Performance bonds have long been used in the construction industry to protect building owners or developers (“employers”) from the consequences if the main contractor becomes insolvent, or (a much less frequent occurrence) if the contractor remains solvent but fails to carry out and complete the works. In a performance bond a surety - usually a bank or insurance company - effectively gives the employer a guarantee of the contractor’s performance.
This article focuses on the conditional performance bonds which are widely used in the UK construction industry.
To obtain a bond the contractor must pay the surety a premium, which is invariably passed on to the employer. Typically, for a contract of (say) £2,000,000, the premium might be around 0.5% of the contract sum.
Experience has shown that, when a contractor becomes insolvent during the construction period, the additional cost of completing the works is unlikely to exceed 10% of the original contract sum. For this reason performance bonds place a monetary limit of this amount on the surety’s liability.
Performance bonds, like most legal documents, may contain traps for the unwary. Frequently a contractor will offer an employer the standard form of bond used by the proposed surety. Bearing in mind that sureties will usually agree to reasonable amendments, the employer should make certain that –
· liquidation or any other insolvency affecting the contractor is automatically a breach of contract by the contractor. Otherwise liquidation or insolvency, instead of being a breach which triggers the surety’s liability under the bond, may simply be a no-fault event (even though it may result in automatic termination of the contractor’s employment), as the Court of Appeal held in the 1994 case of Perar BV v. The General Surety & Guarantee Co. Ltd.
· alterations to the works and to the terms of the building contract are permitted without nullifying the bond. Normal variations to the works under a building contract won’t nullify the bond, but amendments to the contract and extra-contractual variations to the works may do so because they can increase the surety’s liability (which is after all dependent on the terms of the building contract) in ways which - unlike normal variations – require the agreement of both contracting parties.
A conditional bond does not require the surety to pay any sum until the employer’s loss has been ascertained. This normally cannot be done until the works have been completed and their cost has been fully ascertained. At this point the employer’s loss crystallises and can be calculated by adding together the cost of completing the works and the employer’s direct loss and/or damage, and subtracting from it the “notional final account” of the original contractor (i.e. the sum which he would have been paid, including all pre- and post-termination variations, had he remained solvent and completed the contract properly).
It is not uncommon, when a contractor goes into liquidation, for the surety to become fairly proactive with a view to minimising his liability. He may for example demand that the employer should invite tenders for completion of the works from one or more contractors proposed by the surety, even though the employer’s preference might be to employ the next lowest tenderer for the original works.
The employer’s duty to the liquidator following the determination of a contractor’s employment through insolvency is to act reasonably and to do what he can to mitigate his loss. It seems likely that the employer owes a similar duty to the surety under a performance bond, and therefore a well advised employer should co-operate with the surety so far as it is reasonable to do so.
An employer should seriously consider requiring the contractor to obtain a performance bond if there is any doubt about the contractor’s solvency and the employer cannot afford the prospective losses.
It only remains to say that, having decided that a performance bond is desirable, the employer should make sure that it is worded adequately so that it provides the security which the employer is seeking.