What is a Performance Bond?

Brenda Scott

One major concern a person has when hiring a contractor is whether or not that person will be able to perform the job. Even if the contractor is qualified and has a good reputation, his business may suffer a catastrophic event or financial crisis that could jeopardize the project. To alleviate this concern, it has become a standard practice in large construction projects for the contractor to procure a performance bond. A performance bond is a bond issued by a bank or insurance company which guarantees that a contractor will satisfactorily complete a project.

It has become a standard practice in large construction projects for the contractor to procure a performance bond.
It has become a standard practice in large construction projects for the contractor to procure a performance bond.

In Europe, these bonds are usually issued by a bank and are called “bank guarantees” in the United Kingdom, or a “caution” in France. In the United States, the bonds are generally issued by an insurance company, though they may be issued by a bank or even a private party. In all cases, the performance bond constitutes a three-way contract between the owner, or the principal, the contractor, called the obligee, and the company offering the bond, known as the surety. This is not an insurance policy, but a financial guarantee that the work will be performed satisfactorily.

While the contractor is the party to procure the performance bond, the cost is paid by the owner and should be included in the bid. It covers 100% of the contract cost and usually has a defined time limit for completion of the job. The bond also guarantees that the cost of the project will match the bid, provided that the owner sticks to the work defined in the contract. If an owner wishes to make changes along the way, then a contract change should be executed delineating any additional cost and time required for completion. Once the job is completed satisfactorily, the bond becomes void.

If a contractor becomes insolvent, runs over budget, or for some other reason does not complete the work on time, he is considered to be in default. When a default occurs, the bond usually gives the owner three options; he can be given the money to complete the work himself, he can pick a new contractor, or he can allow the surety company to find a new contractor. Funds will be provided, up to the original contract cost, to complete the project.

A performance bond is also the name, formerly used in the United States, to refer to the collateral deposit an investor is required to make when entering a futures contract. This bond, or margin account as it is now called, is used to cover the broker’s financial risk in handling the account. A futures contract is a contract to buy a specific quantity of a commodity or financial instrument at a set price on a future date. These contracts are traded on a central financial exchange.

In the US, a performance bond is only required on government projects which exceed a cost of $100,000 US Dollars (USD). It is not generally advisable for an owner to insist upon a bond for a small job. Since the fee for such a bond would be small, it could be very difficult for a contractor to find a surety willing to cover a bathroom remodel or a new deck. On a major project, however, a performance bond is a worthwhile investment.

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Owner = Obligee

Contractor = Principal

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