By David Johnston
BONDS are one method used by employers in construction and engineering projects to mitigate the risk of non-performance by a contractor.

The overriding principle behind the use of bonds is that the entity which issues the bond contractually agrees to take responsibility for the performance of one or more obligations owed by the contractor to the employer, in the event that the contractor fails to perform.

There are various different varieties of bonds seen in the construction context, each of which is particularly designed for a given situation.

In addition, the duties that are owed to the employer will depend on whether the bond is what is known as an “on-demand” bond. Under normal circumstances, the party relying on the bond would be required to establish the liability of the defaulting party under the underlying agreement. However, in the case of an on-demand bond, the bond issuer is under a duty to make payment where the defaulting party has failed to perform its obligations, without the requirement of establishing a breach of the underlying agreement. This distinction is further explored below. The most common types of bonds are:

Performance bond

These bonds are used to ensure performance of obligations under the underlying agreement. The bond issuer does not agree to perform the contractual obligations that the contractor has failed to meet, but agrees to pay a sum to the employer in this event. The bond issuer will protect its position by requiring a counter-indemnity from the contractor. A performance bond would normally ensure protection for the employer even in cases where the failure of performance is attributable to the insolvency of the contractor.

Advance payment bond

In larger construction and engineering projects, it is common for the employer to make an advance payment to the contractor in order that the contractor has sufficient funds to carry out the initial steps necessary to perform its obligations under the construction contract. An advance payment bond protects the employer by ensuring it can recover this advance payment where the contractor fails to meet its obligations to repay the advance payment or otherwise, most importantly in cases of contractor insolvency. The construction contract will provide that it is a condition for the provision of the advance payment that an advance payment bond be issued in favour of the employer, which will require the bond issuer to refund the advance payments to the employer in cases of contractor default.

Tender or bid bond

Tender or bid bonds are often required by procuring authorities to protect against the submission of tenders that are withdrawn prior to the execution of a binding agreement or failure to provide a performance bond as required by the contract, and the consequent delay and cost suffered by the authority (including, in extreme cases, where the procurement process has to be restarted). Tender or bid bonds are usually submitted as part of the tender submission. The tender documents will specify the form of the bond, as well as the circumstances in which the procuring authority is able to call on the bond.

Retention bond

Retention in construction and engineering contracts is the withholding of a proportion of the sums due to the contractor, usually deducted from monthly payments and disgorged at a contractually agreed date (for example, completion of works or the expiry of any defects period). An alternative to deductions from interim payments, which may be suggested by the contractor, is the issue of a retention bond. The value of the retention bond would be for an amount equivalent to any retained sum, and would be paid to the employer upon failure by the contractor to complete the works or remedy defects. The contractor’s cash flow situation is, therefore, improved and the employer retains the protection of retention in relation to completion and defects liability.

On demand?

The obligations of the bond issuer to the employer will vary depending on whether the bond is an on-demand one.
Under an on-demand bond, the issuer is subject to a primary obligation to pay the employer on demand where the contractor is in default. The employer usually submits a statement that the contractor is in default and that the bond issuer is now required to pay under the bond. An on-demand bond is independent of the construction contract. It is applied in accordance with its own terms, rather than those of the underlying agreement.

Where the bond is a more traditional guarantee, however, the bond issuer’s obligation to pay is a secondary obligation, which requires the employer to establish the liability of the contractor under the construction contract. The bond issuer is able to rely on the rights and defences available to the contractor under the construction contract. The bond is applied in accordance with its own terms read together with the terms of the construction contract.

Clearly, on the face of it, on-demand bonds look to be far more favourable to employers than to contractors. However, while contractors might ordinarily be wary of procuring an on-demand bond, the requirements of the employer or even the potential profitability of the contract may convince the contractor to accept the risk. Employers should also consider the side effects of the contractor accepting the additional risk, including an increase in price or extended time negotiating the wording of the bond to incorporate safeguards.

Gulf Construction

Similar Topics