Many construction contracts – especially large ones – require the general contractor to obtain a performance bond. A performance bond assures the obligee (the owner) that it will be protected if the principal (the G.C.) fails to perform the bonded contract. The amount of protection can be as much as the “penal sum” of the bond, which is the maximum amount set forth in the bond that the surety will have to pay if the principal defaults. Typically, the penal sum of the bond is the same as the amount of the contract between the G.G. and owner.
So a performance bond is NOT an insurance policy. With insurance, the (A) policyholder pays premiums to the (B) insurance company, which will pay the policyholder if there is claim covered by the policy. It is a two party arrangement. However, with a performance bond, the (A) G.C. (principal) pays a one-time premium to the (B) surety, which will pay for certain work if there is default by the GC, thereby protecting the (C) obligee (owner). This is a three party arrangement.
The surety’s liability under the performance bond may arise in two ways. First (and most often), the owner declares that the principal is in default under the terms of the construction contract. Second, the principal can declare itself in default of the contract. (More on this second point in another post.)
Quite often, owners incorrectly believe that once a contractor defaults, all the owner must do is notify the surety, and the surety will then complete the project. However, the performance bond does not require the surety to ensure that the project is completed. Instead, the performance bond only requires that the penal sum of the bond be made available to pay the cost to complete that portion of the project the cost of which exceeds the remaining contract balance being held by the owner. For example, on a $1,000,000 project, with a performance bond for $1,000,000, if the G.C. defaults after the owner has paid it $700,000, and the cost to complete the project is $450,000, the surety is only responsible for paying $150,000.