Introduction
Clients in the global construction industry have traditionally insisted on contractors providing construction bonds on most major projects as a means of providing security for performance. As project values increase, so do the face amounts of these construction bonds, to the point that they now involve a significant expense for the contractor to secure. These expenses are not only the fees charged by bondsmen, but also the cost of tying up credit lines or working capital. The demand for construction bonds varies around the world but it is often the public sector clients, which have the most rigid requirements.
Due to the prevalence of construction bonds, it is timely to consider both the different type of bonds used, as well as the five key checks, which need to be performed by any consultant or client upon receiving a bond for a project.
Key Types of Construction Bonds
The following are the main categories of construction bond found on projects around the world, generally in the sequence in which they would arise on a project. The names of these bonds may vary a little depending upon the jurisdiction, but the function and intent is the most critical aspect to recognise.
- Tender Bonds
These are typically bonds submitted by a bidder with his tender submission. They are normally a fixed value (i.e. a value set by the client in the tender documentation) which indirectly reflects a proportion of the expected tender value. Some government clients establish the value as being similar to the value of any future construction bond. This strategy enables these bonds can remain valid until the main construction bond is provided by the successful contractor. Other clients set the value at a more conservative value to cover simply the risk of a potential bidder withdrawing from the tender process.
Ultimately, these bonds are designed to provide the client with financial security / compensation in the event a bidder decides to withdraw his tender (except in the case of a valid / permitted reason) before an award can be made. Therefore, it is critical that these bonds are unconditional (“On Demand”) so the client can have access to the funds immediately without having to take any other action.
- Advance Payment Bonds
Another consequence of larger construction projects is the increased demand from both contractors and consultants for advance payments. These payments are intended to aid the commercial cashflow of the people performing the work or services. However, they are often seen by clients as being a risk area because payment is being made prior to any services being rendered or construction activities completed.
To balance the client side risks, bonds have become a frequent reciprocal demand in exchange for any advance payment being released. Usually these bonds are of the same value as the amount advanced. In some cases, these bonds are gradually diminishing in value (in response to a periodic repayment of the advance payment during the interim payments). Where the bond value remains fixed it is often the case that the maximum recovery under the bond will be capped at the amount of the advance payment outstanding at the point of any claim. As is the case with the tender bond above, these bonds are also typically “on demand”.
- On Demand Bonds
The previous two categories of bond have both made reference to “on demand” bonds. These bonds are defined as being bonds, which can be presented to the bondsman without having to refer to the other party or providing any reasons for making the call. Obviously, these types of bond act in a similar way to a cash security and therefore attract a significantly higher premium (cost to the provider) than any other type of bond. Interestingly, in those parts of the world where these bonds are the most commonly used (the Middle East for example) the cost premium is greatly reduced. The reason is that in these locations bonds are rarely called and the construction markets are much smaller (i.e. the number of client organisations involved are less numerous) meaning the bondsmen have a closer and more detailed knowledge of the market risks involved.
It is important to note that if a bond has any conditions attached through the wording used, it will automatically fall into the next category of being a “conditional bond”.
- Performance / Default Bonds (“Conditional Bonds”)
As noted above, the most typical construction bond is one, which has certain conditions attached to it. These maybe linked to general performance, or to compliance with specific obligations. In each case, if these stated conditions are met, the bond can be called, usually after a notice / warning period has been initiated. If the conditions are not met, the bond cannot be touched. Therefore, these bonds are providing assurance to the client in the event the contractor fails to perform his duties or obligations (usually progressive performance of the works / services). They are intended to provide the bridging financing for the losses / additional costs incurred by the client if they have to replace the original contractor for the completion of the works.
It is worth noting that in most cases, the amount of loss suffered or additional costs incurred has to be justified prior to any settlement against the bond being reached. In other words, a client has to incur the actual expenses prior to receiving any recovery against the bond. This often results in protracted legal action between the parties and in some cases inflates the actual cost impacts involved.
- Retention Bonds
This final bond category is perhaps still the least common at a global level. A retention bond is typically provided by contractors in lieu of cash retention being held by the client. The value of the bond usually matches the total retention value, which was to be held under the contract, and is designed to provide protection for the client should the contractor fail to rectify any defects identified. The benefit to the contractor is that the cash retention is released immediately (aiding free cashflow). The risk for the client is that this type of bond often has specific conditions attached to it making access to the money more complicated and resulting in difficulties in financing the necessary rectification works. The ideal solution is to request an “on demand” bond, but contractors often resist this arrangement wanting to provide a more direct link between the client’s ability to access the money and the actual default.
Checks to be Carried Out when Receiving a Construction Bond
Once the type of bond has been determined and it duly arrives from the submitting party, there are five critical checks, which need to be performed before the original bond (it must be an original document not a copy / email) can be placed in the company safe.
- Bondsman
Seems obvious, but it is important to ensure that the bond is issued by an organisation who has the necessary authorisation. Although insurance companies sometimes issue construction bonds, this has to be specifically permitted, most clients insist on a bond coming from a locally registered bank only.
In the case of government clients, they typically have an approved list of banks, which are vetted in advance. Ensuring compliance with these requirements is important since the financial stability of the bondsman could be critical in the future.
- Parties
All bonds state the party providing the bond along with the name of the client organisation. It is important that both parties are correctly recorded (i.e. the names and addresses match those set out in the construction agreement and are registered legal entities). In the case of Joint Venture (JV) contractors, it is important to ensure the legal entity of the JV actually exists (in project specific JVs the legal formation may take a number of months after formal contract award); otherwise, there may be issues in calling the bond in the future.
- Value
The value of the bond should be clearly stated in both numbers and words (which match each other). Where the bond value is calculated based upon a percentage of the awarded contract sum, the calculation should be checked and no rounding or modification of the exact amount should be made. It is common for bonds to be issued in advance of the final contract sum being established, in these cases the bond should be updated to reflect the final figure agreed by the parties.
In those contracts where the bond value has to be adjusted periodically, in the future to reflect any agreed variations it is important that an accurate track of all changes be maintained.
- Duration / Validity Period
Depending upon the type of bond involved, the validity period may vary, but typically for main construction work, the bond will be valid for the construction period, maintenance / defects liability period, plus a further 90 days.
Tender bonds are typically issued to cover the tender validity period only. Similarly, retention bonds are usually valid up to the end of the maintenance / defects liability period. For these types of bond, it is important to include wording to cover specifically how any delay in issuing the Final Completion Certificate will be handled.
Advance payment bonds are usually valid until the point that the advance payment has been repaid in full, which is often for the complete duration of the contract period.
- Conditions for Calling Bond
Where the bond is a performance / default one, then the conditions, which have to be satisfied before it can be called, must be clearly defined and met. Often a contract may have a fixed wording for these types of bonds; in these cases, it is important to ensure the bond submitted matches exactly the requested wording. These bonds typically require the client to prove that the all the conditions have been met before they can make a claim.
As noted above, any deviation in the bond wording can dramatically change the ability to call the bond in the future. Therefore, this check is by far the most important of the five identified.
In the case of “on demand” bonds, there are no such conditions and the bond can simply be presented to the bondsman for payment.
Conclusions
The provision of any type of construction bond is now so common it has become increasingly important that both clients and consultants fully understand the nature of the different bonds being provided. Furthermore, ensuring key basic checks are carried out when the bond is submitted ensures future surprises are avoided.
A final note, as project deadlines are either extended or delayed, it is important that regular reviews are carried out to ensure the validity of the bonds submitted remain in accordance with the contract provisions. There is no excuse for having a bond expire prematurely.
Plateau Group 