The use of bonds in construction projects

The use of bonds

The provision of bonds is a long-standing feature of the construction market in some jurisdictions. Now, generally across all jurisdictions, we are seeing more and more employers insist on the provision of a bond. As a result, the ability to procure a satisfactory bond is being given increasing weight when employers come to select their preferred bidder.

The growing prevalence of bonds is partly to protect against supply chain insolvency. It is also, however, a retaliative 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. Given the financial stress seen in many markets as a result of materials shortages and inflation, it seems to be inevitable that the industry will see more distressed projects in the coming years. Therefore, the provision of bonds and the use of them is likely to be an important aspect of those projects.

Types of bonds

There are two main types of bonds: an on-demand bond and a default bond. There are critical differences between each type, and each raises different considerations when a party is calling or resisting the call on a bond.  

On demand bonds

The main difference between an 'on-demand' bond and a 'default' bond is that, under an 'on-demand' bond, the employer does not have to prove loss to encash the bond. The bondsman has a primary and independent obligation to pay out under the bond, which is not linked to the liability of the contractor under the underlying contract. Provided that the employer can show that they have complied with the, mainly procedural, conditions for demanding the bond, the employer can call on it and will get paid out – unless the contractor obtains emergency injunctive relief from the courts, which is very difficult to obtain. This is not true of a default bond where the employer must prove that it has suffered loss before calling the bond.

On-demand bonds are usually backed up by an indemnity from the principal contractor, via its own bank, for any losses suffered by the bondsman as a result of payment being made under the bond. This means that, in essence, the liability still rests with the contractor and the contractor still pays, just in an indirect and roundabout way. The bond allows the employer to get the cash quickly, and with relatively little hassle, and the bondsman/bank has to recoup the money from the contractor or the contractor’s bank.

Due to the greater risk to the bondsman in paying out under an on-demand bond, they are more expensive to procure and only available to larger and more creditworthy counterparties. As a result, they are less prevalent in certain construction markets, such as the UK, and more common on larger international projects. This is also due to parties operating across different jurisdictions and needing to have safe and efficient access to cash.

Default-based bonds

A default-based bond, often known as a performance bond, is effectively a guarantee of performance by the bondsman. The bondsman's liability is linked to, and will be determined by, the position as between the employer and contractor under the contract. This is much like a parent company guarantee, although the bondsman will only guarantee financial loss, as opposed to a parent company which will have an obligation to ensure its subsidiary performs and which may be obliged to step in and perform if it does not.

Critically, the bondsman will have the same defences as the contractor under the contract to any claim under the bond and cannot have any greater liability than the underlying contractor, subject to whatever the maximum amount payable is under the bond.

The most common forms of default-based performance bond used in the UK construction market are in a specific form of default-based bond commonly referred to as an "ABI form". The ABI is The Association of British Insurers.

The standard wording in the ABI form requires the employer, as beneficiary under the bond, to "establish and ascertain" its losses "as against the guarantor pursuant to and in accordance with the provisions of or by reference to the contract and taking into account all sums due or to become due to the contractor".

There is little case law around the meaning of "establish and ascertain". However:

• most banks/bondsmen will require the beneficiary to obtain a binding judgment or award against the contractor in order to pay out under the bond, including in circumstances where the contract has been terminated. This means the beneficiary will have to incur the costs of pursuing a judgment or award, which, depending on the precise wording of the bond, includes an award at adjudication as well as via litigation or arbitration, before getting paid out under the bond. The costs of doing so will be recoverable under the bond, subject to the general principle that the bank/bondsman will have no greater liability than the contractor under the underlying contract. Therefore, any limitations of liability under the contract will apply under the bond, along with the limitation of the maximum sum under the bond.
• In an insolvency scenario, the ABI form will not provide immediate cashflow to the employer, and the employer will be required to establish and ascertain its losses by reference to the termination account mechanism under its contract with the insolvent contractor, which can take months or even years to finalise, depending on the progress of the works at the point of insolvency and termination.
• In the Ziggurat and Yuanda cases, the court found that a final account assessment issued by the employer, which was used to evidence the debt owed by the contractor to the employer, was insufficient to establish and ascertain the employer’s loss because the contract stipulated that the final account statement must be issued by the employer’s agent, not directly by the employer. Therefore, employers will need to be careful to satisfy all requirements of the contract and issuing bank/bondsman to get paid.

Strategic considerations

On demand bonds, in particular, can be powerful levers in the administration of a project. They offer employers potentially instantaneous access to funds, and having a bond in place can also have a “Sword of Damocles” effect, where the threat of a call is enough to persuade a contractor to return to site to correct defects or ensure a contractor continues and completes its works even when it is clear that the project has turned into a loss leader for it.

Avoiding an on-demand bond once it is called

Where the bond is an "on demand" instrument, the party that procured it is likely to have limited rights to prevent the bond from being called or from the issuing bank paying out.

Ultimately, the principal would have to apply to court for urgent injunctive relief preventing the demand from being made or payment being made under the demand. Alternatively, or perhaps in addition, the principal could apply to court for urgent injunctive relief to prevent its own bank from reimbursing the issuing bank under the counter indemnity. Case law has, however, shown that the only two real bases under English law upon which the principal could seek to dispute the demand are clear and obvious fraud; or where it is "positively established" under the underlying contract the demand should not be made or payment should not be made under a demand. Evidence of a dispute between the parties is not enough, and each case will turn on its facts. The sorts of arguments that may be successful include:

• where the bond was called too late and the rights under the bond have therefore expired. This point should be checked carefully as sometimes a bond will not contain a fixed date but rather a date linked to an event such as the project being certified as having achieved practical completion under the contract.
• where the right only exists because of the beneficiary’s own breach. For example, in the Doosan v Comercializadora de Equipos case, the court found that a call on the bond could not be justified where the guarantee only remained in force by virtue of a continuing breach of contract on the part of the beneficiary.

Other jurisdictions will have their own legal tests in respect of challenging a bond from being called or from the issuing bank paying out, but the requirement to demonstrate some form of fraud or procedural irregularity in the making of the call are generally common throughout.

The other, very practical way of protecting the commercial consequences of a bond call being made is to flow down the requirements for bonds to the supply chain, such as tier two subcontractors. However, unless the entirety of the works is being passed down, the cost of putting a back-to-back bond in place is likely to be disproportionately high and the subcontractor’s credit rating may mean that no bond is available, or at least not one from a reputable bank, or comes at an even higher premium. Where there is a subcontractor bond available, the main contractor will be susceptible to all the same pitfalls noted above so should be careful to call the bond in the correct way.

The future

Current expectations are that bonds will be used more frequently in the coming months and years. It is, therefore, important for parties to understand the bond options that are open to them and the circumstances in which they may be used.

With contributions from Andrew Robertson of Pinsent Masons.