What kind of guarantee?
The construction industry should provide performance security for contractual obligations, but what method is best?
It is common practice throughout the construction industry that contractors are required to provide performance security in relation to their contractual obligations. The same requirement often applies to subcontractors and suppliers, as well as consultants to a lesser extent.
Performance security generally falls into one of two types: bonds or guarantees. It can be required in respect of tenders, performance, advance payments, supply, maintenance and retentions. In my experience, although contractors and subcontractors must regularly provide such performance security, there is frequently an alarming lack of understanding of that which is provided. There is also, from time to time, a similar lack of understanding from those who request it.
The terms Ã'bond' and 'guarantee' are synonymous. They are an irrevocable commitment by a bank acting on the instructions of its client to effect payment, provided the terms of the bond are met, if the client fails to comply with the contractual terms. In such event the named beneficiary can 'call' the bond and receive payment from the bank.
All bonds contain certain basic information, including the names of the beneficiary and issuing bank; a description of the contract in respect of the which it is being issued; the bond value; the basis on which it is issued ('on demand' or 'conditional'); the governing law; and its duration.
Of the two classes of bond - on demand and conditional - on demand bonds are usually those that are required from a contractor or subcontractor. The phrase on demand means exactly that, the beneficiary makes a written demand to the bank indicating that the contractor has failed to perform its obligations and demands payment of the bond value.
Conditional bonds are those where payment is dependent upon proof that the contractor has failed to meet its contractual obligations. Such conditions may require, for example, the production of a court judgment or arbitration award. In each case it will take time to obtain such evidence, which rather reduces the effect of the bond as a form of performance security.
Sometimes a bond will include a provision that the demand must be accompanied by a certificate or other evidence that confirms the persons signing it are duly authorised on behalf of the beneficiary. On other occasions a bond will provide that notice must be given to the contractor prior to a demand being made. A copy of the notice sent to the contractor must be submitted with the demand. The latter provision is intended to ensure that only proper demands are made. In reality it is often used as a ploy, in the event of a notice being given to the contractor for it to go to court to seek some relief and preventing the demand being made.
Whether a bond requires the signatory to the demand to provide evidence of their authority or prior notice of it being given to the contractor, in neither case do these requirements make the bond conditional.
Another type of bond is a surety bond, which is issued by an insurance company. This is fairly common and in the case of a performance bond, just as with a bank-issued bond, it similarly guarantees satisfactory completion of a project by the contractor.
Surety bonds are seen by some as a cheap alternative to bank bonds. An insurance firm requires only a premium to be paid either for the life or for each year that the bond is in place. A bank, however, will make a charge for issuing the bond and depending upon the financial condition of its customer, may charge for a financing facility or even block funds to the bond value.
Financial considerations aside, the difference between a bank and a surety bond are substantial. As we have seen earlier bonds issued by a bank can be on demand or conditional, but in either case once the demand is made, if it is in accordance with the bond terms then the bank must pay. A claim in respect of a surety bond issued by an insurance company is really no different to making a claim on an insurance policy.
The claim is made then the insurance company will, often in the case of construction contracts, appoint a loss adjuster who will investigate it on behalf of the insurance company and determine its value. This means that there is no guarantee that the beneficiary under the surety bond will receive the full amount of their claim ie the bond value, unless supported by the loss adjuster.
Whereas a bank bond is unaffected by any change construction contract terms, a surety bond like any other insurance policy, requires that the insurance company be advised of any change ie anything that affects their risk. Examples include changes to the scope of works or programme. Such changes could have the effect of avoiding the surety bond, which would result in a claim from the beneficiary not being met.
Forms of performance security should be considered with the same degree of care as all elements of the contract terms; if the documentation needed is not fully understood professional advice should be sought.
Dennis Brand is senior legal advisor with Berrymans Lace Mawer. Tel: +971 4 359 9939
- Performance security is generally given by a bond or guarantee and can be required in respect of tenders, performance, advance payments, supply, maintenance and retentions.
- Bonds and guarantees are an irrevocable commitment by a bank acting on the instructions of its client to effect payment if they fail to comply with their contractual terms, provided the terms of the bond are met.
- On demand bonds are usually those that are required from contractors. If they fail to meet their contract, the beneficiary can make a written demand to the bank for payment of the bond value.
- Conditional bonds are those where payment is dependent upon proof that the contractor has failed to meet its contractual obligations, this may require the production of a court judgment or arbitration award.
- A surety bond is issued by an insurance company and in the case of a performance bond it guarantees satisfactory completion of a project by the contractor. These require a premium to be paid either for the life or for each year the bond is in place.
- Forms of performance security should be considered with the same degree of care as any other element of the contract terms.