There are recent reports of a shortage of available bond capacity in the construction bond market which is threatening to delay project starts. The cause of this shortage has been attributed to a number of factors including:
- The reluctance by clients to release bonds early where there is a client variation of the contract price;
- The withdrawal of key surety bond providers out of the construction bond market; and
- The increase in demand for bonds which is not met by the supply and therefore affecting the premium rates.
The industry insiders have recommended that one of the ways to avert crisis in the construction bond market is for contractors to have serious conversations with clients concerning the early release of bonds. For instance, it is recommended that where projects are overrunning due to client variations for additional works, bonds should be released at the previously agreed contract value and new bonds can then be issued for the smaller balance of extra works, if needed. Such early release would free up the much-needed capacity.
Contractors are also encouraged to engage with bond providers early and ensure they build relationships with them prior to seeking bonds or guarantees as this would help the parties build confidence in each other.
Bonds and guarantees are used in the construction industry as an instrument of protection against non-performance by the performing party. For this reason, they are often generally referred to as “performance security”.
The growing frequency of the use of bonds and guarantees especially after the pandemic is partly to protect against supply chain insolvency. It is also seen as a response to the drive towards fairer payment practices and the abolition of retentions both of which will increase the risk of employers being left financially exposed.
Further, the ability of a contractor to procure a satisfactory bond is positively weighted by employers when selecting a preferred bidder for projects.
When issued, the bond or guarantee provider undertakes to be responsible for fulfilling contractual obligations owed by one party to the other, or the payment of money, in the event of default. The precise obligation of the bond or guarantee provider will depend on whether the instrument in question constitutes:
- An “on-demand” bond, which takes effect as an independent instrument. or
- A “true guarantee” or “default bond”, which creates a secondary liability predicated on the default of the contractor.
Although the terms for these security instruments are often used interchangeably and frequently both types of instrument are referred to as “performance bonds” or “performance guarantees”. There is however a fundamental difference between the two types of instrument.
Guarantees may be referred to as conditional, default or surety bonds, whereas an on-demand bond may be described as an unconditional bond or a single bond. Further, instruments issued by insurance and surety companies are commonly referred to as bonds, but are usually guarantees, and instruments issued by banks, commonly referred to as bank guarantees, are often on-demand bonds although insurers, sureties and banks issue both types of instrument.
An On-Demand Bond and a True Guarantee/Default Bond
On-Demand bonds impose a primary obligation on the provider to pay in circumstances where the employer makes a compliant written demand, without having to commence proceedings against the defaulting contractor or prove a breach of the contract or obligation in respect of which the on-demand bond is issued.
On the other hand, under a true guarantee/default bond the obligation on the issuer to make payment is dependent on the employer establishing a liability on the part of the contractor under the underlying contract. It is a secondary obligation. In respect of any claim under the default bond or true guarantee the issuer can therefore rely on all rights, counterclaims and defences available to the contractor. In this way, the issuer’s liability is co-extensive with that of the contractor. The default bond or true guarantee cannot be considered in isolation but in conjunction with the underlying contract.
Performance Bond or Guarantee
A performance bond or guarantee, which may be an on-demand bond or a guarantee instrument, is the most commonly used form of performance security on construction projects. In the UK, most performance security on construction projects usually takes the form of a guarantee instrument whereas on-demand bonds are common on international projects.
As noted above, the purpose of this type of security instrument is to ensure the contractor carries out the works in accordance with the construction or engineering contract. If the contractor does not, the employer will suffer a loss. The issuer of the bond or guarantee agrees to pay the employer for its loss up to a stated maximum sum, often a percentage of the contract sum and usually only for a limited time. The industry standard is 10 percent of the contract price. A claim usually has to be made before completion of the project.
Extinguishing the Issuer’s obligations: Variation of the underlying contract
As the issuer’s obligations are the same as the principal’s obligations under the underlying contract, the issuer will be released automatically if there is a material variation or alteration in the terms of the underlying contract without the issuer’s consent (Holme v Brunskill {1878} 3 QBD 495). Therefore, a variation for these purposes will not be material if on the face of it and without enquiry evident the alteration is unsubstantial or beneficial to the issuer.
Likewise, where the employer agrees to allow the contractor further time to perform its obligations beyond that agreed in the underlying contract, the issuer will be released in the absence of an express clause to the contrary.
The reasoning behind this is that the nature of the obligations which the issuer had assumed have changed without its knowledge or approval, and the issuer has given no guarantee for those differing obligations. However, the rule in Holme does not apply to indemnity (as opposed to guarantee) obligations contained within a hybrid agreement which contains both guarantee and indemnity obligations (Brown-Forman Beverages Europe Ltd v Bacardi UK Ltd {2021} EWHC 1259 (Comm) (19 May 2021)).
An Indulgence Clause
Notwithstanding the above, the parties to a contract with a bond or guarantee may need the ability to agree changes, however minor, to the underlying contract without being concerned that those changes may release the issuer of a bond or guarantee relating to the contract. Accordingly, guarantee instruments will typically contain an indulgence clause, so that the issuer will not be discharged by any variation to the terms and conditions of the underlying contract, changes in the extent and nature of the work, or allowance of additional time for completion of the works.
Parties should however take care when relying on indulgence clauses as they do not provide absolute protection.
Early Release
Contrary to variation under the underlying contract, a variation of the works made in accordance with the relevant provisions of the relevant contract (i.e. variation under the contract) is not variation of the contract and therefore would not discharge the issuer of a guarantee instrument even in the absence of an indulgence clause.
Conclusion
The expectations are that bonds and guarantees will continue to be used in the construction industry in the years to come and it is therefore important for parties to understand the bond options that are available to them and the circumstances they may be used.
Although the construction bond market has had some difficult recent years, it has traded profitability over the long term. It is therefore anticipated to continue to have capacity even if the providers have changed as a properly-run bond and guarantee providers will always find capacity.