal courts.
Cornelius specializes in the reconstruction industry. He represents contractors, charities, lenders, and litigation cases, and appeals of both state and federal courts. He also has extensive experience in the transactional aspects of construction and surety law, including preparing construction contracts and loan agreements. As well as documents in default and termination cases, workouts, financing of principles, asset sales, and acquisitions. As part of his construction practice, he has participated in mediation and arbitration proceedings.
Brent and Cornelius will be discussing the three main types of construction bonds: bid, payment, and performance bonds, and how each protects everyone involved.
Brent: Good morning Cornelius. Welcome to the podcast.
You’ve got experience dealing with surety firms on bid payment and performance bonds. Now I worked in the engineering construction industry for three decades and I know firsthand that bonds can be extremely complicated. And basically, whenever I had an issue, I go to someone like you, to help me navigate through it.
So I’m excited to have you as a guest speaker, and I know our listeners will get a lot out of this discussion. So, If you’re ready, we’ll dive in.
So Con, why don’t we start with the basics. If you would describe to the audience what bid, payment, and performance bonds are, and basically how each of these works. Just the mechanics.
What is a Bid Bond (in Construction)?
Cornelius: Okay. A bid bond is a bond, like it says, that a bidder submits with his bid package and the bid bond. If the bidder is successful, secures his, going forward and actually signing the contract and providing the payment and performance bonds. The amount of the bid bond is typically set at 5% of the bid, and if the contractor (the bidder) backs out, the surety company, if the contractor cannot pay the damages, will pay the bond penalty or part of it, depending on what the damages are.
The owner, if the successful bidder backs out, will then turn to the second lowest bidder, and the delta between the two would be the damages to the owner. Sometimes the 5% isn’t enough. Sometimes it is. And that generally is how bid bonds work.
Some surety companies will in their bid bond, commit to provide the performance and payment bonds. Others do not have that provision. I’ve had a few instances where a surety company provided the bid bond and then for some reason decided they would not go forward and provide the performance and payment. You may have a situation where the bidder has another job that goes into default, or there is large claims associated with it that the timing of which is right about the time of the bid on the first job. So that’s how a bid bond would work.
What is a Payment and Performance Bond (P&P)?
A payment and performance bond, again, they’re typically what they say, a performance bond is posted by a contractor to an owner or a subcontractor to a general contractor. And what happens there is that the surety guarantees or assures performance up to the amount of the bond of the bond principle’s work. So let’s take, for instance, we’re talking about a general contractor. The surety will provide a bond that says if the general contractor does not complete the work, the surety company will complete the work or make some other type of financial arrangement to satisfy the owner so that the owner can complete up to the amount of the bond.
What is a Payment Bond?
A Payment bond is a bond, again, it’s payment to subcontractors and suppliers. So if you are a general contractor and you hire subs, and you hire suppliers, and they hire subs and they hire suppliers, those subcontractors and suppliers can look to the payment bond if they are not getting paid by the general contractor.
Typically, payment bonds, either by statute or in the bond itself, have very tight notice and suit limits in them You need to be very careful about complying with those. But if you can get through those two thresholds, generally, the coverage of the payment bond will most often satisfy all of the amount of the claim that the subcontractor or supplier has.
Brent: So Con, we’ve, we’ve got limited time today and I’d like to, for us to talk more about the bid bond, but let’s focus on the payment and performance bonds moving forward and for the audience, you’re gonna hear us say “P&P bond” and that is just simply the performance and payment bond.
So based on my experience, it will be the owner and/or the contractor (the general contractor) that will require that a project be bonded. As such, they themselves become the obligee and the bonding company, as I understand it becomes the obligor. So what rights and remedies are available to the obligee when a claim is made on a P&P bond by a sub or supplier?
Who has the rights when a claim is made on a P&P bond?
Cornelius: Well, the obligee on a payment bond under the law typically has no rights under the payment bond, but it does satisfy, it relieves the owner of any lien threats because the bond is there. It also helps to keep the project funds flowing because they’re not tied up by a sub-lien. There are certain bond forms where owners have rights, but typically the owner can’t make a claim on the payment bond. It can only make a claim on the performance bond. If an owner say, has notices from subs that they’re not being paid. It can look to its performance bond surety to make those payments because the contract itself generally has provisions in it that say the general contractor is required to pay its subs and suppliers.
Brent: Excellent. That’s very helpful. So what I will tell you in reading, you know, a lot of contracts in the construction space, a lot of contracts will require a professional liability or otherwise known as errors and omissions insurance versus a bond. Can you explain, the difference between those two types – one being an insurance and the other being a bond?
What’s the difference between errors and omissions insurance and a surety bond?
Cornelius: Right. And I think what you’re talking about, Brent, is the general contractor will have to procure and maintain a comprehensive general liability policy. And that policy can, in many instances, cover some of the same losses that a surety bond can. But the two are really different. And the reason is an insurance contract is a two-party instrument where you pay the premium to the insurance company and you actually transfer the risk of loss to the insurance company. That is, the insurance company will pay the loss if it’s covered, but it doesn’t look back to the policyholder to get repaid.
In a surety bond situation, it is not insurance, but it’s an extension of credit. And anyone who’s gone to a surety company to procure bonds will know that the surety underwriters are really more like loan officers than they are insurance agents. And they look at your financials and your capacity to perform work much in the same way a lender would.
And if the surety takes a loss, the principle is never off the hook. It simply has to pay the surety back instead of paying the owner or the obligee its loss.
Brent: Excellent. Thank you for the definition.
Now I want to turn to (something) a little bit off-subject but I want to frame this up so that maybe you can help. Our audience understands the difference between a mechanics lien and a bond.
Now as a lender in construction, which is where we practice, we rely solely on a mechanics lien to help ensure payment from a debtor. In fact, it’s our number one mitigation tool in construction. Can you explain to the audience the similarities and as well as the differences between the use of mechanic’s lien to get paid, and a claim against a payment bond to get paid?
What’s the difference between a mechanics lien and a payment bond?
Cornelius: In a general sense, there are liens on public jobs and private jobs, and they differ greatly. But in a general sense, a lien is a claim by a subcontractor or supplier against the real estate of the project and the funds of the project in order to get paid. Mechanic lien perfection, and mechanic lien litigation, is highly technical. In most states, the uh, statutes require that they be filed literally, and if you make a misstep with the mechanic’s lien, you could lose your lien rights.
A bond, although it has, you know, certain steps to get your foot in the door, so to speak, as we talked about, notice and suit limitations, and we’ll get to that a little bit later, all you have to do is provide a notice to the surety that you’re not getting paid, and if nothing happens, you file suit (on time) and essentially then it becomes a contract case, breach of contract case, much the same as you would if you were a sub, you would sue your general contractor. So they both provide protection to subcontractors and suppliers, except if you have a bond and you’re a subcontractor, it’s the easier road to go.
Can you file a lien on a public property?
Brent: You made a statement there that I wanna explore a little bit. You said that you could lien a public property. I was always under the understanding that public properties could not be leaned. So what did you mean by that?
Cornelius: Well, I’m gonna take my own home state, Illinois, for an example. Illinois has a specific statute called the Public Lien Statute and what you do in a public lien is you don’t file a lien against the property, you file a lien against the funds that become due, the contractor. So you’re only the funds, and it provides additional protection to subcontractors and suppliers to get paid, although it’s very limited in nature because it’s limited to the funds that have been earned by the general contractor.
Brent: That’s interesting. I did not know that. That’s great information.
One more thing here on the mechanic’s lien topic. At times, even though we don’t like to do it, we will lien the property, the real estate as you said, the real property, so that we can, you know, we basically puts a cloud on the title as you know. It forces those out there, the owners, to try to get us paid. But often I hear people talk about bonding around a mechanic’s lien. Now that doesn’t have anything to do with the P&P bond. So what kind of bond is this and how does that work?
What is a mechanic’s lien bond?
Cornelius: Traditionally, a mechanic’s lien bond, and I’m going back before the advent of many of the statutes I’ll get to in a second, you would post a bond as a general contractor in favor of the title company and the title company would then eliminate the bond – the lien exception from its title, when it funds a draw. So that if the mechanic lien litigation ended in favor of the subcontractor, and the general contractor couldn’t pay, then the title company would actually make the payment and look to the surety for reimbursement.
But recently, and I’m talking about the last 20 to 30 years, many states have enacted statutes that enable a general contractor to post a bond and record that bond, and have the lien actually taken off the property. And where you have a mechanic’s lien bond running the title company, the lien is not removed. Your only relying on the credit of the title company as the owner to make good satisfaction of the lien. But under the statutory scheme, the lien is actually taken off the property. And owners love those kinds of statutes because they know the lien is gone and the surety then steps into the shoes of the owner and would make good on the lien if the general contractor cannot.
Brent: We got into the weeds a little bit and you know and I took us there, but I’d like for us to take a few steps back and chat about the genesis or origins, however you wanna put it, of the P&P bonds and the types of projects these bonds are typically associated with.
So when I was working in the construction space, it was my experience that P&P bonds were almost always required on a public project, especially federal jobs. Furthermore, I always understood that this was due to a federal statute called the Miller Act. I should have, but I never really took the time to understand the statute. I just knew it was, it was the reason I needed to bond a project. So can you explain for the audience and for me what the Miller Act is and how it works?
What is the Miller Act and how does it work?
Cornelius: With the advent of the Industrial Revolution and the Mechanized Society, the size of public projects, and the number of public projects, grew exponentially. And public owners were finding that many of the contractors that they were awarding bids to were failing, because they had no criteria within which to accept a bid. “Is this a competent contractor?” et cetera. So the federal government took the lead and enacted a bonding statute in the early part of the 19th century, which eventually became the Miller Act. And the Miller Act provides that on any federally owned job, that is by the federal government, like the Army Corps of Engineers or the Department of Defense, et cetera, a bond must be furnished to the federal government to secure performance of the contractor.
And it also contains a payment provision so that the subcontractors and suppliers get paid. And each state in the country followed suit and adopted its own bonding statutes. Most of them are patterned after the Miller Act, and thus you hear the term “Little Miller Act.” That refers to the state statute that requires bonding on state projects or local projects.
Brent: And I think this probably applies to both the federal and then the state, which are the Little Miller acts. Are all federal state projects required to be bonded, or is there a dollar size limit that triggers the requirement for a bond?
Are all state projects required to be bonded?
Cornelius: Well, each state statute is a little bit different. I believe the Miller Act threshold, I haven’t looked at it in a while, but it’s low. And it really hasn’t been changed in many years. When it was enacted, it was high. It was like $10,000 or $50,000. But as we’ve gone through time, that is a very low figure, and so virtually every federal project has to be bonded.
The same is true in the states, and I’ll again refer to my own home state of Illinois. If you’re involved with a state project, if the amount of the project exceeds $100,000, you need to get it bonded. But if there’s a state and local municipality project, it has to be $5,000 or less where no bond is required. Anything over that, you have to get a performance and payment bond.
Just a little bit of a tidbit on federal projects, if you have a demolition project, which could be considered construction that is not required to be bonded because it doesn’t improve the property.
Brent: So very similar to the mechanic’s lien – it has to be a permanent improvement to the property, to the road, right?
Cornelius: Generally that’s what the bonding statutes are getting at.
Does the P&P bond protect every subcontractor on the job?
Brent: Does the P&P bond, does it protect all subcontractors down chain or is there a limit?
Cornelius: First of all, every state’s statute is different, but let’s take the Miller Act. As kind of what we call the granddaddy of ’em all. The Miller Act protects first and second-tier subs and suppliers only. So if you are a third-tier subcontractor supplier on a federal job, you will not be protected by the Miller Act bond, and you would only be able to look to your direct subcontractor or subsupplier in order to recover. So there is limited protection under the Miller Act. And it’s designed that way because of the broad amount of protection it provides so that if you do give notice and file suit on time, your claim is gonna be covered because of the broad coverage of the bond. And so the surety’s get a trade-off of a short tail, so to speak, on the claims so they, they don’t have to worry about claims odd infinitum. But once the claim is made, their exposure is significant.
Brent: To be clear here, it protects two tiers below the prime or otherwise called the general contractor, correct?
Cornelius: That’s correct. So first-tier sub and second-tier sub.
How does a third-tier subcontractor protect himself?
Brent: And then what happens? I mean, if a tier three subcontractor, isn’t being paid and it’s a public project, so the mechanic’s lien isn’t there for their use. What do they need to do to ensure payment?
Cornelius: if they’re a third-tier sub, let’s talk about the Miller Act. We’re in the federal job. They could talk to their immediate contractor and have ’em sign a credit agreement, which could be collateralized. They could have them post a letter of credit. They could perhaps require joint check agreements whereby they say when a draw is made, uh, a check from the general contractor is jointly paid to you and to me, which protects me. That can be difficult sometimes because general contractors don’t like to deal with that additional administrative issue. And some major suppliers will require cash-on-delivery or they will not furnish their goods.
Brent: And what you’re saying is that the third-tier or the supplier has to have a mechanism within the contract that protects them and as you said, most general contractors, especially the larger ones, and they’ve got a lot of leverage, it’s either “my way or the highway”, and you’re, they’re not gonna put those provisions in the contract. So the third tier can, it can get, let’s just say, become muddy water.
Cornelius: The third tier, if they’re a major supplier, for example, let’s say, Trane, for example, is delivering rooftop units. Well, Trane is gonna say, “I’m not gonna deliver thousands of dollars of rooftop units unless I have some assurance of getting paid. I’m third-tier, therefore you better work something out.” Now a general contractor in that situation may do that because of the nature of what’s being supplied to the job.
Brent: Well, exactly. And if their product is specified in the contract, in the specs, they’re gonna have some leverage. But if you’re just a normal subcontractor out there that’s third-tier, you can be pretty exposed.
Cornelius: Exactly. You can be.
When would an owner or lender usually require a bond on a private job?
Brent: We’ve talked about federal and state projects, and again. Having been in construction, I would occasionally see contracts that would come through on private jobs requiring a P&P bond, but not always. So under what circumstances would an owner or lender usually require a bond on a private job? What drives that decision?
Cornelius: I think what could drive the decision is who you’re dealing with as a general contractor. If you don’t have a lot of history with that contractor, many owners use the same general contractor, and that general contractor tends to use the same set of subcontractors and suppliers in the private sector. But if there is some financial issue that creeps up, you don’t see a lot of bonding of generals in the private sector because of the funds control generally, you have through title companies. But you see more and more bonding of major subs like your mechanical, your electrical, your plumbing subs, the larger components of the work. That gives a backstop to both the general contractor and the owner and lender because the owner and lender could be named as additional obligees under those subcontractor bonds which would give them rights to demand performance from the surety if the subcontractors are unable to perform and God help us, the general contractor is unable to perform.
When should you use subcontractor bonds?
Brent: Let’s look at subcontractors. Talk a little bit about subcontractors and bonding. Funding you many subcontractors in the construction space, we read a lot of contracts and, and often we will see that a general has required they’re flowing down the bond to the subs, but sometimes they don’t. What goes into this decision of when and when not to flow down the bonding contractual term or requirement?
Cornelius: Well, I think there are two reasons why you see subcontractor bonds. One is the nature of the work itself. As I said before, if it’s a large component of the project, for example, the mechanical subcontractor, his work is highly technical. It involves the purchase of very expensive materials and equipment. And the financial pressures on a mechanical subcontractor could be great because of what they’re doing. They’re both labor-intensive and material-intensive projects. The same is true for electrical and plumbing. And if one of those types of subcontractors fails, that leaves a huge financial risk on the general contractor.
If you have a small subcontractor doing a discrete portion of the work that isn’t financially significant, you’re not gonna see subcontractor bonding.
The other portion is if the general contractor likes a subcontractor, likes the way he does his work, has had good experiences with him, but he knows that the subcontractor is financially-stressed. He may require bonding in order to give that subcontractor the bond because he doesn’t want his job to be the one that breaks the subcontractor because of the financial pressures.
What should you do if you want to work with a subcontractor that can’t get a bond?
Brent: But if they’re financially stressed, they’re gonna be a lot of times that they won’t be able to secure a bond. And I’ve known in my past where we had, you know, large public projects, even private projects where my client would require that I use a specific subcontractor. They’re too small, they’re stressed, they can’t get a bond, and I would bond around them. Can you explain for the audience what that means?
Cornelius: What I see, you know, in my practice is, where you have a situation like that, a general contractor may go to his surety or it’s surety and say, I need to get a bond for my plumbing subcontractor because my contractor requires that I get that kind of a bond. You know, you’ll see general contracts sometimes where the owner will require these major subs to be bonded. But the subcontractor can’t qualify for the bond. And so the general contractor will use his financial strength to back up the issuance of the bond to the subcontractor.
There will probably be a separate agreement between the sub and the general about what happens in the event or the default, but those probably aren’t worth much because if there is a default, that subcontractor is not going to be able to respond anyway to a demand from the general. But the other way you could see it is where a general will increase the penal sum of the bond in order to provide more financial protection to the owner against a specific subcontractor being in default. The problem is that a general contractor’s bond increase does not, is not segregated and dedicated solely to a default by a specific sub. And it gives the owner more financial protection in the event the general or any of the other subs may also default. But it is a way that the general contractor can at least assure the owner that my surety is going to provide more financial protection by way of an increase in the amount of the bond.
Another third way, it’s not really bonding, many general contractors will purchase what’s called subcontractor default insurance in order to guard against a subcontract fall.
Brent: Well Con, I’ve gotta tell you, we’re, we’re running out of time. We try to keep these podcasts to around 30 minutes. I’m trying to keep attention.
We intended this to be Part 1 and Part 2 because it is such a big subject. There’s a lot to it. I wanna welcome you to come back and engage in Part 2 and let’s talk in more detail in terms of what occurs when there is a claim on a bond… how does it work? And I know you had mentioned funds control, that’s a big topic that I want to talk about.
But I wanna say thank you for your time here today and I will assure you that I’m learning, you know, I learned some things today and I guarantee our listeners did as well.
We appreciate your time today and I’m sure our listeners will find the information you provided extremely valuable, I look forward to the next episode. So, thanks for listening to this episode of the Construction Insider Podcast, and if you would like more information on today’s topic, you can reach out to us.
And while you’re there, check out our other interesting podcasts. So until next time, be well, and thanks again for listening.
Please note: the information in this article is not legal advice and should not take the place of talking to your attorney.
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