Payment Bonds: A Guide for California Construction Companies
What is a Payment Bond?
A payment bond, also referred to as a “labor and material bond”, is a specific kind of surety bond that guarantees subcontractors, laborers, and material suppliers are paid according to the terms of a contract. You’ll often see payment bonds required for a contractor bidding on public projects or a general contractor requiring them from their subcontractors.
A payment bond is an agreement between three parties:
- The Principal: The contractor who is awarded the project and needs to obtain the bond.
- The Obligee: The entity that the principal’s contract runs to.
- The Surety: The company that issues the bond and provides the assurance that the contractor will fulfill their contractual obligations.
People who are unfamiliar with bonding might mistake payment bonds for being a type of insurance, but there are key differences. For example, they don’t protect the contractor that obtains them. The bond benefits the subcontractors, laborers, and suppliers in case they aren’t paid. When and if that occurs, they can make a claim on the bond. If the bond company is required to pay a claim, they would then look to their contractor (called the principal) to reimburse them.
When and Why Payment Bonds Are Required
The rules for payment bonds in California change depending on whether you are working on a public or private project.
- Public Works: If you bid on government projects, you will frequently see payment bonds required. The Miller Act is a federal law that requires payment bonds from contractors on all construction projects valued at $100,000 or more that are funded with federal dollars. Under the Little Miller Act, the State of California applies this same law to publicly funded projects. The reason this is important is because subcontractors cannot file a mechanic’s lien against public property so this law helps provide them protection.
- Private Works: State law does not usually require payment bonds on private projects. However, some property owners may ask for them to protect their property from mechanic’s liens. General contractors might also require them from their subcontractors to lower their own risk.
Payment Bonds vs. Performance Bonds
People often confuse payment bonds with performance bonds. While you usually need to get both at the same time, they have separate functions.
| Feature | Payment Bond | Performance Bond |
|---|---|---|
| Who it Protects | Subcontractors, material suppliers, laborers, and equipment lessors. | The project owner or the public entity funding the project. |
| What it Does | Ensures that all lower-tier project workers and suppliers get paid. | Ensures that the construction is finished according to the contract specifications. |
| When a Claim Happens | The prime contractor fails to pay a subcontractor or supplier for their labor or materials, a subcontractor on the project doesn’t pay their subs or suppliers, or laborers aren’t paid proper wages. | The prime contractor abandons the site, goes bankrupt, or fails to meet construction standards. |
How Much Does a California Payment Bond Cost?
When issued with a performance bond, one premium is charged for both the payment and performance bond based on the contract amount. In other words, there isn’t a separate premium for each bond.
If a payment bond is issued as a stand alone bond without the performance bond, generally speaking the premium rate is typically less than when a performance bond is included but there are exceptions.
The premium rates for a payment bond vary depending on the following:
- Size of the bond
- Whether the bond is based solely on personal credit or financial statements are provided
- If financial statements are provided, whether they are internally prepared or done by an outside CPA
- The overall financial strength of the contractor
How to Apply for a Payment Bond
Applying for a payment bond involves surety companies determining whether you have the experience and financial capability to complete a construction project. The specific aspects of the process depend on the size of the bonds you need, but always involve two primary areas of underwriting:
The Contractor’s Experience
- Do you have the labor and equipment to complete the project you’re being bonded for?
- What is your track record of profitable jobs completed?
- Do you have the internal controls to account for and manage the work?
Financial Capability
- Depending on the project amount, the surety company may require financial statements from the company and owner.
- Your personal credit.
- For projects over $3 million, a CPA may be required to prepare company financials.
Does it Matter Where You Get a Payment Bond?
Where you get your payment bond can be the difference between being able to obtain the bonds you need to win new work and being stuck unable to reach your goals due to a lack of bonding.
There are two primary places a contractor can go for a payment bond:
An Insurance Agent
Insurance agents can potentially help contractors obtain the surety bonds they need. What they might not be able to help contractors with is a smoother bonding process. Insurance agents don’t handle bonds exclusively so it’s more likely they lack the professional experience that can make getting a bond much easier. Due to not specializing in this area, they likely won’t have access to that many surety companies. This means they could be lacking access to specialty programs, making it difficult and sometimes impossible for them to match you with the right surety company.
A Surety Specialist
A surety specialist handles contractor bonds exclusively, giving them the expertise to guide contractors through the process. Due to that professional exclusivity, they have formed quality relationships with surety companies to better match contractors to the right provider. These relationships also give them access to special programs that others don’t have and can provide assistance in structuring the financial side of your business to help grow bonding capacity and gain larger projects down the road.
Payment Bonds FAQ
Do payment bonds expire?
Payment bonds expire after the project is completed and statutory timeframes have lapsed.
What is the difference between a surety bond and a payment bond?
A payment bond is a type of surety bond.
Who pays for a payment bond?
The contractor, or principal, purchases the bond and pays for it. However, they should factor the cost into their bid as it should be passed onto the obligee.
What is a payment bond?
A contractor payment bond ensures that all of a contractor’s laborers, subcontractors, and suppliers are paid on a particular project.
Who requires payment bonds?
Payment bonds are required on almost all public projects. General contractors sometimes require them of their subcontractors, and occasionally private owners will require them.
What is the difference between a payment bond and a release of mechanic’s lien bond?
A release of mechanic’s lien bond removes an existing lien from a property after a payment dispute has already occurred, while a payment bond proactively guarantees upfront that subcontractors and suppliers will be paid before any dispute arises.
How does a payment bond work?
A payment bond works by tying together three parties (the obligee, the principal, and the surety) so that if a contractor fails to pay their subcontractors, laborers, or suppliers, those parties can file a claim and the surety will pay them, then seek reimbursement from the contractor.
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