Payment bonds are required by law for public projects (meaning a construction project that is funded by tax dollars). However, public projects aren’t the only projects that you might come across a payment bond requirement. It is becoming more common to see payment bond requirements on private projects as well. So, how do payment bonds work in private projects and why have they become important to private owners?
How Payment Bonds Work
As a reminder and to set up the explanation as to why private projects might have a payment bond requirement, let’s first review how the bond works in general:
A payment bond provides assurance that subcontractors, laborers, and material providers on the job will be paid according to their agreed-upon contract. Public property cannot be liened so without the payment bond, when it comes to public works projects, subcontractors, laborers and suppliers do not have a lot of options for course of action if they aren’t paid by the general contractor, and would likely have to file a lawsuit that could be expensive and even crippling to their business. We’ll discuss why private companies and individuals have taken up imposing this requirement for their projects in a later section, even though mechanic’s liens can be filed on private jobs.
First, let’s break down the three parties involved with the payment bond and how it works:
- The obligee (This is the entity who requires the bond. Typically the project owner but it can also be a general contractor when a subcontract payment bond is being required.)
- The principal (The contractor who obtains the bond.)
- The surety (The company that issues the bond and guarantees payment will be made if a claim is filed and validated.)
If anyone protected by the payment bond (subcontractors, laborers and suppliers on the job) doesn’t receive proper payment, they can file a claim against the bond and if it is found valid, the surety will provide payment to the wronged party. To read more in-depth about how the bond works, we encourage you to read here:
How Does a Payment Bond Work? – CSBA
Why Payment Bonds are Important in Construction
Before payment bonds were required by law, if a contractor failed on a public works construction project and was unable to complete the job, then the additional costs to correct and clean up the mess would be passed onto the public agency that funded it, and thus passed onto the taxpayers. To stop tax money from flowing to failed projects, the federal government passed The Miller Act, which requires payment and performance bonds to be obtained for projects that use tax dollars. In addition to providing protection to the taxpayer, there are other benefits that make the payment bond important for the construction industry. Some of those benefits are as follows:
- It shifts risk to the surety
- Provides payment protection to subcontractors, laborers and suppliers on the specified project
- Provides assurance that the contractor has been prequalified by a surety company.
- Adds incentive for a contractor to pay their subcontractors, laborers and suppliers properly because if the surety ends up paying out on a bond claim, they will hold the contractor accountable for reimbursement
In short, payment bonds help stabilize the industry by providing financial security for the taxpayer, owner and those working on a project who might not otherwise have payment protection.
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Why a Payment Bond Benefits Private Projects
It was mentioned in the previous section that the reason payment bonds exist is that a mechanic’s lien cannot be placed against public property, but then why have owners of private projects taken up requiring them as well? The short answer is that surety bonds, including the payment bond, provide more protection to the owner of the private project than other forms of security. More specifically, the payment bond provides an outlet for subcontractors, laborers and suppliers working on the project to file a payment bond claim instead of filing a mechanic’s lien on the property, which would be more trouble for the owner.
Other benefits to private projects that the payment surety bond include:
- Demonstrates to project owners that the contractor has been vetted by a surety company.
- The risk of the general contractor not paying their subs, laborers and suppliers is shifted to the surety.
- If a general contractor also requires their subcontractors to provide bonding, then the subcontract payment surety bond provides the general contractor protection from second and third-tier subcontractors and/or suppliers from filing a claim on the general’s bond if the first-tier subcontractor does not pay their laborers, subs and suppliers properly.
A Contractor’s Guide to Payment Bonds
The best way to navigate bonding and learn how a payment bond is beneficial even to those involved in private projects, is by working with a surety expert. A surety agent, or surety specialist, can help grow your bonding capacity, match you with the best surety provider for your business, and provide guidance on how to set up your internal financials in a way that will open up the door to more options for bonding.
We at CSBA are committed to helping California contractors navigate bonding in both public and private construction projects. With over 225 years of combined experience with surety bonds and possessing the key relationships with surety providers, working with us gives you access to programs most other surety agencies don’t have. Help secure your business’s growth successfully by working with the experts.
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We want to know more about how we can help your construction company get the right contractor bond for your next project.
