Performance bonds and parent company guarantees in construction contracts

Sydney Rich and Rachel Murray-Smith explain performance bonds, PCGs and how building contracts are affected.

Performance bonds and parent company guarantees (“PCG”) are a means of protection for an employer against non-performance by a contractor in carrying out works under a building contract.

There are various ways in which an employer to a building contract can secure the performance of the appointed contractor.

In this article, we consider performance bonds and PCGs – being the most commonly used forms of security within the construction industry.

What is a bond?

A bond will often be obtained by a contractor, usually from a bank or insurance company who will be the ‘surety’ under the bond, as a means of providing an additional layer of protection for the employer. There are a number of bonds available but the most common are performance bonds.

Performance bonds enable the employer to have the benefit of a third party who accepts liability for the performance of the contactor under the underlying building contract.

The bond issuer agrees to pay the employer up to a maximum sum which is generally a percentage of the overall contract sum for a limited period of time (for example, a bond may expire or reduce in value on practical completion of the works).

In the event of default by the contractor, the bond issuer will be required to pay the employer’s losses up to the maximum amount stated.

The maximum amount of a bond provided by issuers will vary between projects, but generally range between 5 -15% of the overall contract sum.

It is not uncommon for a form of bond to be included as part of the building contract or at least clauses setting out the terms on which a performance bond is to be obtained.

There are two ways in which performance bonds can be drafted, namely:

• As a guarantee instrument (which is also referred to as a conditional bond); or
• On-demand bond.

Bonds: Guarantee Instrument

Under a guarantee instrument, the issuer’s obligation to pay is triggered by the employer being able to successfully establish a breach of contract by the contractor.

In some forms evidencing the loss is also required. The Association of British Insurers (ABI) publishes a guarantee instrument standard form of bond and this form is widely used across the industry.

Bonds: On-Demand

An on-demand form of bond is different in that it creates a primary contractual obligation (and thereby an independent obligation) on the issuer of the bond to make payment to the employer in the event the employer calls upon the bond and provides a written statement of its purported loss.

This allows an employer to make a demand for the payment without having to prove a breach of contract or its actual loss.

It is for this reason employers often prefer this form of bond albeit they can be difficult to agree and obtain.

There are often certain provisions that set out how to ‘call’ on the bond and any employer should follow these conditions carefully to ensure they comply.

In addition, although an on-demand bond does not require the employer to establish its actual loss at the point it calls on the bond, if it is found at a later date the actual loss is less than the amount called for, then it may need to repay those additional sums to the surety.

Bonds are generally considered to be a strong form of security – banks and insurers who provide the protection are generally deemed to be financially secure and are able to provide greater covenant strength.

Assuming appropriate drafting is included within a bond, and insolvency is a specific trigger, then it should provide good security for an employer in the event of contractor insolvency owing to the issuer being entirely independent from the contractor and is therefore offering better protection than a PCG.

What is a PCG?

A PCG is a guarantee given by a contractor’s parent company or ultimate holding company (the ‘guarantor’) in favour of the employer – guaranteeing the performance of the contractor under the building contract.

The guarantor can be called upon by the employer to remedy the breach by the contractor, complete the works or otherwise fulfil the contractor’s obligations under the building contract, or pay damages.

PCG’s differ to bond instruments in that under most PCGs the guarantor’s obligation is contingent on the primary obligation (being the contractor’s obligations under the underlying building contract) and so the obligation to make a payment, for example, is dependent on the employer establishing liability on the part of the contractor in respect of the underlying building contract.

One of the key principles of PCG’s is co-extensiveness. This means that under a PCG a guarantor’s obligation will not be greater than that of the contractor under the underlying building contract and the guarantor will benefit from the same defense and limitations as the contractor under the building contract to which the PCG relates.

There are some key provisions that an employer may want to see included within a PCG, some examples include:

• Provisions allowing recovery of losses incurred by the employer as a result of the contractor’s breach of the building contract and/or as a result of insolvency;
• An option for the guarantor to make good defects together with an obligation to pay the employer for any losses suffered owing to the relevant defects which need to be made good;
• Terms as to period in force (generally set to the same liability period under the underlying building contract); and
• Provisions as to whether variations to the building contract alter the guarantor’s liability under the PCG.

Conclusion

Bonds:

• Bonding capacity – as contractors can only obtain bonds up to a finite aggregate amount (i.e. bonding capacity) a contractor may be unwilling to provide a bond for low value smaller works to preserve their bonding capacity for larger projects. Employers will therefore need to consider how this position sits with its overall risk profile.
• Expensive – contractors are generally keen to recover the cost of obtaining a bond from the beneficiary and may therefore seek to recover the cost of the bond through its pricing for the project.
• Bonds are time limited to the expiry period set within the bond.
• The maximum amount under the bond may not necessarily cover an employer’s loss.
• Depending on the type of bond, employers may have to spend time and resources being able to establish a breach and loss in order to successfully call on the bond.

PCG’s:

• The contractor must have a parent company to provide a PCG.
• The value of the security is dependent on the financial standing of the parent company and employers should ensure they have carried out their own due diligence in this regard.
• Should the contractor become insolvent, there is potential for risk in the parent company’s ability to pay under the guarantee.

Ideally an employer will seek to obtain at least one or more appropriate forms of security in respect of construction projects, but this may not always be feasible.

Ultimately, the question of whether a bond, PCG or other form of security is required for a project is a commercial one and will vary on a project specific basis.

The duration and coverage of forms of security should also now be considered in the context of the extended liability and specific requirements introduced by the Building Safety Act 2022.

Please contact the construction team for tailored advice, assistance or training on any legal issues related to your construction projects.

Sydney Rich is a Junior Associate and Rachel Murray-Smith is a Partner at Sharpe Pritchard LLP.

This video is for general awareness only and does not constitute legal or professional advice. The law may have changed since this page was first published. If you would like further advice and assistance in relation to any issue raised in this article, please contact us by telephone or email This email address is being protected from spambots. You need JavaScript enabled to view it.