Before engaging a contractor to undertake your development, apart from relying on the standard obligations placed down in your chosen form of contract, you might be seeking additional surety in the form of a bond or parent company guarantee. Understanding the difference between each is key to ensuring that your requirements are realistically attainable through whichever form of security you choose, as many can be misleading and will not operate as intended.
Both a bond and parent company guarantee protect the employer from default by the contractor, but there are different cost implications dependent of which one is chosen. In the current economic climate, there is a large amount of investment from the government to grow infrastructure, as well as the continuation of schemes to support housing growth, all of which then support private investment in a developer’s services. The construction industry has often been used as a means to increase spend in the UK economy, but with fine margins and risk adverse clients the risk of default by a contractor remains high.
The type of security can be either primary or secondary, with the former operating on the basis that no default needs to occur for the employer to call upon it e.g. an on-demand bond. As there is no need to demonstrate a breach has occurred, the employer can call on the bond and demand the amount covered is paid out immediately. Due to the ease of accessing funding through this type of bond, they are very costly to take out and many contractors may simply refuse to provide one. For this reason, they are seldom used in the UK construction industry.
A secondary obligation bond is one whereby a breach must be demonstrated before any payment is made. Both are separate legal contracts with their own terms and conditions, therefore reliance only on the construction contract to serve notices may not be sufficient to act on the specific terms of either. In the event of a breach, close management and review will be required if you are to successfully receive the amount claimed.
What’s the difference between a parent company guarantee and a performance bond?
A parent company guarantee could be made available if you are dealing with a group of companies whereby your contract is with one of the subsidiary companies with a direct legal link back to the larger group or parent company. In this situation, the parent company will sign up to guarantee that if the subsidiary company defaults on its contract, they will step in and ensure the contract is completed to the satisfaction of the employer and will incur the costs of this undertaking.
A performance bond on the other hand is provided by an insurer or a bank as an independent financial surety. The requirement to provide such a bond will need to be stated by the employer in their contract documents before the works are awarded, with the cost of taking such a bond typically included by the contractor in their priced return. If you contrast this to a parent company guarantee, which will likely bear no cost to the employer, then one advantage is that taking out a parent company guarantee, as opposed to a bond, is less expensive to the employer. If you are operating on a management contractor basis, this saving could be considerable.
There is no standard form of parent company guarantee, therefore if one is offered it should be carefully reviewed before agreeing to its terms. For a performance bond, a standard form is available by the Association of British Insurers (ABI), with such a form being widely used in the industry, but more often than in the form of an amended version.
In the event of a claim on a performance bond, the amount paid out is usually offered as a cap on the main contract value, typically between ten to twenty percent. It’s linked to the original contract value before variations are issued, so be mindful of this on a project that may have been subject to significant changes.
The advantages of a parent company guarantee over a performance bond (either on-demand or secondary obligation bond) are that there might not be a cap on the liability or time limit, whereas performance bonds are capped at a percentage of the original contract value and usually expire on the issuing of a defects completion notice or practical completion.
As a bond is subject to market forces and the contractor’s financial performance, the costs could fluctuate from project to project, which will not be the case with a parent company guarantee. Also, the contractor will need to allow for the liability of a bond on their balance sheet, as opposed to a parent company guarantee which is only a contingent liability, therefore they are likely to have a finite amount they are able to issue.
However, parent company guarantees are clearly only as good as the health of the group. If the insolvency of the contractor stretches back to the group, you are unlikely to have any fall-back position. Equally, if there is no option of a parent company, you’ll be left with little choice but to take out a performance bond.
Do I need security on all projects?
It is a question that can only really be answered once you have a clear view as to the financial strength of your supply chain or the individual contractor that you are intending to work with. Putting material breaches to one side, the biggest concern for developers will be that their contractor enters into insolvency, leaving them with the prospect of finding a new contractor to complete the works, usually at a premium, and potentially having to fund the completion themselves before making a claim under a bond.
To ascertain the financial health of a company, a credit report that provides you with the companies last three years of accounts should suffice, alongside asking them what their current workload is compared to their capacity. Turnover is important for a company to grow, but cash at hand is required to maintain liquidity. There is a saying that turnover is vanity and profit is sanity, so you should satisfy yourself that the company is not overstretching itself by taking your contract on and that it has sufficient working capital to deliver their contractual commitments.
Another factor to consider is the value of the development compared to your overall portfolio of developments and the duration of the project. The risks that you are seeking to cover as a developer by taking out security will of course still be there. However, weighing up the premium you could face for taking out a performance bond and the administration of making a successful claim versus the costs of simply rectifying the issue directly will aid your business making decisions.
On what events can I call a performance bond?
Calling on a bond should not be done without considering all options first, as by doing so it can cause serious damage to the contractor’s ability to obtain future bonds and therefore affect their ability to win future work, notwithstanding the reputational impact to their business. If you do need to make a claim, ensure you write to the guarantor setting out the details for your claim, including relevant details such as bond number, the cause of the breach with confirmation details as substantiation, and where appropriate you should also demand payment is made.
For on-demand performance bonds, it is not a requirement to demonstrate that a breach has occurred, as they can be called upon at any time irrespective of whether there has been a fault or not.
However, for the more commonly used secondary obligation bonds, you will need to demonstrate that there has been a clear and unambiguous breach of contract in your chosen form of contract. This could amount to the contractor becoming insolvent and therefore abandoning the works, rendering them unable to complete their contractual obligations. It could also be a failure to proceed with the works or more simply failing to comply with instructions from the employer.
Why may a performance bond be problematic for a Main Contractor?
As noted above, margin may be tight in the construction industry and the flow of money can be restrictive on contracts with long payment terms. If you are a developer and your contractor has become insolvent, the guarantor of the bond is likely to refer to the conditions whereby until the amount is due as a result of this breach has been properly calculated i.e. at the end of the projects once all costs have been ascertained post completion, then no pay out will be made. As a developer, you could be faced with re-tendering costs, making the site safe and secure, plus paying any on-going security and maintenance charges whilst you source a new contractor.
If you are operating as a main contractor who has taken out a bond on a subcontractor, then you should be careful not to alter the terms when administering it e.g. making advance payments to assist with cash flow or agreeing to alter the sequence of works to assist their valuations. This is because you could be jeopardising the terms of the bond and therefore once you try and make a claim, it could be seen to be void as you have not stuck to the intent and operation of the original contract.
In the case of insolvency, under JCT contracts, the employer will need to decide whether to notify termination of the contract or not. If the contractor does become insolvent then the obligation to carry out the works is suspended automatically, as is the employer’s obligation to make payments. If the employer decides to terminate the contract, they should check this does not affect the ability to make a claim against the bond, as a claim for insolvency may be permissible, but once the contract is terminated the ability to claim could be limited. If the default position in your contract is termination upon evidence of insolvency, then there has arguably been no breach of contract, therefore no claim can be made.
To support the argument about not deviating away from the terms of the contract, refer to the case of Aviva Insurance Limited v Hackney Empire Limited (2012) whereby the contractor fell into financial difficulties and the employer made ad-hoc payments via a side agreement. The contractor then fell into insolvency regardless and upon the employer making a claim against the bond, the guarantor refused to pay on the basis that the employer had altered the terms of the contract. However, once at the court of appeal, it was ruled that whilst advance payments paid by the employer to the contractor would have discharged the guarantors obligations, the fact that payments were made through a new agreement meant the guarantor was not absolved of their obligations and the claim against the bond was upheld.
However, if you do believe that you have good ground to operate outside of the terms of the contract for the best interests of the project, you should seek dispensation from whomever has taken out the bond before deviating away from the current terms.
The usual approach for developers who are concerned about financial security is to request both a parent company guarantee and performance bond in your tender documents, but be clear to isolate the pricing of these items in your pricing schedule. By doing so, you will be able to see what the cost is for each tenderer to provide them. A higher bond cost is an indicator of financial health of the supplier.
Image credit: iStock.com/deimagine
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.