Articles | Performance bonds and guarantees

Needless to say, a construction project depends for its success on the contractor performing its obligations under the construction contract. This guide gives an overview of the methods used by developers to protect themselves against default by a contractor.

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Cathrine Ripley

Cathrine Ripley

Introduction

Two of the most common security instruments made available in the construction industry to employers are performance bonds and parent company guarantees.  There are a number of crucial conceptual differences between the two, and this results in there being different advantages and disadvantages to each.

Performance Bonds

These are a form of financial surety put up by the contractor in order to provide the employer with a specified sum (usually 10% of the building contract sum) in the event that there is default in the performance of the building contract (either by a simple failure on the part of the contractor to perform its obligations or as a result of a contractor's insolvency).

As with any insurance-backed instrument, bonds come at a cost. This cost is passed straight on to the employer through the contract sum, and so the employer should be aware of the cost implications when considering what contractual protections it requires from the contractor.

An on demand or an on default bond?

Generally, performance bonds fall into two categories: on demand or on default. With an on demand bond, payment is triggered simply by service of a written demand. These bonds are now rarely encountered or indeed accepted by contractors, because they effectively give the employer the right to dip into the contractor's bank account at will, and they come at a very high cost.

On default bonds require not only the service of a written demand on the bondsman, but also proof that the contractor is in default and that this has caused the employer loss. The premium required for these bonds is therefore less than for an on demand bond.  The benefit of on default bonds to the employer is, however, questionable, because it is extremely difficult to obtain payment of the bond amount from the bondsman. Bondsmen have a very poor track record of payment, and generally prefer to litigate a bond claim before paying it. Their excuse for this is that if they litigate then this discourages claims, thereby keeping premiums down.  This may of course be regarded as an advantage by the contractor, who will ultimately be liable to the bondsman if payment is made to the employer under the bond.

Bonds usually expire at practical completion of the project or alternatively 12 months after practical completion/issue of the certificate of making good defects (whichever is the later).

Parent Company Guarantees

Parent company guarantees ('PCGs') are particularly important in the construction industry because, since construction is such a high risk business, contractors' corporate structures are often designed to protect the ultimate parent company by dividing their construction operations into numerous distinct subsidiaries.  Employers therefore often ask for a PCG to underwrite the obligations of the subsidiary that enters into the building contract.

A PCG guarantees the due and punctual performance of any of the obligations of the contractor, including payment of any sums due to the employer.  It provides additional reassurance in relation to any defects that may arise in the works because it is not limited to a percentage of the contract sum and its term is usually longer than that of a bond, being concurrent with the contractor's liability under the main contract (6 or 12 years).

A Contract of Guarantee or a Primary Obligation?

The most important point to investigate when considering a PCG is the financial strength of the parent guarantor, without which the PCG is effectively worthless.

However, another significant issue to consider is whether the PCG is a contract of guarantee or a primary obligation. A contract of guarantee is a secondary obligation where the guarantor fulfils the contractor's obligations. The beneficiary of the guarantee (i.e. the employer) must always deal primarily with the contractor, and only if and when the contractor does not perform/pay can the beneficiary bring a claim against the guarantor. More preferable for the employer is for the PCG to be drafted as a primary obligation, which is independent of the building contract. This allows the beneficiary to claim directly against the guarantor without first having to pursue the contractor.  This is not likely to be the guarantor's preferred choice!

Which is Preferable: a Performance Bond or a PCG?

The answer to this question will depend on whether it is considered from the employer's or the contractor's point of view.  From the contractor's perspective, the answer is likely to hinge on how willing its parent company is to be exposed under a guarantee.  From the employer's perspective, both PCGs and bonds have their weaknesses: a PCG is entirely dependent on the strength of the parent company, and an on default performance bond very rarely pays out.  The crucial point for an employer (and for that matter any party providing finance to it) to be aware of is that performance bonds come at a financial cost and are not an instant solution.