The Increasing Importance of Performance Bonds
There are now 25 states in the U.S. that hold that construction defects are not an “occurrence” and are therefore not covered under commercial general liability policies insuring contractors. Couple this troubling statistic with the ever increasing number of policy exclusions and limitations, and we begin to realize that in many situations the contractor’s insurance policy is inadequate (or non-existent) protection against defects.
The importance of performance bonds as security to pay for construction defects is therefore growing. While some sureties who sell the bonds will tell you that bonds merely guarantee completion, and do not insure against latent defects, the language of the typical bond defies this position.
Bonds plainly state that they guarantee each and every obligation of the contractor under the contract. Those obligations usually include the duty to perform work according to the plans and specifications, the standard of care, and without defect or nonconformity. This author has not seen a bond that attempts to carve out construction defects from its coverage. And bonds do not have the host of exclusions or limited coverage grants that plague the value of insurance policies. By the same token, bonds are not perfect and owners should consider the following to get the most protection from a bond:
First, the bond duration should extend at least as long as the warranty period (typically one year from completion but sometimes longer) and for as many years thereafter as possible, up to the statute of repose period in the state in which the project is located. Because construction defects often appear years after completion, the bond duration is critical. You may pay more for a bond with a longer duration, but if the bond is needed, you should be paying less for the unreliable insurance carried by the contractor.
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Bond. Performance Bond.
Performance bonds—insurance-like arrangements in which a surety (the bonding company) contractually agrees to pay for the performance of a principal (the contractor) to an obligee (the owner) in case the principal fails to perform the obligations of its contract—should be used more often in construction agreements to provide owners with a source of funds to cover defective work in a project.
Currently, owners typically require contractors to obtain insurance policies with the hope that such policies cover defects in the work they perform for the owner. Though owners are willing to spend a lot of money, time, and effort in obtaining these policies, insurers continue to make revisions to their policies to limit, and sometimes prevent, coverage for these defects.
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Performance bonds may provide better protection to an owner. Typically, the bond provides funds to pay for repair of defective work that may not be covered by insurance as part of the bond’s guarantee of the faithful performance of the contract by the contractor.
Unlike insurance policies, performance bonds provide coverage only for the owner’s project—if an owner discovers a defect in the contractor’s work, the owner will not have to worry whether another owner’s claim against the contractor for another defective project will reduce the coverage available under the contractor’s bond. The performance bond’s recovery pool belongs to the owner for the specific project it is drafted to cover.
