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?
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.