What kind of security is available for employers, e.g. performance bonds, advance payment bonds, parent company guarantees? How long are these typically held for?
Contracting parties are free to determine which specific securities the contractor is to provide. Performance bonds as well as parent company guarantees are very common.
Most of the time, a performance bond shall be released in 2 steps: one half at provisional acceptance of the works, the other at final acceptance.
Note that the Royal decree of 14 January 2013 on the general rules of performance of public procurement contracts contains specific rules governing the specific performance bond to be provided by the contractor to the client.
The Act of 9 July 1971 relating to house construction and the sale of houses to be or being built provides for an obligation of the contractor to constitute a specific security to the benefit of the client. This is a guarantee of 5% of the contract price for certified contractors. However, non-certified contractors must provide a guarantee of full completion, i.e. a guarantee of 100% of the contract price (Royal decree of 21 October 1971 implementing the Law of 9 July 1971).
It is market practice for construction contracts to require advance payment guarantees and performance bonds until completion of the contract works and/or expiry of any defects notification period. The Oman Standard Documents require the contractor to provide a performance bond to the employer equal to 5% of the contract value. Article 44 of the Tender Law also requires entities to which the Tender Law applies, to obtain a performance bond equal to 5% of the contract price. Employers usually require that such performances are unconditional, irrecoverable and on-demand.
Employers may also require parent company guarantees where the contractor is not the ultimate parent entity. Omani law recognises the concept of a guarantee and companies may guarantee the obligations of parents or subsidiaries.
Under AB 92/ABT 93, a contractor must provide a performance bond within 8 working days from entering into the contract. The amount of the performance bond must equal 15% of the contract price (exclusive of VAT).
At the time of the hand-over of the work, the performance bond is reduced to an amount equal to 10% of the contract price. One year after the hand-over, the performance bond is reduced to 2% of the contract price, and five years after the hand-over, the guarantee expires (in both cases unless the employer has made claims for defects, in which case the performance bond will be reduced/expire when such defects have been rectified).
Contractors are usually paid for the work (already) performed, however, where a contractor is entitled to advance payments for materials not yet delivered at site, the employer will be entitled to an advance payment bond.
Parent company guarantees are not common but may be required in some cases. If requirements for financial solidity of a contractor are included in a tender, such requirements can sometimes be met by issuing a parent company guarantee.
For projects funded by APBN, Article 30 of PR No. 16/2018 provides examlples of security for project owners in a relation to the procurement of goods/services which may be inform of bank guarantee or surety bond. The types of security consists of:
- offering bond (jaminan penawaran),
- objection appeal bond (jaminan sanggah banding),
- performance bond (jaminan pelaksanaan),
- advance payment bond (jaminan uang muka), and
- maintenance bond (jaminan pemeliharaan).
The effective period of each security/bond above depends on the character of the bond/security itself. For example, (i) the performance bond (jaminan pelaksanaan) is effective up to the transfer of the construction work and (ii) the maintenance bond (jaminan pemeliharaan) is effective up to the maintenance period and shall be returned within 14 (fourteen) working days after the maintenance period is accomplished.
The above forms of security is also commonly used for privately funded projects based on the specific business requirements of such private sector.
For construction contracts funded by APBN, the Ministry of PWPH standard form contract (which may be used as a reference), contains a clause regulating the forms of performance bonds.
In public and private projects that have advance payments (anticipo), anticipo bonds issued by a bonding company are often used. This remains until the end of the performance of the works when the advance payment (anticipo) has been amortized and used adequately.
In public and private projects there is usually a performance bond that guarantees the correct performance of the projects. In the case of government contracts, performance bonds cover approximately 10-20% of the project value. In the case of private contracts, performance bonds does not have a limit, and in some cases reach up to 50% of the value of the contract.
In public and private projects, after the reception of the works, the employer usually requests a hidden defects bond issued by a bonding company. Usually up to the 10% of the contract value.
All those examples are available. In general, there is a 10-year term after project completion regarding buildings only and a 5-year term regarding public infrastructure.
There are two kinds of securities which may be required by the principal: during completion of the contract (so-called “performance guarantee”) and after completion, to secure claims arising out of defects in the work (so-called “guarantee for defects”). Performance guarantee is generally served at signing of the contract and is given back upon delivery of the work against delivery of a guarantee for defects. Different types of guarantee can be used, such as first demand bank guarantee, joint surety bond, first demand insurance guarantee, etc.
Security in the form of performance bonds is often provided to principals on contractors' behalves by the four major Australian banks. Increasingly, insurance bonds are also provided by large insurers. Bank guarantees are available and often take the form of an unconditional undertaking by a financial institution, or standby letters of credit given by the contractor to the employer. Parent company guarantees are also regularly obtained.
It is the industry standard to withhold 5% to 10% of the Contract Sum as security, of which half is returned on certification of practical completion, and the balance on the expiry of the defects correction period (typically 12 months).
Normally the contractor provides the employer with a performance bond from a third party guarantor (usually a bank or an insurance company), to ensure compensation in case the contractor fails to meet his contractual obligations.
Where the contractor is a subsidiary of another company, it is also normal to provide the employer with a parent company guarantee. The parent company guarantee is typically valid as long as the employer, in accordance with the contract, is able to make claims against the contractor.
According to the NS contracts, the contractor is required to provide security for the performance of his contractual obligations during the execution period and the defects liability period. Under both NS 8405 and NS 8407 the secured amount is 10 % of the contract price during the execution period, which is then reduced to 3 % upon delivery of the work for a period of three years.
Bonds or guarantees or insurance solutions similar to bonds or guarantees are commonly used in Sweden. Public sector entities are usually not allowed to make advance payments without an advance payment bond. Accessory bonds or guarantees are normally used. On-demand type of bonds are not so common. Bond and guarantees are usually held during both the construction period and the warranty period. The most common level of bond or guarantee is 10% of the contract price.
In general terms, all of these types of security are common in Hong Kong. Cash retention funds are the norm whereby 5% to 10% of progress payments are held until a reserve is reached of 5% to 10% of the contract sum, but other types of security also are common, as discussed below.
Contractor defaults, if they do happen, are likely to inflict huge financial losses on all parties involved and may hinder the completion of projects. Therefore employers may adopt some or all of the risk management tools described below as security.
At tender stage, a contractor may provide a tender deposit/bond which guarantees the employer that the tender has been submitted in good faith, that the contractor intends to enter into the contract at the tender price if successful, and that it would further provide other required bonds (for example, performance bond and advance payment bond) if it is awarded with the contract. A tender deposit/bond is not normally required in government projects.
A performance bond of usually 5% or 10% of the contract sum commonly is required by an employer from their contractors to protect the employer from the cost of contractor failure. If a contractor defaults on the contract, or in the case of contractor breaches such as defects or delays, the bond can be used to compensate the employer for the losses.
An on-demand or unconditional performance bond, which entitles the employer to call for payment in the absence of evidence of the contractor’s default, may also be used as security to guarantee performance of the contract. On-demand bonds, though available as an option, are not common in construction contracts because of the high premium typically charged by bondsmen, although they are being increasingly common.
An advance payment bond may also be required by an employer when the employer has advanced funds to the contractor ahead of the scheduled project milestones. This is to ensure that the cash advanced is used in accordance with the terms set out in the contract and to provide security for repayment.
These bonds typically are valid until either the date of practical completion or final completion of the construction project. In some contracts, the validity only ends upon the expiry of the defects liability period.
As noted above, in most cases, construction contracts contain terms which provide that certain retention monies would be held by the employer after completion which would only be released to the contractor after the expiry of the defects liability period. In rare occasions where such contractual terms are not in place or when full payment has been made to the contractor following completion, a retention bond may be used to guarantee that the contractor will carry out all remedial works necessary to correct defects during the defects liability period.
An employer may also require personal or parent company guarantee(s) from a contractor as an additional or alternative way of protecting itself from the contractor’s default or non-compliance with the contract.
On-demand performance bonds are relatively rare. The majority of UK performance bonds are default bonds (which require the employer to establish a breach of contract by the contractor and resulting loss before a call can be made). These are typically issued by specialist security companies, rather than banks.
Employers often require contractors to provide performance bonds. These typically expire either at practical completion or after the end of the defect rectification period (usually 12 months after practical completion).
Parent company guarantees are commonly required as an alternative to performance bonds, although their effectiveness will depend on the profitability, stability and reputation of the parent company.
Retention bonds are an increasingly popular alternative to the traditional approach of withholding a cash retention from interim payment, given their beneficial impact on contractor cash flow.
When the employer agrees to make an advance payment to the contractor (e.g. to cover the acquisition of raw materials or to obtain manufacturing slots), it will often request an advance payment bond.
Since retention and advance payment bonds are a substitute for cash, they are usually provided by banks.
Defects liability bonds are less common, but required under certain forms of contract (e.g. IET MF/1).
The most common types of security used to guarantee performance in the United States are surety bonds. Surety bonds for construction projects typically include payment and performance bonds. Payment bonds assure the owner that subcontractors, material suppliers and others downstream from the owner’s contractor will be paid for work performed or for materials supplied. A performance bond guarantees an owner that the contractor will perform the contract in accordance with its terms and conditions. Payment and performance bonds usually have strict time requirements for claims, and often expire at the completion of the project or when the warranty period is reached. Typically the cost for obtaining the bonds is included in the contract price and passed on to the owner.
The other common type of security used in the United States to guarantee performance of a contract is a parent company guarantee. A parent company guarantee, as the name implies, requires that the ultimate parent company guarantee the prompt performance of the contractor’s contractual obligations. This gives the owner additional assurance that any defects or delays in the contractor’s work will be promptly corrected or addressed. The benefit of a parent company guarantee over a surety bond is that the parent company’s liability is concurrent with the contractor’s liability under the contract. That means that claims can be brought against the parent company as long as they are timely under the applicable statute of limitations (unless otherwise modified by contract).
In addition to these types of security, a less common type of security that is occasionally used in the United States is Subguard. Subguard is an insurance policy originally developed by Zurich North American Insurance Company that shifts the risk of subcontractor default from the contractor to an insurance company. Unlike surety bonds, Subguard policies are procured for an entire project and cover all the subcontractor trades working on the project. Subguard policies are typically claims-made policies, meaning that any claims for defective workmanship must be made during the policy term. While Subguard is sometimes used on private projects, surety bonding is required for any public project in the United States.
There is a wide range of securities that are available for employers, amongst which are mainly performance bonds, advance payment bonds, all mainly in from of bank guarantees. The use of parent company guarantees is not that common. The time for which such guarantees/bonds are held for depends on the purpose thereof. Advance payment bonds until the repayment of the advance, plus some additional number of days on top of it, e.g. 15 or 30 days. Performance bonds during the time needed for the completion of construction works, again plus some additional adequate number of days on top it. The latter is usually substituted by a guarantee for the good quality of the conducted works that is issued upon the completion of works, which lasts as long as the agreed upon warranty period, which is in practice not shorter than 24 months.
Employers in the UAE typically have a significant bargaining power advantage and can, therefore, include favourable conditions in contracts to secure their position.
Performance bonds are almost universally required and the majority of these are “on demand” rather than conditional, giving an Employer significant financial protection should the Contractor default on its obligations. Performance bonds are generally required to be in place throughout the term of the contract and are usually between 5-10% of the contract value.
FIDIC Red Book 1999 sets out the circumstances in which the Employer using that form of contract can call on the performance bond. Some Employers may attempt to exclude these clauses so that the Employer has unconditional access to the bond and to avoid scope for a claim by the Contractor.
In addition, Employers can require further bond guarantees from the Contractor. Bid bonds, which can be called if the Contractor reneges on its tender proposal before a performance bond is in place, and advance payment bonds feature in a many forms of procurement. Whereas the bid bond is usually superseded by the performance bond after the contract is signed, the advance payment bond generally stays in place throughout the term of the contract. The value of the advance payment bond will typically reduce in accordance with the remaining liability of the Contractor to repay the advance payment. Normally an advance payment bond can only be called-on to satisfy the liability of the Contractor to repay the advance payment – not against a general failure to perform.
Depending on the corporate structure of the Contractor, parent company guarantees may be required by an Employer. However, due to the “on demand” nature of most performance bonds, parent company guarantees are less common. Parent company guarantees will typically only be offered as a means of guaranteeing performance, or offering step in rights prior to termination, as opposed to unconditional financial security.
Customers usually retain 5-10 percent of the agreed contract price until the project is completed or the contractor has to provide a performance bond that secures the same amount. Bank guarantees are also widely used. After completion of the project the customer usually withholds around 3-5 percent of the agreed contract price until the end of the warranty period, which usually lasts 4-5 years. Instead, the customers warranty claims can also be secured by a warranty bond (“Gewährleistungsbürgschaft”).
Security interests will depend on the contractual agreement. Customary types are performance guarantees, pre-payment guarantees and guarantees provided by parent companies. The period covered by the security will depend on the parties’ contractual agreement. Parties will also agree to so-called retentions. A retention is a percentage of the amount payable under a partial invoice, which is then only paid at the time of the final payment.
This is left to the negotiation of each project, but project owners usually request a performance bond issued by a bank, which will be held until completion of the works.
An advance payment bond, issued by a bank or a parent company, are fairly common for contractor agreements. They are usually held up until a certain level of advancement of the works.
Retention on the price of the contractor agreement is also very common in contractor agreements, but is strictly regulated under French law (see our answer to question 16 below for more details on such retention).
Security available for employers commonly involves the following: (i) performance bonds (i.e. on first demand bank letters of guarantee) that usually represent 5% of the construction contract price; these are usually released on final acceptance of works (i.e. following the lapse of the guarantee period commencing with the provisional acceptance of the works); (ii) retentions on payments that usually represent 5% of each payment effected under the construction contract; these are usually released on provisional acceptance of works (i.e. on provisional hand over of the works); (iii) advance payment bonds (i.e. on first demand bank letters of guarantee) for an amount equal to the advance payment received under the construction contract (usually 10%); the advance payment bond is returned to the contractor following its full amortisation. Further, it is not uncommon in large-scale projects for employers to request a parent company guarantee, especially in cases where the project is performed by an SPV or a subsidiary with limited financial creditworthiness; these are usually released on final acceptance of works.
Performance bonds, advance payment bonds, bank guarantees, and (in rare instances) parent company guarantees, are available for employers on EPC projects. These types of security are held for the construction period plus a retention period. For project finance, the lenders can take security over performance bonds, advance payment bonds, bank guarantees, equipment, receivables, banks accounts, IP rights and shares in joint stock companies. These types of security are held for the duration of the loan.
Owners/Employers often stipulate in the contract that the contractor must provide on-demand performance bonds to guarantee the due performance of the contract. On-demand bonds entitle the owners to call on the bond without the need to first establish a default on the underlying contract. These bonds may be used to compensate the owners/employers when the contractor defaults, or if there is a delay in the performance of the contract.
Parent company guarantee is another form of security commonly seen in situations where a special purpose vehicle (“SPV”) has been formed solely for a specific project. This form of security provides owners with the comfort that the parent company is willing to undertake any default of the SPV.
Advance payment bonds are not unknown but are not commonly used. This would be applicable in circumstances where a contractor applies for an advance payment from the owners to help with mobilization and procuring materials. Typically, the advance payment will be repaid through the deduction of a pre-determined amount from each progress payment of the project. The advance payment bond will then be cancelled upon full repayment.
The norm is for such securities to be tied to cover the entire project phase. What ‘entire’ means will be dependent on the provisions within the contract. Some contracts may stipulate that a bond shall be valid and enforceable until the practical completion of the project whilst others may extend that period till the end of the applicable defects liability period. It is also common for contracts to impose an obligation of procuring separate bonds covering different stages of the contract (i.e. construction bond and warranty bond).
Unaccounted delays may result in the lapse and expiry of these securities Therefore, it will be prudent for contracting parties to insert provisions imposing an active renewal obligation to ensure the validity of these securities.