In our previous blog, we discussed factors to consider when deciding if a performance bond is required for your project. The protection a bond will offer the employer and what hurdles must be jumped must be considered before a call can be made on it.
Bonds in the UK construction market are either 'on demand' or conditional bonds (or sometimes are a hybrid between these two forms).
'On demand' bonds can be called at any time by the beneficiary and the surety or guarantor is obliged to pay on demand on receipt of a simple demand notice from the beneficiary This means that calling an on demand bond is effectively not linked to the contractor's default under the building contract. The employer does not have to demonstrate that it has suffered any loss at the time at which the demand notice is issued demand. On demand bonds provide instant and easily accessible redress to employers and therefore they are unsurprisingly, less readily available. Provided that the procedural requirements are complied with, there is little scope for the contractor or the guarantor to challenge the demand and so this risk is often reflected in the increased costs (or non-availability) of on demand bonds as compared to conditional bonds.
Conditional bonds (such as the Association of British Insurers (ABI) model form of bond) oblige the surety or guarantor to reimburse the employer provided that certain conditions have been met. Usually, these conditions would be the contractor's insolvency or breach of contract. However, calling on the bond usually requires the employer to first 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, where there is a contractor insolvency, a conditional bond does not necessarily provide immediate cash flow for the employer to complete the works.
Interestingly, contractor insolvency under a JCT/SBCC form of contract, is not an automatic breach of contract. For a call to be made on a conditional bond in the event of contractor insolvency, the employer would need to terminate the contract on the grounds of insolvency, complete the works using another contractor and then establish its losses with reference to the additional costs expended in doing so compared with what it would have paid under the original contract. At that point if the insolvent contractor fails to reimburse those losses, the employer could establish a breach of contract and make a claim under the bond. Quite the timeline between insolvency and claiming under the bond and certainly not a panacea for any cash flow issues arising from contractor insolvency.
A useful hybrid is to draft the bond to provide that the bond amount shall be payable 'on demand' in the event of insolvency but otherwise be conditional on established and ascertained losses. This can provide the cash flow to the employer in the event of insolvency. However, in practical terms, these types of hybrid bonds can be quite difficult and expensive to procure (especially in the current market) However, we do see these being procured more frequently than pure on demand bonds.
The overriding benefit of a performance bond to the employer is having that monetary guarantee provided by a third party surety whose financial covenant is not linked to the contractor procuring the bond.