A quick guide to the practical uses of bonds on construction and engineering projects
A quick guide summarising the different forms of bond that may be used on a construction and engineering project, focusing on the practical use of the bond rather than the law affecting bonds and guarantees.
What is a bond?
Bonds are used in UK and international construction and engineering contracts as a means of protection against contractor non-performance.
The bank or other bondsman’s obligation will vary depending on whether it has provided a true guarantee or an “on demand” bond. Although the terms are often used interchangeably, there is a crucial legal difference between the two:
- An on demand bond imposes a primary obligation on the bank to pay in circumstances where the contractor fails to perform the building contract, without the employer having to sue the contractor and prove breach of contract.
- The obligation to make payment under a default bond (a form of guarantee is dependent on the employer establishing the contractor’s breach of the building contract.
A performance bond is designed to ensure that the contractor performs the works in accordance with the building contract. If it does not, the employer will suffer a loss, for example because of delay. The bank agrees to pay the employer for its loss up to a stated maximum sum, often originally set as a percentage of the contract sum.
A performance bond may be an on demand or default bond. On a property development project carried out in England and Wales, if a performance bond is required, it is common practice to procure a default bond. On an international project (and, in some circumstances, on other major projects that do not have an international element), an on demand bond is more common.
Advance payment bond
The parties may use an advance payment bond where the employer has agreed to pay the contractor an advance payment under the building contract, but is concerned that the contractor may not be able to perform the contract or repay the employer if something goes wrong. For example, the advance payment may relate to the pre-order of goods or equipment. An advance payment bond is usually drafted as an on demand bond, whether used in connection with a project in England or Wales or an international project.
Some standard form contracts refer to a similar, but different, bond in respect of off-site materials or goods. This provides some security to an employer who pays for materials that are kept elsewhere before delivery to site. For example, see Part 2 of Schedule 6 to the JCT Design and Build Contract, 2011 edition (JCT DB11).
A bid bond (also known as a tender guarantee) is intended to prevent a bidder from abusing the bidding (tendering) process. However, as an on demand bond, it can be open to abuse by the employer or act as a barrier preventing smaller companies from bidding. Despite these drawbacks, and while remaining rare in England and Wales, a bid bond is sometimes part of the procurement process for an international construction and engineering contract.
In England and Wales, the employer and the contractor often agree that the employer may retain a specified percentage of payments due to the contractor from each interim payment as the project progresses (the retention). When the project reaches practical completion, half of the retention is paid to the contractor. At the end of the rectification period, the second tranche of retention is released.
If the parties agree to do without a retention, but the employer still wants some protection against the cost of remedying defects in the works, the contractor may agree to procure a retention bond. The sum covered by the retention bond reflects the amount that the employer would have held as a retention and, just like a retention, usually reduces after practical completion.
For an example form of retention bond, see Part 3 of Schedule 6 to the JCT DB11, which is drafted as an on demand bond.
Defects liability bond
On some engineering projects, at practical completion or taking over, the contractor may have been paid in full and the employer may have released any other security it held. To continue to provide the employer with some security in case the contractor does not remedy a defect, some standard forms of engineering contract (such as the IET’s MF/1 contract) include a defects liability bond, known (in that case) as a defects liability demand guarantee. The bond remains in place during the defects liability period and in the case of the IET MF/1 form, is payable on demand.
On a PPP project, an adjudication bond specifically allows the beneficiary of the bond to call for a payment ordered by an adjudicator’s decision.
The difficulty with such bonds is that, where the adjudicator’s decision is temporarily binding, but the same dispute may subsequently be referred to litigation or arbitration, the parties may need to provide in the bond for a balancing payment if the court or arbitrator reaches a different final result. This is complex to achieve in practice.
As such, adjudication bonds are most suitable when the “adjudication” referred to is final and binding. In that sense, a person known as an adjudicator may be acting more like an expert with authority to finally determine the parties’ dispute.
This quick guide was produced by PLC Construction
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