Performance Bond – Definition & Explanation

Cite this article as:"Performance Bond – Definition & Explanation," in The Business Professor, updated January 18, 2020, last accessed May 25, 2020, https://thebusinessprofessor.com/lesson/performance-bond-definition/.

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Performance Bond Definition

A performance bond (or contract bond) is a guaranty issued by a third-party guarantor (also known as a surety) to one party to a service contract. The guarantor assumes financial responsibility for the service provider’s failure to meet specific contractual obligations.

The guarantor is most often a bank or an insurance company that ensures that a contractor fulfills the obligations of the projects assigned to him.

A Little More on What is a Performance Bond

Performance bonds are extremely common in the construction industry. Contractors bid construction jobs. If awarded the contract, the contractor may be required to secure a performance bond. The bond protects the firm requesting services from losses if the contractor fails to perform as agreed. As such, if a contractor fails to perform, the guarantor will be required to pay a sum of money (the “penal sum”) representing the losses incurred by the party employing the contractor. The terms of the bond generally place a monetary limit or cap on the guarantor’s liability.

The concept of modern-day performance bonds materialized with the passing of the Miller Act. This act mandated the placement of such sureties in all public project contracts worth $100,000 and above.

In commercial construction projects, performance bonds are secured in combination with payment bonds. Payment bonds guarantee that all entities associated with project work, such as subcontractors, construction workers and suppliers are paid in full after the completion of the project. This protects against subcontractors who are not paid filing a workman’s lien or materialman’s lien against the property.

Cost of Performance Bonds

By convention,  for contracts valued under $1 million, performance bonds costs are typically in the range of 1% to 2% of the total project cost. For projects over $1 million, performance bonds costs generally do not exceed 1% of the total value of the contract. The credit-worthiness of the contractor also plays an important role in determining performance bond costs.

Academic Research for Performance Bond

  • Owner Delay Damages Chargeable to Performance Bond Surety, Sobel, K. (1984). Cal. WL Rev., 21, 128. Sobel’s paper studies the scope of performance bonds of ensuring compensation to the owner from the bond surety for damages resulting from delays. He identifies two procedures for the payment of compensation: Providing for liquidated damages in the contract or bond. In the absence of a provision for compensation of valid liquidated damages, the owner is liable to legally claim delay damages, citing that they amount to a breach of contract. Sobel identifies two categories of damages resulting from contract breaches: General damages, which are natural and foreseeable consequences of the breach. Consequential damages, which are unanticipated.
  • Legal Analysis on Malaysian Construction Contract: Conditional versus Unconditional Performance Bond, Supardi, A., Adnam, H., & Yaakob, J. (2009). J. Pol. & L., 2, 25. The authors examine performance bonds in Malaysian construction contracts and compare the attributes of conditional and unconditional performance bonds. This study analyzes relevant court cases in order to determine whether the performance bond involved in a construction contract is a conditional or unconditional on demand guarantee. The authors conclude that courts interpret performance bonds as on-demand covenants that depend on the obligees’ assertion that contracts have been breached.
  • Payment and Performance Bond Coverages and Claims., Hinchey, J. W. (1986).Arbitration Journal, 41(2). This paper scrutinizes the roles played by payment and performance bonds in the construction industry. It concludes that both types of bonds are crucial in guaranteeing contractor performance as well as upholding the rights of the parties. These bonds are especially useful in case of disputes that may arise during or after completion of the project. The author also highlights the issues involved in including payment and performance bonds in construction contracts and suggests that the parties privy to such contracts be fully knowledgeable of the rights and responsibilities that are entailed.
  • Performance bond: Cost, benefit, and paradox for public highway agencies, Kraft, E., Park, H., & Gransberg, D. (2014). Transportation Research Record: Journal of the Transportation Research Board, (2408), 3-9. The authors scrutinize the costs involved in performance bonds and peruse the benefits offered. The paper samples data collected from the DOTs of five states –  Iowa, Oklahoma, 8 Utah, Virginia, and Washington. The authors conclude that the performance bonds in effect fail to distinguish between high-performing and average-performing contractors. Also, contractors in the sampled DOTs have a low default rate (less than 1%), while performance bonds add an extra 1.5% on average to project cost. Nevertheless, the authors noticed reluctance on the part of both DOTs as well as contractors to remove performance bonds from contracts.
  • Performance bond benefit-cost analysis, Myers, L., & Najafi, F. (2011). Transportation Research Record: Journal of the Transportation Research Board, (2228), 3-10. This paper studies data samples collected nationwide from various state construction projects for the period September 2007 to September 2009. The authors analyze the benefit–cost ratios of performance bonds involved in the sampled construction projects and note that performance bonds were of little benefit to states with negligible number of contractor defaults. However, performance bonds did benefit states with higher numbers of default incidents. As such, the paper concludes that in states with a large number of defaults, performance bonds do provide noticeable benefits in relation to the costs involved.
  • Pilot Results and Developmental Prospects Analysis of Performance Bond and Guarantee System in Public Projects–Based on the Survey of the Bond and Guarantee …, Chun-yang, D. X. M. W. (2006). Construction Economy, 5, 006. This paper surveys the pilot system of construction bonding in two cities in southeastern China – Shenzhen and Xiamen. The author analyzes the attributes and outcomes of construction performance bonding procedures that are in effect in public projects in these two cities. The paper concludes that performance bonds are quite effective in public projects. Furthermore, the use of differential bonds together with performance bonds delivers outcomes that are similar to outcomes of high-penalty-bond models.
  • Performance Bond, Agreement, P. B., & DATE, B. This is a sample bond form endorsed by The National Association of Surety Bond Producers and The Surety & Fidelity Association of America. The bond form details the terms and conditions that are associated with Design-Build Institute of America (DBIA) projects, and  includes owner’ obligations, surety’s obligations, owner’s rights, damages covered and bond liabilities. The form also provides directives for resolution of disputes in courts of law.
  • Surety Bad Faith: Tort Recovery for Breach of a Construction Performance Bond, Frakes, A. J. (2002). U. Ill. L. Rev., 497. This study scrutinizes tort recovery for performance bond violations in the construction industry. The paper disapproves of a tort action by the project owner as a means of damage recovery in case the terms of the performance bond have been violated by the contractor. The author also asserts that a surety’s breach of the covenant of good faith and fair dealing is outside the purview of recovery processes and that legal proceedings should disallow project owners to receive tort damages against sureties.
  • The Miller Act Performance Bond-An Additional Payment Bond, McManus, R. P. (1968). Ins. LJ, 875. The Miller Act made it mandatory for contractors to post two bonds –  A performance bond, that ensures that the contractor completes the assigned project. A labor and material payment bond, that ensures that laborers and suppliers are paid in full after the completion of the project.  The Miller Act was passed to remedy the lapses of the earlier Heard Act, which had prioritized compensations due to the government over compensations due to laborers and suppliers.
  • Performance Bond Servicing of Government Contracts, Rudolph, H. W. (1952). Ins. Counsel J., 19, 171. The 1951 amendment of the Federal Assignment of Claims Act sought to protect assignees against government claims that were set-off against contract residues received by the assignors. The modified Act was intended to make government contracts fully bankable. However, as far as sureties were concerned, government contracts were still not safely bondable. Several government victories over surety companies in legal battles bore testimony to this fact.
  • Legal comparison between conditional and unconditional on performance bond in Malaysian construction contract, Supardi, A. Z. I. Z. A. N., Adnan, H. A. M. I. M. A. H., & YAAKOB, J. (2011). International Surveying Research Journal, 1(1), 45-55. The author samples several legal cases involving performance bonds in construction contracts in Malaysia. In this paper, he discusses whether the performance bond in a construction contract is a conditional or an unconditional guarantee. The author concludes that from the perspective of a court, a performance bond is an ‘on-demand’ bond, that is, it depends on the beneficiary asserting claims upon the surety in case of a breach of contract.

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