Performance security is a topic often put to the bottom of the list in construction contract negotiations but is an important consideration for clients and contractors before commencing a project. 

We are seeing a lot of movement in the market around performance security. Developers and clients are placing more importance on sufficient performance security packages – big name contractor insolvencies have certainly contributed to this – and we are seeing that trend extend to the smaller, less complex projects in sectors that didn’t tend to previously place much focus on additional performance security, for example in the housebuilding sector.  

 In this series of insights, my colleague Anna Reilly and I are considering the recent trends we are seeing around performance security and what these trends mean in practice. In this one, we focus on bonds.

Bonds

Performance bonds are probably still the most common form of performance security used in construction. 

What does a performance bond do?  

It’s intended to cover the damages arising and losses sustained as a consequence of a breach or default by the contractor of the building contract or, under some types of bond, the insolvency of the contractor.

There are three main types of bond:

On demand
These are not common on typical construction projects and in our experience, are usually the priciest option.

The principle of an ‘on demand’ bond is to impose a primary obligation on the surety to pay the beneficiary on its first demand (or ‘on demand’) where the contractor fails to perform a specified contractual obligation owed to the beneficiary. The obligation of the surety is not affected by disputes relating to the underlying contract between the beneficiary and the contractor, and the beneficiary is usually entitled to payment simply on submitting a statement to the surety that the contractor has failed to perform a specified obligation under the contract. Contractors understandably are reluctant to provide these. 

Ascertained bond
Ascertained or conditional bonds (such as the Association of British Insurers (ABI) model form of bond) oblige the surety to reimburse the employer provided that certain conditions have been met. Usually, these conditions would be the contractor's breach of contract or insolvency. However, calling on the bond usually requires the employer first to establish that default by the contractor has occurred in the underlying contract. This is often achieved by obtaining a judgment or adjudicator's decision evidencing both a breach of the underlying contract, together with the loss suffered by the employer as a consequence of this breach. So, the amount due has to be ‘ascertained’.

An ascertained bond can be problematic in contractor insolvency situations as it does not necessarily provide immediate cash flow for the employer to complete the works.

Blended bond
Enter, the blended bond and arguably the most common form of performance bond we are seeing in the current market.     

The blended bond provides that the bond amount shall be payable 'on demand' in the event of insolvency but is otherwise conditional on losses being established via an adjudicator’s award. ABI bonds are commonly amended to provide for this.  

Such an approach means that:

• This can provide the cash flow to the employer in the event of insolvency.
• A debate over how far a party has to go to ‘ascertain’ the amount due is avoided.   

There are also other forms of bonds such retention and advance payment bonds.  These are not considered here.  

Key points include:

• Identity and financial covenant of the surety – it is not unusual to specify that the surety must have AA+ rating from Moody’s, but we are seeing a number of new sureties enter the bond market where additional due diligence is recommended.
• Amount – bonds are usually for 10% of the contract sum but are often reduced if the period of the bond is extended from practical completion to the certificate of making good.
• Expiry – bonds commonly expire at practical completion, but bonds which expire at the certificate of making good are not uncommon. Sureties usually prefer a specific date rather than an event. The risk for a client is that the works are delayed, practical completion has not occurred yet, but the anticipated date of practical completion stated in the bond is approaching fast. Accordingly, we regularly see a date reflecting practical completion plus an additional period and provision within the contract that if it’s anticipated that the bond will expire, the contractor has to procure a new bond or extension of the original bond prior to it expiring.
• Trigger – as noted above, a breach of contract or default by the contractor. Or, in some cases, the insolvency of the contractor.
• Cost – this is usually covered by the contractor but then passed to the client. A lot of contractors have a bond facility with a particular surety or their funder, but in the current market we are seeing the costs fluctuate and bonds being very expensive to procure.

In summary bonds remain an important form of performance security, commonly used in construction. Current trends include:

• Bonds are still the preferred form of standard performance security, but the market has pockets of volatility.
• The price of bonds has increased significantly and as this is a cost passed onto the employer, it’s often a commercial call on whether a bond is required, particularly on short-term contracts when financial due diligence has been carried out at the tender stage and contractor insolvency seems a very low risk.
• In some sectors, there’s a move away from the use of bonds or parent company guarantees (PCGs), so there’s a bigger spotlight on pre-contract award financial due diligence.  
• New sureties are entering the bond market, so additional due diligence by clients and funders is a must.  

In the next part of this series, we discuss another form of performance security - parent company guarantees which you can read here.

If you would like to discuss performance security and how this may affect your organisation, please get in touch with our team.

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