Back to Basics - Guarantees and Bonds

14 July 2015


In this article we look at two of the ways in which an employer will try to deal with the risk of contractor default or insolvency on construction projects - performance guarantees (sometimes referred to as performance bonds or guarantee bonds) and parent company guarantees.

What is a performance guarantee or bond?

In the construction industry, a performance guarantee is usually provided by a bank, insurer or other financial institution who guarantees that it will pay the employer (up to a capped sum) for the losses incurred as a result of the contractor being in breach of its obligations under the building contract.

While the terms tend to be used interchangeably, in a construction context a bond does in fact differ from a guarantee, as it does not require the employer to establish a breach under the building contract, whereas this is required under a guarantee.

In contrast, the bondsman has an independent obligation to pay out pursuant to the bond, following a written demand by the beneficiary. For obvious reasons, these "on demand" bonds are less frequently available and more costly than guarantees. They will also usually stipulate strict requirements for notifying the guarantor of a claim.

What are the main provisions of a performance guarantee?

The principal obligation - The guarantor guarantees that, in the event of the contractor's breach of contract, it will satisfy and discharge the damages sustained by the employer. Employers will usually require that this provision specifically covers the contractor's insolvency.

Maximum liability - This is usually 10% of the contract sum but may be more or less. For a project which will run for a particularly long period of time, the amount may reduce as the project progresses. The guarantee will usually also say that the guarantor's liability is co-extensive with that of the contractor, and therefore it will have no greater liability than the contractor would have had under the building contract.

Expiry - The guarantor's liability will usually expire at practical completion of the project or at the end of the rectification period. A longer period of cover is likely to increase the cost of the bond.

Assignment - Employers will want to make sure that the guarantee is assignable to any person to whom the building contract is assignable. In some cases, this right to assign will be subject to the consent of the guarantor.

Variations to the underlying contract - It is important that variations to the building contract do not impact upon or reduce the guarantor's liability under the guarantee.

How is this different to a parent company guarantee?

A parent company guarantee is given by the contractor's parent or other connected or group company and guarantees the performance of the contractor's obligations under the building contract.

Parent company guarantees vary significantly but commonly include satisfying the employer's claim for damages, warranting to carry out the contractor's obligations in place of the contractor itself or indemnifying the employer for any losses incurred as a result of the contractor's non-performance.

A parent company guarantee should last for the duration of the building contract (i.e. 12 years if executed as a deed, six years if executed as a simple contract). There is usually no cap on liability but the guarantor will have no greater liability than the contractor would have had under the building contract. As a result, the guarantor is liable to the employer in the same way, and for the same period of time as the contractor would have been under the building contract.

Which is best for my project?

Whether the employer requires a performance guarantee or parent company guarantee (or both) will need to be assessed on a project by project basis, considering the nature and value of the works and the financial standing of the contractor. However, the starting point should be that they are entirely separate forms of security.

An advantage to having a performance guarantee is that it gives the employer a cash sum from an independent third party which may assist in dealing with short term losses incurred as a result of having to find a replacement contractor.

However, the reality is that the guarantee (unless it is on demand) will often include a requirement (as is the case with the guarantee bond produced by the Association of British Insurers) for the damages to be established and ascertained pursuant to the building contract. This is likely to require formal proceedings against the contractor before any sums can be recovered from the guarantor. Accordingly, the sums may only be available at a much later stage and the employer may be out of pocket for some time.

As a parent company guarantee tends to have the same limitation period as the underlying building contract, it may be called upon in relation to defects which arise at a much later stage whereas a performance guarantee is likely to expire once the project is complete.

Significantly, a parent company guarantee is, in most cases, supplied at no cost to the employer. However, if a contractor is suffering financial difficulties, the parent or group company may also be affected, leaving the guarantee worthless. The financial standing of a parent company will therefore need to be considered.

As with a performance guarantee, a parent company may also require the losses to be formally ascertained before any sums can be recovered from the guarantor, unless the parties have agreed otherwise.

More practical tips...

  • As contractor, it is best to deal with procuring guarantees as early on as possible in the project as an employer may insert wording into their building contract permitting them to retain a percentage of all payments to be made to the contractor (or allowing them to make no payment at all) until the relevant guarantees have been delivered.
  • Contractors should be aware of any required forms of guarantee that are included in the tender documents and bear this in mind when approaching prospective guarantors who may have their own form of guarantee. The court has previously ordered a contractor to make payment of the bond amount into court when a suitable bondsman could not be found (Liberty Mercian Ltd v Cuddy Civil Engineering Ltd [2014]).
  • In most cases, guarantors are likely to require various counter guarantees and possibly indemnities from contractors and the terms of any such documents need to be carefully checked.
  • As an alternative approach to guarantees, an employer may propose withholding a percentage of payments throughout the course of the project as a retention. However, both parties should consider the potential risk to the contractor's cash flow and any resultant negative impact on its ability to carry out the works.

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