Performance Bonds in Construction

You’re about to enter into a contract as a developer placing a contract. You have concerns about the credit of the organisation you are about to enter into contract with or simply want surety concerning the contractor’s performance to protect your investment. Rather than seek alternative suppliers you are keen to find out what other assurances are available that will give you the comfort the works will be completed in the event things do not go according to plan.

In this regard Performance Bonds can be thought of a type of promise from a third party, usually a bank or insurance company, to pay out in the event of contractual breach by the Contractor or in the event they should enter into liquidation.

Performance bonds are typically set between ten to twenty percent of the contract value with the intent that this value would be reimbursed by the bank or insurance company in the event a replacement contractor is required to cover such losses that an employer will accrue whilst this take place.

There are different types of bonds that can be taken out dependent on the level of cover the developer requires such as conditional bonds, on-demand bonds, retention bonds and those which are a combination of all the above.

On-Demand Bond

This is likely to be the most risk adverse approach for the developer as there are essentially no conditions that the developer needs to meet to invoke the bond. The developer does not need to demonstrate their loss, that the contractor has breached the contract or defaulted on terms. The contractor will likely face paying a premium to take out such a bond as the risk for the guarantor is significantly higher. If the contractor can demonstrate a track record of delivery and no breaches, the guarantor will likely reduce the costs, but what must also be considered is the contract value that will set the liability value of the bond itself.

There is a risk that on-demand bonds are subject to abuse by developers on the basis they can be called upon where there has not been a breach of contract and no loss is incurred. When issuing tender documents, it is worthwhile considering if such a bond is needed as the costs to take one out are almost certainly built into the contractor’s price return.

Conditional Bonds

This is a more common approach as the risk is shared between the developer and contractor i.e. to use the performance bond the developer must demonstrate through clear evidence there has been a breach of the contract and they have suffered a loss. Complicating factors come into play if the contractor can argue against such a breach, albeit the legality of the bond is such that it is between the provider and client only.

As a developer it is good practice to check the conditions of the bond to ensure they reflect your requirements.

Another factor to consider when using conditional bonds is that the guarantor will want to ensure the original contract conditions have not been changed before paying out. That is why it is important to always follow the contract precisely as in the event of a breach. For example, if the employer has granted the contractor dispensation for more time to resolve an issue before the ultimate breach, this can be construed to have affected the losses incurred and the bond provider may consider this a change in the contract conditions and refuse to pay out some or all of the value of the bond.

Retention Bonds

These are held by the provider and operate in a way such that the provider acts between the parties e.g. the contractor receives payment of a retention sum once the developer issues a defects certificate. In the event there are outstanding issues the retention bond can be used to remedy defects.

Performance Bonds are common. The main forms of contract in the construction industry already make allowance for using performance bonds.

For example, the NEC Engineering and Construction Contract has a Secondary Option Clause that can be selected, “X13 – Performance Bond”. If required, this clause would be selected in Contract Data Part One and included as a requirement in the tender pack. Note the Project Manager has discretionary acceptance over the insurer or bank selected to provide the bond.

The JCT form of contract contains in Section 7, Clause 7.3.1, and by way of a reference to Contract Particulars, the need for a performance bond is stated. It operates on a similar basis to the NEC ECC whereby the Employer (developer) can dictate the terms. In ICE Forms of Contract, and if a Performance Bond is stipulated as a requirement, the bond can only be used if the Contractor is expelled from the site as a matter of insolvency or by way of Clause 65 which essentially means a general default or breach of contract.

What are the benefits of Performance Bonds?

The continued cash flow from an on-demand bond will allow a developer to continue delivering their project to completion in the event of a contractor’s breach or liquidation.

As a developer using an on-demand bond, the benefit to them is the ease of administration if they decide to use it. There is no need to provide any evidence of a breach. However, it is for this reason that on-demand bonds are rare in the UK construction industry.

The developer can also set the duration the bond applies for as they may wish to extend this beyond the normal contractual provisions of completion and the defects period if, say, there is a significant amount of M&E works required.

When should you use a Performance Bond?

In the case of a property developer you may wish to protect the development investment in case of contractor insolvency or simply breach of contract. To protect this investment a performance bond could be a good solution. If you are a contractor, then you would be best placed to consider stepping down the contract requirements to your subcontract supply chain or being ‘back to back’ in order to protect your position and share the liability.

Circumstances where you do not need a Bond

If the company that you intend to place a contract with is part of group of companies then you may also wish to consider asking for a Parent Company Guarantee (PCG). A PCG provides assurances for a developer and operates in a way whereby if the smaller company breaches the contract the parent company is obligated to remedy the breach and to cover the loss and expense incurred by the developer.

This may seem like a better and less expensive way to obtain a ‘performance bond’ but what must also be considered is the financial health of the parent company i.e. do you also need a performance bond in case the parent company fails.

Risk of not having a Performance Bond

In the event a contractor went into insolvency and there was no bond in place, the developer will be liable to pay all costs to deal with the insolvency. These costs will likely include sourcing a new contractor to complete the works and any premium this will attract. The developer will not be able to pursue the contractor as the company will be in the process of liquidation.

What to do if a Contractor goes into insolvency

To obtain a performance bond you will need to include the requirement in the contract documents. It may be prudent to include a separate item in the pricing documents for the bond in order you can ascertain the cost each tenderer is facing to take one out. Those contractors who face a premium charge for a bond may indicate deeper underlying financial issues. The most common form used, in terms of performance bond wording, is available from the Association of British Insurers Model Form of Guarantee Bond.

In the event the developer wishes to make a claim against a performance bond, the answer is to refer to the terms of bond in the first instance. Ensure that notice periods for making a claim are adhered to and you follow all contractual provisions as required.

If there is an on-demand bond in place, the developer will simply write to the guarantor requesting its release. In terms of contractor insolvency and assuming the bond is a conditional one, the owner of the bond (the developer) will need to formally write to the contractor and declare they are in breach of the contract conditions. They will then need to evidence the breach and that the contractor is unable or unwilling to cover the developer’s costs and forward this to the guarantor. It is important to be able to demonstrate an actual breach has occurred as calling on a bond should not be done without good reason.

Once the guarantor has accepted the claim, they will pay out the costs properly due as calculated under the form of contract between the employer and contractor or contractor and sub-contractor etc. The guarantor is likely to pay out once the breach is remedied, for example, once a replacement contractor has completed the works and all costs are known. Also, bear in mind the risk to the developer is the value of the bond may not cover the costs incurred to rectify the breach.

Taking out Performance Bonds

The requirement for a contract bond should be stated in the tender documents such that a contractor can make enquiries before entering into contract. The contractor pays for the full costs of the bond and, as noted above, will likely include this is his tender return. An example in practice would be in the NEC ECC, optional clause X13: Performance Bond. If this was selected in the tender documents the contractor will need to provide the bond by the Contract Date or within four weeks of the Contract Date.

To insert new conditions into the contract, a deed of variation is needed including a requirement to be signed by both parties. Therefore, bear in mind that a contractor may refuse to accept such an amendment.

This only highlights the importance of including the requirement from the outset.

Performance Bond case law

There is a lot of case law that exists around the wording using in bonds and whether they are conditional or on-demand bonds. This is why using the Association of British Insurers (ABI) model form or another standard form can be advantageous and is recommended.

An example of a dispute is Trafalgar House Construction (Regions) Ltd v General Surety v Guarantee Co. Ltd where a Judge decided the document in question was a conditional bond. However, the court of appeal decided it was an on-demand bond. Finally, the House of Lords no less decided that it was in fact a form of guarantee. This is a good example of parties believing that a document titled “surety” or “performance bond” would be just that where legal interpretation of the finer points can lead to a different conclusion.

The importance of submitting a proper claim to the guarantor is referred to above and the risk of defaulting on a claim leading to a refusal to pay out was seen in the case of Tetronics v HSBC (2018) whereby the first claim was rejected on the basis it was submitted as a single document and the bond required two documents. Then, once the two documents were submitted HSBC decided the particulars submitted did not met the requirements and rejected the claim as fraudulent which was an exception in the conditions. Once this ended up in court the Judge decided the beneficiary is indeed required to issue a “compliant presentation of documents” and therefore supported HSBC in the first instance but in the second instance decided the claim was valid as they had complied with the underlying contract and identified and evidenced the breach of contract. This is a good example of why a great deal of consideration should be given before invoking a conditional bond as they are by no means a guaranteed pay-out.

Conclusion

If you are interested in protecting an upcoming development, taking out a performance bond would offer a degree of safety in the event your chosen contactor entered into insolvency or another serious breach of contract occurs. However, what should be considered is good industry practice when taking such a bond out: using the ABI model is preferential or if a bespoke agreement is drawn up then always check the final wording operates in a way that you intend.

Whilst on-demand bonds offer the most protection for the developer they are likely to be prohibitively expensive and resisted by the supply chain. Also, consider setting the correct percentage of contract value for the bond. Will 10% cover your likely costs in the event of insolvency or does it need to be higher? Setting the right parameters at the outset will be important for your supply chain to buy into level of risk they are taking on.

About Dean Suttling

A member of the Royal Institution of Chartered Surveyors, Dean has twenty years of experience in commercial management and quantity surveying, undertaking roles for contractors, clients, and consultants.