Bonds are an increasingly common feature of contracts in the construction industry, especially on larger or higher-risk projects.
A bond is a form of financial guarantee, usually provided by a third-party surety such as a bank or insurance company and secures performance or payment obligations under a contract. If the party to the bond fails to meet its obligations, the bond may allow the other party to claim compensation.
They are generally intended to provide financial security up the chain in case things go wrong, but not all bonds are the same are there are various considerations that need to be understood. Bonds are binding, so it is essential for all parties involved to know the different types of bonds, how they work, and what are the major issues to avoid before signing them.
This article explains the most commonly used bonds, highlights key considerations, and offers practical tips to help you manage risk effectively.
Main Types of Bonds in Construction
Performance Bond
Performance bonds aim to protect the employer financially in case the contractor fails to complete the project in line with the construction contract. Some key features of performance bonds are:
- The bond generally covers a percentage of the contract sum, most commonly 10%.
- Performance bonds can be on-demand or conditional:
- On-demand bond: The employer can demand payment without proving the contractor’s default.
- Conditional bond: The employer has to establish a breach by the contractor and loss before claiming the payment under the bond.
- Usually issued by a bank or surety provider
What to look out for in a Performance Bond?
- It is important to check if the bond is on-demand or conditional. This affects your risk exposure. On-demand bonds are extremely risky for the contractor or the subcontractor and should be avoided.
- You should review the expiry date and any conditions for release.
- It is important to assess and review the language. It is not always made obvious whether the bond is on-demand or conditional. You should consider seeking professional help if you are unsure. For instance, you should be wary of language like “unconditional obligation to pay,” which implies an on-demand bond.
- It is important to ensure a performance bond reflects the underlying contract accurately.
Advance Payment Bond
An Advance Payment Bond protects the employer when an upfront payment is made to the contractor or supplier by ensuring that the money can be recovered if the recipient fails to deliver the works. Some key features of advance payment bonds are:
- Advance Payment Bonds are often required when substantial mobilisation or material procurement is needed early in the project.
- The amount of the Advance Payment bond typically matches the amount of the advance payment.
- The Advance Payment Bond may reduce automatically as work progresses.
What to look out for in an Advance Payment Bond?
- It is important to keep records showing how the advance payment was spent by retaining documents like purchase orders, delivery notes and invoices.
- It can be helpful to ensure that the bond expires or reduces once the advance has been balanced against completed work.
Retention Bond
A retention bond replaces the need for cash retentions, which are common across the construction industry, especially in the UK. This form of bond is less common than other forms of bond. Retention deductions, which are made from a contractor’s applications for payment, generally allow the employer to be protected against defects and ensure their rectification. A retention bond allows the contractor to receive the full payment, helping in cash flows while giving the employer security if defects are identified at a later stage. Some key features of a retention bond are:
- A retention bond is typically equal to 3–5% of the contract value, which is consistent with cash retention percentages.
- A retention bond can be provided at practical completion to release retained funds. Generally, the value of the retention bond will reduce after practical completion has been certified, just like most cash retentions.
- In some instances, a retention bond may continue until the defects liability period (now the rectification period under JCT contracts) ends.
What to look out for in a Retention Bond?
- It is important to ensure that the bond terms reflect the contract and any defects period.
- Employers may require the bond to remain valid until a specific event, like the final certificate, not just a fixed date.
Parent Company Guarantee (PCG)
A PCG is not a bond, strictly speaking, but is often used alongside or instead of bonds. It is a contractual promise by a parent company to fulfil the obligations of its subsidiary or compensate the employer for its subsidiary’s failure to do so. Some key features of a Parent Company Guarantee (PCG) are:
- Parent Company Guarantee generally covers performance, payment or contractual obligations.
- Parent Company Guarantees are common in large, international or complex projects, especially if the contractor is a SPV (Special Purpose Vehicle).
- Unlike most other bonds or bank guarantees, a PCG does not involve assets or cash deposits. It is essentially based on contract terms and is not collateral.
- Parent Company Guarantees are only as good as the guarantor’s ability (and willingness) to pay.
What should I look out for in a Parent Company Guarantee (PCG)?
- For employers or contractors, it is important to assess the creditworthiness of the parent company.
- For contractors or subcontractors, it is important to ensure the parent company is willing to and capable of complying with the Parent Company Guarantee.
- It is important to ensure that the wording is clearly linked to performance obligations and not just financial loss.
Conclusion
Construction bonds are vital risk management tools, but they come with significant legal and financial consequences. For contractors and subcontractors, understanding the type of bond, the terms it imposes, and the events that trigger liability is essential to protecting their position.
Whether you are being asked to provide a bond or are relying on one for security, you can understand and minimise the risks by keeping the following in mind:
- Language
- Always review the wording carefully and do not assume standard terms apply. Each bond or PCG should be reviewed individually and carefully.
- For subcontractors and contractors, “On-demand” wording significantly increases financial exposure and should be avoided.
- Expiry and Release Conditions
- It is important to know the automatic expiry dates or conditions for release like a final certificate, which are important to know how long your liability lasts or when it is triggered.
- It is important to ensure that the release is tied to clear, achievable milestones and is not ambiguous.
- Limitation of Liability
- Check if the bond has a capped amount, and whether that figure includes legal costs or interest. Many subcontractors or contractors prefer to limit this to a certain specific amount, like the contract sum or its proportion to a milestone.
- Notices
- Employers often have to give notice of default or claims, and these should be strictly complied with, or they may lose the benefit of the bond.
- Contractors should ensure any claims processes are fair and limited in time to ensure there are no surprises.
- Back-to-Back Obligations
- Subcontractors may be required to provide equivalent bonds to those in the main contract.
- Contractors should check any such requirements early and ensure this is communicated to the subcontractors and procured swiftly to avoid being in breach of the contract.
If you are dealing with a situation where a call has been made on a bond then it is important to seek advice and act quickly.
How can CCC help?
CCC has decades of experience in dealing with contracts in the construction industry, including advising parties on how to limit and manage their risk. Our extensive experience in construction adjudications helps us navigate complex contracts, assess risks and provide bespoke services to our clients. We can assist you with:
- Reviewing any bonds, guarantees and collateral warranties
- Draft or provide suitable amendments
- Ensure that you understand your obligations and rights, including triggers, releases and notices
- Ensure that any bonds, guarantees and collateral warranties are back-to-back
- Providing advice and legal support if you end up in a dispute
- Dealing with claims and calls made on a bond
