What is a performance bond?
The Contractor (or the principal) purchases a bond from a bank or insurer (or the surety) to guarantee the quality of his work. The Employer (or the obligee) can file a claim to receive the bond if the Contractor fails to perform according to the contract. If the claim is valid according the bond’s contractual language, then the bank or insurer will release the bond’s funds. The bond’s funds will typically pay for a second contractor to come in and complete the works.
Any Bond is an agreement whereby a bondsman (bank for example) undertakes to pay a sum of money to a beneficiary (Employer), where specified conditions are met, within the terms of the bond, as previously stated.
There are broadly two types of Bonds;
On-demand Bond: this is worded in such a way that the Bondsman is under a ‘primary obligation’ to make a payment to the Beneficiary ‘on-demand’ that is without having to prove specified breaches under the main contract. The Bondsman is described as being under a Primary Obligation liability.
Conditional Bond: also known as a ‘default bond’ or ‘proven bond’ is where the Bondsman’s obligations under the bond are conditional upon the Beneficiary proving both the default (breach of contract) and also the direct loss and expense suffered. In certain high value situations this may involve litigation to establish both these points. The Bondsman is described as being under a Secondary Obligation liability.
Both types of Bond are ‘ancillary’ to the principal contract,
Conditional Bonds have been held to be guarantees and consequently the law of guarantees applies to them. A Performance Bond may be determined to actually be a Guarantee, so the description can be misleading. Whether it is a Bond or Guarantee would depend upon the wording and the various obligations created. Where the Bond is actually a Guarantee, any variation of the Principal contract may discharge the bondsman’s liability so careful wording needs to be included to overcome this, also making insolvency a breach of contract.