What Are Performance Bonds In Construction Projects?

Dan Nailer
Dan NailerLegal Assessment Specialist
Updated on 16th May 2024

Performance bonds and guarantees in construction projects are agreements that say if one party doesn’t do what they’re supposed to, another party will step in to make things right. 

For example, if a contractor is hired to build a house and they agree they’ll stick to the plan and finish the work as agreed, if they don’t, the bond or guarantee ensures you’re protected, and the project can still get done properly. 

Performance bonds and contracts are essential in construction because they make sure projects stay on track, deadlines are met, and the quality of work is maintained. 

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In this article, we’ll look at performance bonds in construction projects, including their benefits, risks, requirements, and key considerations for contractors and project owners.

What are performance bonds? 

Performance bonds are agreements where a third party, like an insurance company or bank, promises to step in if the contractor can't finish a construction project.

They mean that, if the contractor messes up or can't complete the work, the project owner can claim on the bond to get compensation. This protects the project owner from any financial harm caused by the contractor's failures or mistakes. 

Performance bonds are often used in large construction projects to give the project owner peace of mind.

Different types of performance bonds in construction projects 

There are two main types of performance bonds: 

Guarantee (Payable on Demonstrable Default)

Guarantee (Payable on Demonstrable Default) performance bonds work like an insurance policy for the project owner. By that we mean, if the contractor defaults, the bond kicks in to cover the losses up to a certain amount (usually a percentage of the contract value). But, the bond only pays out if there’s solid proof that the contract didn’t do what they promised in the contract. 

On-Demand (Payable on First Demand)

Instead of needing solid proof of the contractor’s default, an on-demand performance bond means a project owner can just ask for payment from the surety company (usually the contractor’s bank) if the contractor messes up or there’s a risk they won’t finish the job. This gives them immediate access to financial compensation if things go wrong. 

Who pays for a performance bond? 

Usually, the contractor pays for the performance bond. Although they likely pass this expense on to the project owner by factoring it into their bid or contract price. 

When are performance bonds required in construction projects? 

Performance bonds are typically a pre-requisite of construction projects with a significant financial investment or risk involved. 

For example in: 

  • Public sector projects to ensure that taxpayer funds are protected and projects are completed as agreed. 

  • Large-scale projects such as infrastructure developments, commercial buildings, and residential developments. 

Project owners may also require performance bonds to assess the financial stability and reliability of contractors bidding on a project. 

What should be included in a bond agreement? 

Bond agreements can be quite complex. Typically, they are created by the insurance company and then reviewed by the project developer and contractor. It’s wise to seek advice from a construction lawyer for specialist guidance on these agreements, they can review the contract and provide personalised advice based on your needs. 

Some important things to look out for in bond agreements include: 

  • How much the bond covers (usually around 10% of the project’s total cost) 

  • How long the bond lasts, including any warranty period. 

  • How to claim compensation if something goes wrong. 

At Lawhive, our network of specialist construction lawyers is on hand to provide fast, affordable legal advice on these kinds of agreements to make sure you are informed your interests are protected. They will review the proposed bond agreement to make sure it's fair and clear. Contact us today for a fixed-fee quote.

How long should a performance bond last? 

Performance bonds usually last until the achievement of Practical Completion of the works or at the end of the Rectification Period upon the issuance of the Certificate of Making Good Defects. 

Ultimately, a performance bond should last for the duration of the project, including any warranty period to ensure adequate coverage throughout the construction process and beyond. 

Can you get out of a performance bond? 

A performance bond may include provisions for termination under certain conditions. For example, if both parties agree to cancel it or the bond agreement specifies an expiry date that passes. The performance bond agreement should clearly state the conditions under which it can be withdrawn or cancelled. 

What happens when a performance bond expires? 

A performance bond expires when the period of coverage specified in the bond agreement comes to an end. This is usually upon completion of the project or upon reaching specific milestones. 

Once the performance bond expires the surety’s obligation to provide financial protection under the bond stops and the project owner no longer has recourse to the bond for any issues or defaults related to the contractor’s performance. Further, any funds or assets held as collateral for the bond should be released to the contractor or party providing the bond. 

How do you enforce a performance bond? 

If you are a project owner looking to claim compensation from the surety because a contractor has defaulted or failed to fulfill their contractual obligations, you should first look at the terms and conditions of the performance bond to understand the process for making a claim, what documentation you need, and any limitations or exclusions. 

Once you have sufficient evidence to demonstrate that the contractor has defaulted you should notify the surety in writing of this and your intention to make a claim under the performance bond. You should follow the procedures in the bond agreement for providing notice, including the timeframe and required format. 

The surety will then review the documentation and circumstances and either approve or deny the claim based on their findings. 

If the surety approves the claim, you will receive compensation according to the terms of the performance bond agreement. This may involve payment of a specified amount or other actions. 

What is the difference between performance bonds and guarantees? 

Both performance bonds and guarantees provide a form of collateral warranty in contractual agreements, however, performance bonds are specific to construction contracts and focus on ensuring the completion of the project, whereas guarantees can apply to a broader range of obligations and transactions.

How can Lawhive help?

At Lawhive, our network of specialist construction lawyers offers fast, affordable legal advice on performance bonds and guarantees. They can review bond agreements and provide personalised guidance to help you make informed decisions relating to construction projects. Importantly, they’ll make sure you understand the terms and conditions of a bond agreement and, if you need them to, they can negotiate on your behalf. 

Further, if you’re facing issues with a performance bond or guarantee, a lawyer can help you with the claim process, from gathering the necessary documentation to submitting your claim and beyond. 

Finally, in the case of construction disputes or legal challenges related to performance guarantees, our experienced lawyers can represent you in negotiations, mediation, arbitration, or litigation. 

Contact us to discuss your performance bond or guarantee needs and get a fixed fee quote for the services of a specialist lawyer. 

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