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Performance bonds and guarantees in construction

Whether you are a seasoned project developer or just starting your journey in construction, it is important that your project is completed in an orderly way to protect your investment. A large part of the project’s success will depend on the contractor meeting the specifications, timelines and/or other requirements prescribed in the construction contract.

Performance bonds and guarantees are commonly used to ensure that contractors fulfil their obligations, offering a level of protection against risk and uncertainties. In this guide, our experienced construction solicitors will explore the purpose, benefits, requirements, and key considerations to keep in mind when dealing with performance bonds and guarantees.

What is a performance bond?

A performance bond serves as a financial guarantee provided by a surety (usually a bank or an insurance company) on behalf of the contractor to the project developer. It acts as a protection for the project developer against any potential financial loss or damages incurred due to the contractor's failure to meet the agreed-upon performance standards. In case the contractor defaults or fails to deliver the completed project as agreed, the project developer can make a claim on the bond to recover any losses incurred in putting right the situation or finding an alternative contractor.

The bond typically covers a percentage of the contract value. It is a common requirement for most major construction contracts, especially for public sector projects, as it provides reassurance to the project developer that the contractor can fulfil its contractual obligations.

What are the different types of performance bond?

There are two main types of performance bonds/guarantees commonly used in construction contracts:

Guarantee (Payable on Demonstrable Default): This type of performance bond or guarantee is similar to an insurance policy provided by a Surety that is designed to protect the project developer in the event of a demonstrable default by the contractor. It means that the bond will only be payable if there is clear evidence of non-performance or breach of the obligations stated in the contract for the actual loss suffered, up to a maximum the bonded sum. The bonded sum is usually a figure representing 10% of the contract value, for which the contractor pays a one-off fee, which is determined by the maximum amount guaranteed under the bond.

For example, if a construction company agrees to complete a project within a specific timeframe but fails to meet the deadline, as a project developer you may be entitled to make a claim against the performance bond. However, you would need to provide concrete proof of the default, such as evidence of delays, lack of progress, or other substantial breaches of the contract terms.

On Demand (Payable on First Demand): Unlike a guarantee bond, an on-demand performance bond is usually provided by the contractor’s bank and allows you to make a claim and receive compensation from the surety company without having to prove or demonstrate that the default has occurred. You can demand payment from the surety of the entire bonded sum if the contractor fails to fulfil its contractual obligations or if there is a risk of non-performance.

Who typically pays for a performance bond?

Whilst it is the contractor who works with the surety to obtain the bond, in most cases it is the project developer who ultimately bears its cost. This is because the contractor usually incorporates the bond expenses/premiums into the contract pricing.

When do you need a performance bond in construction projects?

To provide security for a contractor's satisfactory performance of its contractual obligations: The main reason a performance bond/guarantee is required in construction projects is to ensure the satisfactory completion of the project in line with contractual obligations, helping to mitigate the risks associated with potential delays, cost overruns, substandard work or the insolvency of the contractor. It serves as a financial protection to the project developer, who can claim against the bond to cover the costs of additional works or appointing a replacement. By requiring a performance bond, the developer is afforded a level of protection to enable it to complete the project if the original contractor is in breach of contract and unable to do so.

Large local authority construction projects: Performance bonds/guarantees are particularly important in large local authority/public construction projects. These projects often involve significant investment and public funds, making it crucial to safeguard the interests of the authority and taxpayers. Having a performance bond in place can help build trust and credibility with stakeholders, as it demonstrates the contractor's commitment to completing the project as per the agreed-upon terms and budget.

How does a performance bond work in practice?

In most cases, the delivery of a performance bond is a condition to the parties entering into contract and is arranged in advance so that it can come into effect when the contractor begins work. For on demand bonds, the project developer can simply call upon the bond in the event of breach, provided they follow the procedural requirements and terms outlined in the bond document. The situation is not as straightforward for default bonds. Here, the project developer must be able to prove the breach, whether that is substandard work, a missed deadline or other specification failure. In the event of a default, the contractor is usually given a chance to rectify the situation within a specified timeframe. If they fail to do so, the surety may step in and either hire a replacement contractor to complete the project or reimburse the project developer for the costs of completing the work.

Negotiating terms

We advise on their terms where the client is provided with them by a third party and we also draft them where requested, but with most parties opting to use either the ABI or BBA model bonds, where the sum bonded is by way of a guarantee.

The bond agreement is typically drafted by the surety, being the entity issuing the bond, then sent to the developer and contractor for review. Many surety companies have standard bond forms that they use as a starting point, but the precise wording of key terms and conditions are often the subject of negotiations.  

Whether you are the project developer, contractor or surety, it is crucial for all parties involved to seek expert legal advice during the negotiation process to ensure that your position is appropriately represented, and interests protected.

Examples of key terms in the bond agreement include:

Scope and amount: determining the scope of the bond and the amount of coverage that can be claimed is one of the first steps. This is typically capped at a fixed amount (commonly 10% of the contract value), but it can vary depending on the project's size and complexity.

Duration, termination and expiry: it is important to consider the project timeline, including any warranty period, to ensure adequate coverage. All parties must be in agreement and clear on the circumstances under which the bond can be terminated/cancelled as well as when it expires. However, in most cases the bonds are drafted to terminate on either the achievement of Practical Completion of the works, or at the end of the Rectification Period on the issue of the Certificate of Making Good Defects.

Claims process: negotiating the claims process is vital to ensure a fair and efficient resolution of any potential disputes. This includes establishing the timeframe for notifying the surety of a claim, providing documentation requirements, and outlining the process for investigating and settling claims. All parties should have a clear understanding of the steps involved in filing and resolving claims.

Here at Harper James, we have helped clients to navigate the terms of bond agreements. These are often lengthy, complex documents which can seem daunting to unfamiliar eyes. Our expert construction solicitors can review and advise on whether the agreement accurately reflects the negotiated terms and provides the necessary protections, as well as highlight any unusual or onerous terms to minimise your risk/exposure. We also draft bond agreements where requested.

How long should a performance bond last?

This depends on the specific scope, complexity and timeline of the construction project. Typically, it lasts for the duration of the project or until the contracted work is completed to the satisfaction of the project developer. In some cases, the performance bond may also include a maintenance period after the completion of the project, during which the contractor is responsible for addressing any defects or issues that arise.  

Can you cancel a performance bond?

Most performance bonds or guarantees can be cancelled if both parties agree to cancel the bond. However, there may be specific terms and conditions outlined in the construction contract that dictate the process for cancelling the bond. It is important to review the terms of the bond agreement and consult with your legal advisory team to ensure that the cancellation is done in accordance with the contract.

What happens when the performance bond expires?

Once the performance bond is fulfilled and expires in line with the terms of the guarantee, the surety company is released from its obligations. It is therefore important to clearly define when the bond/guarantee expires. This is usually at practical completion of the project or the end of any rectification/defects period.

How to enforce a performance bond

Our commercial property dispute solicitors can also enforce performance bonds/guarantee if necessary

If circumstances arise, enforcing the performance bond/guarantee is best done by following a structured process to ensure any vital information, requirements or time limits are not overlooked:

Step 1: Identifying the breach

To enforce a performance bond, you must demonstrate that the contractor has breached the terms of the contract. You must pinpoint the specific breach or failure to meet contractual obligations. Common breaches may include delays, substandard workmanship, or failure to complete specified tasks.

Step 2: Reviewing the contract

Conduct a thorough review of the project contract and bond agreement to understand the circumstances under which the bond can be enforced, including any procedural requirements such as notice requirements and time limitations.

Step 3: Notify the surety:

Inform the surety quickly and in line with any notice requirements outlined in the bond documentation. Provide clear and detailed information about the breach, including supporting evidence such as project records, correspondence, or inspection reports.

Step 4: Surety’s investigation

The surety will conduct an investigation to determine the validity of the claim, assess the contractor's performance and decide the best course of action based on the terms outlined in the bond.

Step 5: Claim compensation

If the surety accepts that a default has occurred, any compensation issued may cover the cost of completing the project or rectifying any damages caused by the defaulting contractor. This may involve the surety stepping in and appointing new contractors to complete the project.

Here at Harper James, our construction solicitors can also help you successfully enforce the terms of performance bonds/guarantee agreements.

Summary

In summary, a performance bond/guarantee is required in construction projects to provide security for the contractor's satisfactory performance and to protect the interests of the project developer. This is especially relevant in large local authority construction projects where significant investment is involved and public funds are at stake. Given the risks generally associated with construction projects, performance bonds/guarantees are becoming an increasingly popular safeguard against non-performance. It is important that the rights and obligations of each party involved is clearly defined in the bond agreement, as well as any specific conditions or processes that must be followed to give effect to its terms. Obtaining legal advice from experts in this complex yet crucial area of law is key to protecting your interests, and where necessary, enforcing your rights.


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