These bonds have attracted plenty of criticism over the years from commentators and the judiciary. This is because they date back to at least the 19th century, in a form that has repeatedly been described as obscure and archaic.
Indeed, the House of Lords was recently asked to consider what these antiquated forms of bond actually meant. The decision – as everyone but the Court of Appeal had assumed for some time – was that these forms of bond were simple guarantees of the contractor's performance. They were not "on-demand" instruments.
Since then, there have been attempts to introduce performance bonds in a more modern form, which is resulting in more readily understandable documents.
More importantly, however, a new breed of performance bond is now available for significantly larger sums than was previously the case. Performance bonds for 50%, 80% or even 100% of the contract price are now available from a select group of insurers.
These new, large bonds differ markedly from the existing product. The sheer size of the cover available means that the insurer takes a much greater interest than has hitherto been the case in both the contractor's abilities and the project risks that it is covering.
In order to protect the provider's interests, these bonds typically contain step-in rights. These require that any call on the bond be preceded by notice to the insurer. On receipt of that notice, the insurer usually has two or three options. These include the right to:
- Accept the call and make the payment requested (up to any cap or limit contained in the performance bond).
- Procure, within the period prescribed in the performance bond, the remedying of the contractor's default.
- Step into the construction contract and accept responsibility for the project construction as if it were the original contractor with the same liability as the original contractor (regardless of any cap or monetary limit contained in the performance bond, but subject, of course, to any such limitations contained in the construction contract).
This last power, in particular, marks a radical departure from the traditional forms of performance bond. Performance bonds of this size, and containing these terms, are commonplace in the USA. It is, therefore, perhaps no surprise that they are being offered by international insurers with large capital bases and experience of the way these bonds operate in other markets.
- Up to 100% performance bonds are now available from large insurers
- They are cheaper than letters of credit
- Step-in provisions protect the insurer
- No call has yet been made on one of these bonds
One interesting question is why these bonds have appeared in the UK market at this time and the uses to which they are being put.
Their most obvious use has been in credit-enhanced, bond-financed private finance initiative projects. Here, they have been used to replace the letters of credit required by monoline insurers to cover completion risk and to supplement parent company guarantees. In earlier PFI projects, parent company guarantees were the principal means by which the construction contractor's performance was secured.
Their advantage over letters of credit is mainly one of cost. Performance bonds – even these large ones – appear to be much cheaper than a letter of credit of equivalent size, although the nature of the cover will not be identical.
As against simple reliance on a parent company guarantee, the benefits of large performance bonds are obvious. The systemic failure of the contracting group is covered, as well as the theoretical case of the isolated collapse of the particular operating subsidiary.
However, their use has not been restricted to projects financed in this particular way and it is possible that they will become the norm in PFI projects financed by other means, such as traditional bank loans.
Indeed, there is no reason in theory why they should not become the performance bond of choice in a wider range of projects where the employer (or its lender) is looking for a contractor with sound financial backing.
In practice, however, their immediate use is likely to be restricted to major projects where completion on time and in accordance with the specification is especially important for project debt servicing.
It should, however, be recognised that these performance bonds have only been available in the UK market for two or three years. Even in that time, the form of the security that is on offer and the nature of the protection afforded to the insurers has developed swiftly.
It is also worth noting that no call has yet been made on one of these bonds. The result of this is that the terms of the various existing bonds, their value to the beneficiary and the exposure of the insurers has not been tested.
Taken together, these factors indicate that this immature market has some way to go before a standard product emerges. Developments in this area will be keenly followed.
Simon Stebbings is a partner in the construction department of Freshfields Bruckhaus Deringer. The article was co-written with Nick Bliss.