Negotiation & enforcement of performance bonds - key considerations

01/04/2009

By Chris Kirby-Turner, Solicitor in Construction & Engineering.

In the current economic climate, a contractor may well become insolvent during the course of a project, during the defects liability period or before a dispute is resolved.

As such, a prudent employer will seek robust security. Devices such as a parent company guarantee may prove worthless where a group of companies is in significant financial difficulties. By contrast, an insurer or bank-backed performance bond may provide considerably greater comfort. However, they are not necessarily as fail-safe as they are perceived to be. This article outlines some key issues relevant to their negotiation or enforcement.

The two main types of bond

A 'guarantee bond' requires the employer to prove the bondsman's liability, by showing that the contractor is in breach of contract and that recoverable losses have flowed. The bondsman's liability (to the financial cap in the bond) is co-extensive (or 'back-to-back') with that of the contractor.

If the bondsman is to be pursued, he should be made party to the proceedings against the contractor, so that he is bound by the result. Otherwise, the employer will have to litigate twice in relation to the same dispute, thereby duplicating costs and time.

An 'on-demand bond', by contrast, simply specifies certain conditions or events which trigger the employer's entitlement to a specified sum. They are generally issued by banks rather than insurers, who prefer not to be concerned by the nitty gritty of a dispute.

The cost of obtaining an on-demand bond is likely to be considerably higher than a guarantee bond, but the costs of enforcement are generally far lower. Therefore, the financial cap of the bond and its premium should not be considered the be-all-and-end-all.

How and when must notice be given to the bondsman?

Bonds will almost invariably be valid only until a fixed date or a certain event (for example, completion of a specific phase or phases of the project). Correct timing is absolutely critical, as the bondsman will have a knock-out blow if notice is given out of time.

The terms of the bond should make the necessary procedure clear. If there are stepped diminutions in the value of the bond (for example, at the end of sequential phases or for the defects liability period), the bond should specify the dates or events which trigger that diminution. Further, the bond should specify how the contractor should give notice to freeze the value of the bond at the higher level where a claim is contemplated.

There is very little authority from the courts as to the default position where the bond itself does not make the necessary steps clear. Leading counsel instructed on one of our recent cases was of the opinion that a written notice should be sufficient to stop the clock for these purposes, but warned there could be “formidable” arguments by a bondsman that the issue of court proceedings was necessary.

Does the contractor have to exhaust all other available remedies first?

Unless there is a specific condition in the bond itself that the employer must exhaust its other options first (such as a parent company guarantee), there is no general obligation on the employer to exhaust other remedies before pursuing the bondsman.

Settlement

A bondsman will not be automatically bound by a settlement agreement reached directly between the employer and the contractor. Any such settlement agreement will generally require the contractor to pay the employer an agreed sum, in consideration of which the contractor is released from its liabilities in the underlying construction contract.

The co-extensive nature of the bondsman's liability means that no claim can be continued or brought against the bondsman once settlement has been agreed with the contractor. There is a genuine risk that a dying company may fall on its sword by accepting a straightforward offer to settle and then default on paying the settlement monies, particularly where the bondsman holds security over the directors' or shareholders' personal assets, or those of connected companies.

Therefore, the bondsman must be party to the settlement agreement. This will require three-way negotiations to take place and very careful tactical considerations must be made throughout the litigation to ensure that offers to settle tie in the bondsman.