A new age for the performance bond

From what we know so far, it would appear Carillion was operating a broken model that left it chasing revenue, which had a knock-on effect on its cash flow further down its supply chain. Clearly it was an unsustainable model and one that has left the livelihoods of its subcontractors hanging in the balance, and its clients potentially out of pocket as they endeavour to engage alternative contractors to complete unfinished projects.

Considering what has happened to Carillion, there is perhaps about to be a greater demand for main contractor performance bonds to be in place on projects.

What are performance bonds?

Performance bonds provide a way for clients to recover some of their costs if a contractor fails to fulfil its obligations on a contract. There are many reasons why companies choose to put them in place, perhaps to provide security when using a contractor for the first time or for larger projects over certain values. Ultimately, they are used to protect a client if the contractor fails in its contractual obligations.

They are issued by banks or insurance companies and they provide money to cover the additional costs of getting someone else to complete the project work. The amount that can be claimed is usually capped at a fixed amount, typically 10% of the contract value, and the bond has an expiry date of typically a year after the date of practical completion.

It is perhaps time the government looked to provide new legislation to ensure suppliers are paid within a fair and agreed period, with failure to do so resulting in financial penalties.

When should performance bonds be requested?

Some of the companies we work with require specific provisions within their procurement routes, insisting that bonds are put in place for certain value projects to protect stakeholders.

It is clear from the collapse of Carillion that due diligence needs to be an important and integral part of the procurement process and should continue throughout a project. Therefore, bonds should be requested before a contractor is appointed to ensure the contractor has strong financial credentials, posing a lesser risk to the project’s completion.

Why a contractor’s rating matters when it comes to performance bonds?

Each contractor is rated by the bond industry. The lower the rating the stronger the contractor is seen to be. Having a good rating from a bond provider is important because it not only enables main contractors to obtain better rates for bonds but it offers the client confidence in the main contractor’s financial stability. Low ratings enable the contractor to obtain better rates which are then passed on to clients. 

Many clients use supply chain models like Constructionline to select contractors. It is perhaps at this point that a contractor should have some level of grading for client review, via a rating mechanism, that covers their financial strength and ability to deliver and fulfill their contractual obligations, rather than the client encountering issues half way through a project on site, when clearly it is too late.

Future security of the supply chain

There are certainly lessons that can be learnt from the collapse of Carillion in relation to how the industry can better protect the whole supply chain. Businesses that have well managed, positive cashflow and a commitment to pay their supply chain on time, is the minimum the industry needs to be striving towards.

The outsourcing of vital public services will always be an area of risk but we must not lose sight of some of the fantastic public and private partnerships that are delivering key projects now.

Too many SMEs are being starved of cash and this needs to stop if the market is to function in a healthy manner. We need to reduce poor payment practices that are serving as band aids to patch up mismanaged cashflows and pricing structures, and increase the number of companies employing fair payment practices that work for all project stakeholders.

It is perhaps time the government looked to provide new legislation to ensure suppliers are paid within a fair and agreed period, with failure to do so resulting in financial penalties.

As part of this legislation revision, there also needs to be an improved route for recovering late debts – most companies will only go to court as a last resort due to the time and costs involved. There needs to be a simpler, standardised process for this, so that smaller businesses aren’t penalised financially for late payments.

The outsourcing of vital public services will always be an area of risk but we must not lose sight of some of the fantastic public and private partnerships that are delivering key projects now.

A robust due diligence and procurement process instilled in every project, with regular reviews and checks to ensure contracts are being adhered to, is the key to getting this right both now and in the future.