Last edited 10 Dec 2016

Performance bond for construction

A performance bond is commonly used in the construction industry as a means of insuring a client against the risk of a contractor failing to fulfil contractual obligations to the client. Performance bonds can also be required from other parties to a construction contract.

Whether or not a performance bond is required will depend, in the main, on the perceived financial strength of the party bidding to win a contract, as the most common concern relates to a contractor becoming insolvent before completing the contract. Where this occurs the bond provides compensation guaranteed by a third party up to the amount of the performance bond. Bonds are typically set at 10% of the contract value. This compensation can enable the client to overcome difficulties that have been caused by non-performance of the contractor, such as, for example, finding a new contractor to complete the works.

Bonds can be 'on demand' or 'conditional', with conditional bonds requiring that the client provides evidence that the contractor has not performed their obligations under the contract and that they have suffered a loss as a consequence.

The obligation for the contractor to provide the client with a bond is set out in tender documents. The choice of bondsman and terms in regard to cost falls entirely to the contractor who secures it prior to the start of work. From a client viewpoint it is wise to stipulate that the bond stays in place until the end of the defects liability period when the final certificate is issued.

Bonds can be issued either by an insurance company or by a bank, and the cost of the bond is usually borne by the contractor (albeit, this is likely to be reflected in the contractor's tender price). The cost of the bond gives the client a good guide as to the credit worthiness and reputation of the contractor in the bond market, which will view each contractor differently in respect of its history, management and financial health.

Strictly speaking the bond is a guarantee and as such is a contingent liability in regard to the contractor's balance sheet. A smaller contractor might face a limit on how many bonds it can take out.

The contractor sends the bond document to the beneficiary ie the client who holds it until the end of the defects liability period.

The bond is related to the contract conditions and the courts take a view that the bondsman has little protection against adverse risk. So it is wise to seek the bondsman's consent before acting outside the contract conditions, for example by paying the contractors in advance of work undertaken to ease its cash flow difficulties. Such conduct could jeopardise a subsequent claim on the bond.

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