Parent company guarantees and performance bonds are typically used in the construction and engineering industries to provide a developer with some security in the event that the contractor breaches the building or engineering contract or, in some circumstances, upon the contractor's insolvency.
In the current economic climate, contractor default is, unfortunately, even more prevalent in the construction and engineering industries, and so the issues surrounding parent company guarantees and performance bonds are very much in focus for developers.
What is a parent company guarantee?
Typically a parent or other group company of the contractor grants a guarantee in favour of the developer in terms of which that Guarantor guarantees the performance of the contractor under the building contract.
There is no set form of parent company guarantee, however, a well drafted guarantee will provide the developer with the ability to recover from the Guarantor all losses and expenses which the developer incurs or will incur as a result of contractor breach or insolvency.
What is a performance bond?
A performance bond is usually provided in favour of the developer by an independent financial surety (often a bank or insurance company). The surety will charge a premium to the contractor who will usually recoup the premium from its developer under the building contract. The contractor will also be required to provide the surety with a counter-indemnity, should the surety have any liability under the performance bond. Counter-indemnities typically contain onerous requirements on contractors and should be carefully reviewed.
In the event of a valid claim under the bond, the surety will reimburse the developer's losses and expenses arising from contractor default up to a cap (often 10% of the original contract value).
A standard form of performance bond is produced by the Association of British Insurers (ABI) and this form is widely (although certainly not exclusively) used in the construction and engineering industries. The ABI form is often amended to ensure that it clearly provides cover in the event of contractor insolvency.
There are two main types of performance bond:
Provided that the notification requirements of the bond are complied with, in the event of a claim the surety is obliged to make payment on demand to the developer. On-demand bonds are not linked to the contractor's default under the building contract.
Generally, contractors may be more reluctant to provide an on-demand bond as these can have implications for their credit facilities – a parent company guarantee is a contingent liability on the Guarantor's balance sheet whereas a performance bond is a charge on the contractor's balance sheet.
The surety will be obliged to make payment to the developer when certain conditions under the bond are established, for example, that the contractor has breached the contract or the contractor has become insolvent, and that the developer has suffered loss as a result.
What are the advantages and disadvantages of parent company guarantees and performance bonds?
The advantages of a parent company guarantee over a performance bond are typically:
- there may be no explicit financial cap on the Guarantor's liability and no time limit on the Guarantor's liability (although the Guarantor will have the benefit of any caps or time limits in the building contract). The Guarantor will be liable to the developer to the same extent and for the same period as the contractor is liable to the developer. Conversely, with a performance bond, the surety's liability is invariably limited in time and amount. Often, the surety's liability is limited to 10% of the contract sum and will expire on practical completion (or preferably from the developer's point of view, on completion of making good defects); and
- a parent company guarantee should be provided at no cost to the developer, whereas there will be charge for performance bonds which the contractor will usually seek to pass to the developer and this will vary depending upon the insurance market's view of the risk of the contractor. Indeed it can be useful to ask contractors to provide a price for a performance bond at tender stage as part of the developer's investigation of the financial health of the contractor.
However, turning to the advantages of performance bonds:
- the main reason for seeking a performance bond or parent company guarantee is to provide the developer with comfort that it will be able to recover its additional costs of completing the works should the contractor become insolvent. However, if the insolvency event affects the whole group (i.e. the contractor and the Guarantor) then a parent company guarantee will provide little, if any, security; and
- the contractor may not have a parent or holding company from whom a parent company guarantee can be offered.
The standard position is for developers to seek both a parent company guarantee and performance bond at tender stage and then to decide at the point of signing the contract which it wishes to take. However, the possibility of taking both forms of security should be considered if this is warranted in light of the nature of the project, the contractor and the perceived risk of default or insolvency.
A robust analysis of the contractor's financial health should form part of this decision making process and this in itself will be of benefit to the developer in choosing a contractor.
When deciding on a security package, the financial covenant/strength of the Guarantor or surety will be critical. If the Guarantor or surety is not based in the UK, additional precautions should be taken to ensure that the bond or guarantee is valid and enforceable in the jurisdiction in which the Guarantor or surety is based (e.g. a legal opinion from a local lawyer).
Lastly, it is important to note that, under common law, certain events under the contract (e.g. variations to the building contract) can discharge a guarantor's or surety's obligations to the developer, therefore care must be taken when drafting performance bonds and parent company guarantees to ensure that such events do not affect the security afforded to the developer.