Construction performance bonds

What is a performance bond?

A performance bond is a financial guarantee that offers protection to employers from some of the risks associated with contractor default. These bonds are widely used in the construction industry, ensuring money is made available if a contractor becomes insolvent or fails to meet their obligations.

Performance bonds are particularly valuable in large-scale projects. They provide assurance to stakeholders, demonstrating the contractor's commitment to project completion. For small to medium-scale projects, given the cost usually associated with obtaining bonds, we see clients consider alternative options / strategies as a means of gaining a suitable package of measures to protect from the risk of non-performance.

Bond premiums are increasing, potentially affecting project costs. Employers should carefully evaluate whether a bond justifies the expense.

How performance bonds work

• Surety - an independent financial institution (e.g., bank, insurance company) provides the bond.

• Bond amount – typically around 10% of the contract value but can vary.

• Duration - often expires on the date of Practical Completion. It is at this point the project has been handed over, and an employer will hold retention monies in relation to any liabilities during the defect liability period.

• Claims – how and when a claim will be ‘answered’ will depend on the drafting of the bond. In the event a valid claim is triggered, the surety reimburses the employer up to the bond's value.

Types of performance bonds

The two most commonly used forms of bonds on construction projects are:

• Default performance bond (payable on demonstrable default) – this requires proof of non-performance or breach of contract to trigger payment and reimbursement is generally limited to actual losses. This is the preferred option on UK construction projects.

• On demand bond (payable on the beneficiary's demand) - allows payment without demonstrating a default and generally offers full coverage up to the bonded amount. On demand performance bonds are usually issued by banks in the form of a letter to the beneficiary and are more common on international construction projects.

Terms to consider for performance bonds

• Scope and amount - clearly define the bond's coverage and maximum claim amount.

• Expiry - ensure the bond has a clear expiry date which aligns with the project's timeline, deploying common terminology used in the building contract.

• Amendments to building contract – consider whether it is necessary to include a provision that states amendments and changes to the building contract do not release, permit evasion of liability, or otherwise allow for dispute on the extent of the Surety’s liability in such circumstances.

• Claims process - outline the steps involved in triggering and resolving claims.

Alternatives to performance bonds

• Due diligence - conduct thorough and in-depth background checks on contractors.

• Parent company guarantee - consider a guarantee from the contractor's parent company, meaning that if the contractor is in default of the building contract, the "parent" can be required to remedy the breach, and/or complete the works and/or pay damages due to the contractor's default.

• Cash retention - hold back a larger portion of the contract sum as security.

• Other forms of performance security – consider other options to limit the risk of non-performance, such as an advance payment guarantee/bond; off-site materials bond; tender guarantee/bid bond; retention bond; defects liability bond or an adjudication bond.

In summary, performance bonds can offer valuable protection for employers in construction projects. By understanding the different types, key terms, and alternatives, employer’s can make informed decisions on how best to mitigate risks and ensure project success.