Contract bonds are more prevalent in the construction industry than ever before. More and more commercial contractors are required to furnish bid, performance or payment bonds before they will be hired.
This doesn’t mean contractors should sign any contract bond that comes their way, though. Before contractors sign, they should fully understand the language of their bond, including the fine print. Doing so can prevent costly claims and keep money in their pockets.
The Basics of a Bond Form
The three main parts of a bond form include the binding paragraph, reference to or description of the underlying contract and the condition and coverage of the bond. The binding paragraph serves three purposes. It identifies the three parties of the bond:
- the principal, the obligee and the surety;
- it states that the surety and principal are jointly bound to the obligee; and
- it establishes the financial limit owed to the obligee should a default occur. This amount is called the penal sum.
The second part of the bond form—the reference to or description of the contract—is generally just the construction contract. This is normally included in the bond form via reference.
The final part of the bond form is the condition and coverage of the bond. The condition of the bond is that the contractor will perform his/her contract, and the surety is only obligated to cover the contract should the contractor default.
While these are the basic aspects included in a contract bond form, contractors should not assume that modifications won’t be made. Obligees can sometimes place limiting and troublesome language in contract bonds that increase the risk for contractors beyond a reasonable level. Following are three common examples of language contractors should beware of.
Language that Lengthens the Discovery Period
Obligees may establish a period of time for making claims against a contract bond once the bond has been cancelled. This is called a discovery period. Discovery periods usually last anywhere from six months to two years. Generally, the longer the time frame, the greater the risk. This is because it is hard to assert, with any degree of confidence, the outcome of a contractor’s work over a long period of time. When obligees extend the discovery period beyond a reasonable length of time, it creates an increased risk for the contractor.
Contractors should evaluate their bond form for such language to determine if the length of the discovery period is worth the risk of signing.
Language that Makes the Obligee the Sole Judge
Obligees also may place language in the bond form that states they are the sole judge of whether or not a contractor default has occurred. Even further, obligees can include language that makes them the judge of the amount of the loss incurred, should they determine a default be valid. Language like this is dangerous for any contractor because it gives the contractor no recourse. Normally, the surety would be involved in the investigation to determine if a default has occurred, as well as deciding an appropriate payment amount for the loss. When language is inserted into the bond form that limits the surety’s options and makes the obligee the sole decision-maker, simple issues such as disputes between a contractor and owner could be deemed contractor defaults. Contractors should read their bond form closely and beware of language that includes phrases such as “in the opinion of the [obligee]” or “the loss shall be determined by the [obligee].” Limiting language like this could lead to costly and unfair claims.
Language that Includes a Forfeiture Clause
A forfeiture clause provides the obligee the right to demand the entire bond penalty, regardless of the size of the actual loss. When a forfeiture clause is not included in a contract bond form, the penalty is determined by the actual amount of loss the obligee suffered. Contractors should avoid bond forms that include language similar to “…the bond shall be in full force and effect until the full amount of the bond shall have been paid…” By agreeing to such language, contractors are putting themselves at a higher monetary risk.
For proper risk management, contractors should read and understand the fine print of their bond before signing. Contractors should not assume that all contract bonds are fair. The implications of added language have the potential to not only ruin a contractor’s reputation, but also his or her business.