Justin Mendelle examines whether public sector clients achieve value for money from the provision of performance bonds.
It is commonplace across the construction industry for an employer to procure a performance bond for construction works that it is undertaking. For local authorities, the default position is usually that such a bond must be delivered, regardless of the nature or value of the works themselves. This blanket approach often results in clients paying for a form of security that they either don’t need or is difficult to enforce – or both.
So, what lies behind this seemingly illogical approach? To begin at the beginning, it is necessary to understand some of the basic features of a performance bond. It is a type of security from a third party (the guarantor) that gives the employer protection in the event of a breach of contract by the contractor. Whilst there are different types of performance bond, the overwhelming majority of these are what are known as “on default” bonds. These are conditional upon an underlying event occurring (i.e. a breach of contract) in order to become ‘available’ for the client to call on them. They also are typically capped at 10% of the value of the original contract sum. They do not, therefore, offer complete ‘reimbursement’ if the underlying event or default takes place, but instead provide a measure of protection against the consequences of such default. However, they do not come free of charge. Typically, contractors will seek to recover some (if not most) of the cost of procuring the bond. In effect, the employer is paying a premium to have the comfort of a third party to claim against if it is unable or unwilling to pursue the contractor.
That, then, is what is on offer. Assuming an employer does obtain a bond, that is no guarantee that the bondsman will in fact make payment under it in the event of a claim arising. There are both procedural and evidential hurdles that will need to be overcome for a claim to succeed, neither of which are easy in the context of the contractor having breached the underlying contract. Furthermore, the bondsman is not incentivised to pay out. Added to this, the case law on when a claim can be validly made is far from straightforward, the costs of a claim can be significant, and the time required to pursue that claim can be considerable.
At this point, you might be asking what is the point of the bond? You would not be alone. Many local authorities’ standing orders require delivery of a performance bond as a condition of carrying out construction works. Nonetheless, it is right to assess whether this requirement provides suitable protection and real value for money. Certainly, performance bonds have their place and will almost always be required on projects where expenditure exceeds certain thresholds (e.g. £10,000,000). There may also be instances where the authority does not have full confidence in the contractor’s covenant strength and can take comfort from the additional layer of robustness offered by a third-party security instrument. The bond may also be part of a suite of documents (including a parent company guarantee), which together offer a range of remedies to the employer if the contractor does fail to perform. And just because bringing a claim under a bond may be time consuming, costly and challenging, that does not mean that the claim will not succeed or that the authority will not recover a considerable proportion of the value of the bonded amount.
In conclusion, simply requiring the performance bond as a matter of course is likely to be both inefficient and costly. Careful consideration should be given to nature of the project, the value of the works and the circumstances in which a bond is likely to be called upon. In other words, employers should take care before simply ticking the box that says “bond required”.
Justin Mendelle is Senior Partner, Head of Construction at Sharpe Pritchard.
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