Issues with performance bonds
01 February 2015
STUART JORDAN* delves into the subject of performance bonds and highlights two main types: default and on-demand bonds.
PROJECT owners/developers and funders are big fans of performance bonds; none more so than those in the Gulf region where the use of bonds – and in particular, the on-demand version – is widespread in large projects.
This is understandable given the size of the investments made and the big risks inherent in all construction. The first priority of project owners is to be as safe as possible should problems arise.
So performance bonds fulfil an essential function: the basic intention being that they provide a secure pot of money held by a bank or other financial institution which can be called on by the project owner (as beneficiary) in the event that a contractor should default but not then meet its liability arising from that default.
The reality is that the market internationally has become more demanding in terms of the monetary value of bonds, their term (the period until they expire) and most importantly, the type of bond required. The standard requirement has become the on-demand bond. The critical limiting factor is the cost of bonds. Although bonds are procured by contractors, that outlay will ultimately be taken into project cost.
Bond availability is a good thing if it will help project owners and funders to make final investment decisions. Long term, however, the trend for “maximum performance security” will not help if the cost of construction is raised unnecessarily. These are subjective statements: who is to say what is too much security and what is an unnecessarily high price? We can briefly look at the wording of two main types of performance bond:
Default bond
• The guarantor guarantees to the employer that in the event of a breach of the contract by the contractor or insolvency, the guarantor shall, subject to the provisions of this guarantee bond, satisfy and discharge the damages sustained by the employer as established and ascertained pursuant to and in accordance with the provisions of the contract.
On-demand bond
• The bank hereby irrevocably and unconditionally undertakes to pay to the beneficiary upon the day following the day on which it receives a written demand from the beneficiary…. [the amount demanded, subject to the value of the bond.
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• The bank’s obligation to make payments shall arise on receipt of a demand made in accordance with provisions of this bond without any further proof or condition and the bank shall not be required or permitted to make any other investigation or enquiry.
We see immediately the attraction of the on-demand bond: no need for the delay, cost and general trouble of having to “establish and ascertain” damages before the bond can be called. This looks quick and simple for the project owner. Almost too good to be true? That’s the problem – it usually is.
Unfortunately, there are many misconceptions about on-demand bonds – especially about the consequences of making a call on one. This is often the fault of the underlying construction contracts in failing to make the consequences explicit. Many contracts contain no more than the following:
• An obligation on the contractor to carry out the works, etc. This is the performance which is covered by the bond.
• An obligation on the contractor to provide an on-demand bond – usually in a form appended.
The contract might add that the bond is “to cover the contractor’s performance” or “against contractor default” or similar. Even with these words, there remains a big gap between these two provisions, specifically about in what circumstances the bond can be called. One view might be that it can be called if there has been a breach. On the other hand, the contractor has provided a bond which, on its own terms, can be called at any time for any reason or none. There is a disconnect, which has been the subject of disputes and of law created in many jurisdictions. Those disputes essentially ask:
“What happens if a call on an on-demand bond is later established as wrong?”
That would be a bond call where there has not been a contractor default or where the damages are less than the sum demanded. Where the contract doesn’t cover it, there are in theory many possible outcomes, including:
• It is free money (a common view!). The owner can keep it regardless.
• The call was not in breach of the contract but excess money has to be paid to the contractor (essentially as a matter of unjust enrichment).
• The call was not a breach of contract if it was made honestly and in good faith, that is, believing in the breach and the damages arising.
• A wrong call is always a breach of the underlying contract, regardless of intention.
Although some of this uncertainty might be clarified by applicable law, the obvious advice is to clarify it in the contract. If, for instance, the owner is entitled to keep the money, or if on the other hand he will have to pay it all back together with consequential costs including perhaps compensating for reputational damage to the contractor, the parties need to know which it is. Of course, the imposing of conditions on an on-demand bond is to undermine the whole point of it. Equally it might signal that this is not the most suitable type of bond.
Default bonds avoid this uncertainty. True, in some places it isn’t practical to rely on courts to conclude on liability and damages before calling a default bond. The parties can, however, agree some form of quick dispute resolution process such as adjudication (in a dispute board or otherwise) for the purposes of calling the bond. The dispute itself might carry on but there would be no argument about the legitimacy of the call.
*Stuart Jordan is partner and co-head construction for the international law firm King & Wood Mallesons (KWM). Based largely in Dubai, UAE, he specialises in engineering and construction matters, cross border, both front end and disputes.
The firm recently entered into an exclusive association with the Law Office of Majed Almarshad to open an office in Riyadh, marking the first time that a global law firm headquartered in Asia has established a permanent presence in Saudi Arabia.
