Unexpected events can derail a construction Project, causing delay and additional costs. This series of blog posts will look at mechanisms available to help Employers mitigate the effects on a Project of Contractor insolvency or default.
In this blog, we focus on: Bonds
A bond is an instrument used to protect a party, for example an Employer, against the non-performance of a Contractor. The bond is provided by a bank or bondsman. The 2 main types of bond used in the UK construction industry are on demand bonds and default or performance bonds.
What are the key differences between an ‘on demand’ bond and a ‘default’ or ‘performance’ bond?
What other types of bond might you use?
Advance payment bonds
An Employer may agree to pay the Contractor an advance payment under the Building Contract. This could be for pre-order of goods and/or equipment. The Employer may be concerned that, if the Contractor cannot perform the Contract or repay the advance payment, if something goes wrong then they will suffer a loss. In this situation, an advance payment bond is typically drafted as an on demand bond. The bank or bondsman will repay immediately when the bond is called upon.
Retention is a percentage (often 3-5%) of the total amount due to be paid to the Contractor, which is retained by the Employer throughout the duration of the Project. Typically, half of this amount is released upon Practical Completion, and the remaining half upon issue of the Certificate of Making Good. The purpose of retaining an amount due to the Contractor is to incentivise the Contractor to properly complete all work and rectify any defects required under the Contract.
Instead of holding back this so-called ‘cash retention’ of 3-5%, a bond can be procured by the Contractor in favour of the Employer in lieu to secure this amount. This is known as a retention bond. Only if Practical Completion is not achieved, or if the Certificate of Making Good cannot be issued, will the bond take effect. The Employer is then able to call upon the bond, provided the Contractor has had the opportunity to rectify any defects in the works (as is commonly specified in the wording of the bond). These bonds are viewed as advantageous to the Contractor in promoting cash flow, with no need to chase payment of the retained monies after completion whilst still providing the Employer with some form of readily accessible security.
Key issues to consider when selecting a bond for your Project:
- Given the risks associated with each particular construction Project, Employers should carefully consider what type of bond they require and are prepared to pay for.
- Carrying out due diligence on the bank or bondsman is recommended.
- The specific wording of each individual bond is critical. Always carefully consider what is covered by the bond and take appropriate legal advice.