Bonds in construction contracts are often a pain point for Contractors. Especially in international construction projects they are frequent and are used to protect in a way or another the Employer from various breaches and non-performance of the Contractor.
Construction bonds are however rather risky for the Contractor especially if they are issued in the form of an on-demand bond.
If you are a Contractor, read below to see:
A. what construction bonds are and how they work;
B. 5 tips to reduce the risks connected with them.
A. What Construction Bonds are and how they work
Very broadly, they are guarantees which allow the Employer to recover damages or losses in case the Contractor fails to fulfil its obligations. If used correctly, they are therefore a legitimate instrument for the protection of the Employer.
Construction bonds are however the source of several disputes between the parties.
If issued in the form of an on-demand bond, they can be called by the Employer at its simple request and without the need to prove the actual default or breach of the Contractor and might be called even by an Employer who acts fraudulently.
The mechanism of the construction bonds depends on the interest that they are aimed at protecting (for instance default or delay in the completion of the works or defects in the works and the like) and on the form that the bond has.
In other words, there are different types of bonds (each with its features) which secure different risks such as:
- the failure of the Contractor to repay back the advance payment received at the mobilisation/signature of the contract ( Advance Payment Bond). The Contractor receives an advance payment to start the mobilisation or the procurement. Said advance is generally a percentage of the contract price and is repaid back by the Contractor through deductions that the Employer will apply on the interim payments. If the contract is terminated before the completion and the Employer has not recovered the advance payment then the latter will be entitled to call the advance payment bond;
- the breach of the Contractor to properly perform its obligations ( Performance Bond). This is obviously one of the riskiest bonds for the Contractor (especially if issued in the form of an on-demand bond). In fact, especially in complex projects, the identification of what amount to a 'breach' can be somewhat vague and difficult to be identified or can be subject to malicious interpretation from the Employer. In general terms, the Employer can call the Performance Bond if the Contractor does not complete the works (in their entirety or partially) or if it ends the works with a delay which is beyond the maximum amount of the liquidated damages provided in the contract;
- the defect that could arise during the warranty period ( Warranty Bond). In such case, it is crucial to detail in the contract what defects are secured by the bond or, putting it in another way, when the Employer is entitled to call the warranty bond.
In any event, the major risk for the Contractor comes from the fact that often the construction bonds are in the form of on-demand bonds which are guarantees that the Employer can call:
(i) without the need to prove the actual breach of the Contractor; and
(ii) upon simple request sent to the guarantor often even without the need to detail the alleged or declared breaches but simply with a declaration that 'the Contractor has breached its obligations'.
B. 5 Tips for negotiation
There are few tips that the Contractor can follow to reduce the risks related to construction bonds:
- VERIFY first of all if the bond is (a) an on-demand guarantee or instead (b) a conditional guarantee which is a guarantee that can be called only when the Employer proves the actual breaches or default of the Contractor;
- OBTAIN, in the case the guarantee is an on-demand bond, that the Employer will be entitled to call it only upon presentation of a declaration from an independent party that ascertains the existence of the default (the delay, the failure to complete part of the works or the existence of defects) or, in the alternative, only if the Employer has listed in details the alleged breaches of the Contractor (the indication of the alleged breaches will be extremely useful in the case the bond has been called fraudulently and the Contractor is willing to recover the amount called);
- VERIFY which is the governing law of the bond and which is the Court which will be competent to settle any dispute;
- OBTAIN, from your subcontractor and supplier, bonds in the same form you have issued in favour of the Employer so that you will be in the position to eventually recover from them whatever will be called by the Employer in the case the final responsibility is attributable to them;
- OBTAIN that, in the case of documented controversy on the right of the Employer to call the bond, the amount of the guarantee will be deposited in escrow and not paid directly to the Employer until the dispute is resolved.
Construction bonds are rather standard in international projects and it is unavoidable to issue them in favour of the Employer.
They are legitimate tools which protect the Employer from unexpected defaults of the Contractor but that can also be used fraudulently or in bad faith by the Employer who can put a substantial pressure on the Contractor simply threatening him to call the bond.
If the bonds are properly negotiated the risks for the Contractor can be actually limited and this is the reason why if you are a Contractor you should pay particular attention in negotiating the bonds.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.