So far in 2023, we have been involved in discussions on a variety of projects around whether procurement of a performance bond by the contractor in favour of the employer is desired and/or appropriate.
The first of two blogs on performance bonds, here we discuss some issues to think about before deciding on whether a bond is right for your own project.
What is a performance bond?
A performance bond is a financial guarantee commonly used in the construction industry as a means of insuring an employer against the risk of a contractor defaulting on any of its obligations through insolvency or otherwise. The surety or guarantor who provides the bond is an independent financial institution (often a bank or insurance company) and the amount of the security provided under the bond is typically around 10% of the underlying contract value. Bonds will be in place for the duration of the works, expiring at practical completion/ completion or in some cases, at the end of the defects rectification/ correction period.
In response to a valid claim under a performance bond, the surety or guarantor will reimburse the employer's losses and expenses arising from the contractor's default up to the stated value. This reimbursement can enable the employer to overcome difficulties that have been caused by non-performance or insolvency of the contractor such as finding a new contractor to complete the works.
Market trends suggest that bonds are becoming increasingly difficult and expensive for contractors to procure. The cost of the bond will be borne by the employer either directly or indirectly as part of the contract sum and so it is worth taking stock to consider if a bond offers value on a case-by-case basis.
Is a performance bond required?
A performance bond is one of a number of measures the employer can use to mitigate its exposure to contractor default and/or insolvency during the construction phase. The following additional or alternative measures should be considered in the context of whether a bond is required:
- Thorough due diligence on the covenant, experience and track record of the contractor is always prudent. If the contract is relatively short in duration, the risk of contractor insolvency during that period may be assessed as low if the contractor financial covenant is strong, and a bond may not be justified.
- Consider whether a parent company guarantee (PCG) is available (without the price tag of a performance bond) and to what extent the covenant of the contractor is linked to the covenant of the parent company. A PCG is a performance guarantee given by the parent company of the contractor entity in respect of its obligations under a build contract. A commonly cited draw back to PCGs is that insolvency of a main contractor may affect the entire group, rendering a PCG worthless where the contractor is insolvent. However, this may not always be the case depending on the size and structure of the group.
- A 'cash' retention held back by the employer from the contract sum of between 3 and 5 % can provide the employer with security. Half the retention is usually returned to the contractor at practical completion, the other half at the end of the defect's rectification period. We have seen many recent cases of cash retentions increasing above 5% in certain cases in lieu of a performance bond. There are options to structure an increased retention which 'ramps down' towards the end of the project as the risk decreases.
Performance bonds still remain a key part of any performance security package and become more sought after when market conditions are less certain. It is always worth considering what protection a bond will offer the employer and what hurdles must be jumped before a call can be made on it. This will depend on the terms of the bond and whether it is on-demand or conditional. Our next blog will compare and contrast the different forms of bond.