An Advanced Payment Bond in construction

When working with long term and repeat suppliers, it’s not uncommon for them to approach you when their cash flow is under pressure and request advance payment. Similarly, you may be leaning on them to deliver a project that is typically beyond their financial limit and this has placed their banking facilities under pressure. How should you deal with this? And what if the request happens post contract award? You may be under pressure to keep to the programme and deliver, and you can ill afford to let one of your main suppliers enter administration, but what are your options to assist and how will you minimise your risk.

It’s important to understand exactly what is being asked when one party makes a request for advance payment i.e. are they asking for improved payment terms, say from 60 to 14 days, or are they asking for payment in advance of the works being completed, which for any developer is a higher risk situation. If they are asking for payment for goods and services that are yet to be incorporated into the works, but there is a tangible asset to realise i.e. the contractor has purchased a specific piece of plant for the project or high value materials, then you have options to pass the title of these goods over to yourself until they are incorporated into the works. This would go some way to protect you in the event the contractor became insolvent.

What not to do

If a bank were to provide a loan on an unsecured basis, they inherently carry more risk, as in the event you default on that loan, the bank has no leverage on a particular asset that they can call in to offset the default. On the same principle, if you pay a supplier for work they have not completed, and they subsequently are unable to complete the works, you have no collateral upon which to call in the debt.

Moreover, when you come to find a replacement to complete the works, you will find yourself at a significant disadvantage as the budget will be reduced further by the advanced payment, which results in having to find the fund to bridge this gap, resulting in you effectively paying twice.

What are your risks as a client?

The advance payment should be commensurate with the works, goods or services that are being provided, so don’t over commit to the value of advance payment. Be mindful that, according to many standard forms of contract, the advance payment is to be paid back in instalments, therefore check that these are measurable against the predicted progress of the works. A balance is to be struck there that ideally should not benefit either party and is purely reflective in terms of easing cash flow issues.

What this means is that you need to ensure that advance payment provisions enable you to recognise the progress of the works in question. You do not want to end up in the position that you have agreed to make payments that simply do not reflect the progress of the works, as the wider the gap between advance payment and the permanent works being constructed, the longer your risk profile will be extended.

What can you do to treat requests for advance payment?

Most standard forms of contract contain the provision for making advance payment through ‘advance payment bonds’, vesting agreements, or similar themes. However, they should not be viewed as being fool proof; due diligence and judgement should still be applied before making payment. It’s one thing having the mechanism to recoup the monies paid, but another to enact it in a timely manner and without legal due process.

For example, if advanced payment is linked to a vesting agreement, certain conditions will be attached to the certificate of vesting e.g. it should be properly identified, separately stored away from similar materials that be manufactured at a yard, securely stored and insured. If the worst case scenario occurs, you will need to demonstrate to an administrator which of the materials stored are yours and therefore cannot be counted as an asset to creditors. If you are unable to readily identify yours in accordance with the vesting agreement, you could face a challenge to evidence your claim.

Further protection is provided by the advance payment bond. The provisions for calling upon these types of bond are the same across the JCT suite of contracts such as the Standard Building Contract, the Design and Build Contract and the Intermediate Building Contract. If you are making an advance payment, it’s almost a pre-requisite that you should invoke the advance payment bond provisions.

It’s important to note that advance payments are not all one-way traffic if the provision is already included in the contract. This means that if the contract requires the employer to make an advanced payment, which they subsequently do not, the contractor would be within their rights to stop works, claim the costs for doing so, and could even terminate their contract and pursue the employer for breach of contract. Therefore, consider your options if a tender offer from a contractor contains a qualification that it is based upon a level of advanced payment.

In the case of Mirimskaya vs Evans 2007, which involved a fixed price contract, the employer agreed to making advanced payments, but when the works were not progressing, the employer wrote to the contractor stating they would no longer be making payments. The contractor made a claim against the employer for breach of contract. The case was brought before the Technology and Construction Court who determined that due to lack of any works starting against the works in question, there had been a ‘total failure of consideration’, which meant the employer did not have to make payment for works not started. However, the contractor was able to claim damages for the breach of contract, which included the loss of profit on the unpaid amounts.

Whilst the above ruling seems harsh on the employer to pay any amount of value for works that have not even been started, it is for this reason that in the event of termination the contract should adequately describe how to treat any advanced payment.

In regards to advance payment bonds, these are on-demand bonds, meaning that the claimant will not have any conditions to meet before calling upon the bond. However, with all bonds, it’s important to ensure that the conditions are drafted to meet expected operation. This is reflected in NEC Engineering and Construction Contracts, Secondary Option Clause X14 “Advance Payment to the Contractor”, which states that after making any advance payment, if a bond is required the contractor needs to provide it before the next assessment date.

However, it also goes on to state that such a bond must come from a bank or insurer that the Project Manager has accepted. The project manager has discretion regarding who provides the advance payment bond, and until they are satisfied it comes from a reputable source, they will not accept it. If such an acceptance is a pre-requisite for advance payment, the employer will be unable to make it.

This is an important point to watch out for, as the contractor will want to offer an advanced payment bond that is the most economical to them but may not offer the most protection to the employer. Ensure that your contracts are drafted such that you have a right to veto the proposed conditions or supplier from the contractor.

Advance Payment Bonds vs. Performance Bonds: Understanding the Key Differences

In construction contracts, both advance payment bonds (APBs) and performance bonds (PBs) are vital instruments designed to manage risk and provide financial protection for project stakeholders. These bonds, while similar in some respects, serve distinct purposes and offer different levels of security in the event of contractor default. Here’s how advance payment bonds and performance bonds differ and when each is appropriate to use.

Purpose and Functionality of Advance Payment Bonds

An advance payment bond is typically used when the contractor requests an upfront payment before commencing work. This bond ensures that the construction industry client (or employer) will be reimbursed if the contractor fails to meet contractual obligations or uses the funds improperly. It’s essentially a safeguard for clients who need assurance that their cash flow advance will support the intended project expenses.

Key Features of Advance Payment Bonds:

Amount and Value Reduction: APBs are generally a fixed amount corresponding to the advance payment, and their value reduces as the contractor repays this amount through project progress.

Claim Trigger: The bond is claimable if the contractor defaults before fulfilling the initial payment conditions.

Timing: APBs are secured at the contract’s start, ideally during the tender stage to protect the project cash flow as work begins.

Protection for the Employer: This type of financial guarantee provides additional security for employers in the construction sector, offering peace of mind that their funds won’t be misappropriated.

Purpose and Functionality of Performance Bonds

A performance bond guarantees the satisfactory completion of the project, covering a percentage (often around 10%) of the contract value. Unlike APBs, performance bonds are concerned with project completion rather than upfront payments. They protect the project owner from financial losses if the contractor is unable to meet project milestones, quality standards, or deadlines. In the construction industry, this bond is essential to manage financial risksassociated with large-scale projects.

Key Features of Performance Bonds:

Coverage and Consistency: Unlike APBs, performance bonds maintain the same coverage throughout the contract and don’t reduce as work progresses.

Claim Trigger: Claims are triggered if the contractor fails to deliver the project per contract requirements, safeguarding the client against contractor non-performance.

Protection for Client’s Investment: This bond protects the client by shifting the financial risk of contractor defaults to the surety provider, which covers losses and ensures the project reaches practical completion.

Differences in Usage and Timing

Both advance payment bonds and performance bonds are common in construction contracts, but they are applied at different project stages and address distinct concerns:

1. Advance Payment Bond Usage: Utilized before work begins to ensure that any upfront payment made is secure. This bond is especially critical in projects requiring high-value materials or bespoke items.
2. Performance Bond Usage: Implemented post-contract award to guarantee that the contractor will meet the building contract requirements for satisfactory completion.

Choosing Between Advance Payment Bonds and Performance Bonds

Deciding which bond to require depends on the nature of the project, financial strength of the contractor, and the cash flow issues anticipated. While advance payment bonds protect the employer’s initial investment, performance bondssafeguard the overall project completion. In certain cases, both may be requested to mitigate risks across all project stages.

Special Considerations for Contractor Insolvency and Default

In cases of contractor insolvency, the APB can recover initial payments, but additional contract bonds like the performance bond may also be necessary to manage ongoing financial risks. To avoid costly setbacks, employers should carefully evaluate the bond provider and ensure the bond agreement reflects all potential event of defaultscenarios.

Employing both types of bonds provides a comprehensive risk management framework, securing the project from beginning to end. This combination is often required in high-stakes construction projects to ensure that, whether at the advanced payment stage or during project completion, the employer’s investment is protected.

Is there anything else you can do to protect yourself?

An advance payment bond operates such that if the contractor should default on their contractual obligations, the bond issuer will pay back the employer the amounts made as advanced payment. Alongside these measures, there is an option to obtain a payment guarantee that effectively operates in the same way where by the guarantee operates as collateral warranty to call upon in the event of default. However, the details of the guarantee must be legally checked so as to ascertain that there are no conditions that would prevent the guarantee from being operated as intended.

You could also consider the use of a project bank account in which you could make the advance payment and contractor in question would be able to use these funds to draw down upon as the works progressed. This could be suitable on cost reimbursable or target cost style contracts. This approach is not suitable for projects that are operated as fixed price lump sum or bill of quantities payment type arrangements. The benefit here is that the project bank account can be set up jointly, and in the event of insolvency, the employer should still be able to access funds in a project bank account.

If you have made an advance payment, where do you stand in the event of insolvency?

If you have an advanced payment bond, you will be covered in the event of insolvency and will at the minimum be able to recover the advance payments that you’ve made. However, dependent on the terms of the bond, you may not be able to claim for loss and expenses related to the insolvency and the increased cost to find a new supplier. For this, you would need a separate performance bond, either on-demand or conditional.

An interesting case in regards insolvency and advance payment bonds is the case of Rainy Sky SA v Kookmin Bank 2011, whereby Rainy Sky were a ship building firm and they ordered vessels to be built by a South Korean ship builder. The contract included the provision for Rainy Sky to make five equal payments, but in turn required the ship builder to provide them with an advanced payment bond, which they believed they could call on in the event of insolvency.

Unfortunately, Rainy Sky’s ship builder became insolvent and so they triggered the advanced payment bond, but Kookmin Bank challenged the decision on the basis that the bond did not expressly include for insolvency. The clause they relied upon stated that in the event of termination, cancellation or rescission the bank would need to repay ‘such sums’ in regards to the pre-delivery instalments. They determined the word ‘such’ meant that they were only liable in the event of these reasons, and as insolvency was not separately listed, they were not obligated to pay out. The case went through the High Court, the Court of Appeal and the Supreme Court, at which point the ruling was that where unambiguous wording was agreed by the parties, it must be enacted and therefore the bank did not have to pay.

In the event that you agree to advanced payment, ensure that you have adequate protection in place such as an advanced payment bond, but also check that it covers for what you consider the key risks to be that could trigger a default.

Image credit: iStock.com/kbeis

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.