What Happens When a Performance Bond Is Called?
Performance bonds are put in place as an assurance to all parties that a construction project will be completed on time and in the fashion that was laid out in the contract. During the project, however, a developer may choose to call a bond if they believe the contract is not being adequately followed. How this is handled and the recourse a contractor has against a call depends on the type of performance bond that was obtained.
What Is a Performance Bond?
A performance bond is a common type of surety bond used in construction projects. Performance bonds are issued by either a bank or surety company and provide a guarantee that a contractor will finish a project on time while meeting the agreed-upon specifications. Different state laws will often dictate what types of contracts usually call for a performance bond.
Should a contractor fail to deliver on a project, either by not completing it or otherwise failing to meet their obligations, the developer of the project can attempt to recoup their losses by demanding payment equal to the bond’s value. This is known as calling the bond.
How a Surety Company Will Handle a Call on a Performance Bond
When a bond obligee, the project owner, decides to call a performance bond, the claims process is set into motion. The surety company will often attempt to prevent having to pay out a claim, so when there is a call on the performance bond, the first thing they will do is launch an investigation.
During the investigation, the surety company must make sure that three conditions have been satisfied before the claim can be deemed valid. They must:
- Ensure that the obligee has submitted a formal written claim that the bond principal, the contractor, has breached the terms of the contract and is now in default.
- Determine whether or not the contractor actually is in default under the contract’s terms.
- Verify that the obligee has fulfilled their side of the agreement.
If the surety company determines that these conditions have been met when the performance bond is called, they will then move on to one of four different options for handling the situation.
Help Finance the Principal
Some surety companies will try to find a resolution to the default issue between the obligee and principal by financing the principal, either by lending the contractor money or securing a bank loan. This allows the obligee to recall their claim and retain the same contractor to finish the job.
Find a New Contractor
When a performance bond is called and the claim has been deemed valid, a surety company will sometimes find a new contractor to complete the project. When this happens, a new contract is drafted with different terms and prices. Once the new contractor has been found, they will be presented to the obligee for final approval to complete the project.
Complete the Project
If a contractor is let go for falling into default, a surety company can opt to fill the role and see the project through to its completion. The surety company acts as the prime contractor from here on out and will select a completion contractor that will then be subcontracted to finish the project. However, when a surety company chooses to take over as contractor on a project, they forfeit their rights as a surety company.
This approach, which is often referred to as obligee completion, means the surety company has chosen to leave the rest of the work up to the obligee. This is most often the path taken when the surety company determines that the bond principal has a compelling reason for their default. One such reason is nonpayment from the obligee to the principal for the services rendered.