What is a performance bond?

Despite its name, a performance bond doesn’t guarantee performance – the surety promises to pay up to a specific sum for some sort of contractor breach provided the employer gives it enough evidence.

If you’d like an analogy, think of them as a type of insurance. In fact, most sureties are insurance companies and grant the performance bond in return for a premium, so it’s not a massive stretch to use this analogy! 

The basics

An image showing the use of a performance bond. There are three entities represented by text boxes stacked in a column: the surety (provider of the bond), the contractor (providing goods, works or services) and the employer (receiving goods, works or services). There is thick black double-headed arrow between the text boxes for the contractor and employer, representing the contract between the contractor and the employer. This is an exchange. There is single-headed curvaceous arrow flowing from the textbox for the surety towards the the textbox for the employer representing the performance bond. For the bond promises only go in one direction. Image by Sarah Fox

The bond is between the employer (or someone paying for goods, works and services) and the surety. The bond relies on and is secondary to an existing contract, generally between that employer and a contractor (or someone providing goods, works and services).

On construction projects, a performance bond allows an employer to bring a contractual claim against the surety if the contractor breaches that bonded contract. Typically, claims arise when the contractor is insolvent or if the goods, works or services are defective.

What's wrong with bonds?

Bonds became ubiquitous on construction projects in the 1980s, but they are a poor solution to the employer’s problems when the contractor is in breach. The employer really wants the cash to get someone else to finish the job properly, or another contractor who will quickly step in.

Performance bonds provide neither. An on-demand bond might provide ready cash (subject to a duty to account for over-payment once you’ve worked out your losses). A cross-company guarantee might provide for performance by a sister or parent company (although decreasingly so).

The problems with bonds include:

  • Timing: Whether it is for defects or insolvency, the employer must sort out the problems, pay the extra costs and then see if it can claim them back. Bonds are not ‘ready money’.
  • Limited: Because of the volatility of the global economy, sureties will only offer bonds to a limited range of contractors; even when they do, many sureties limit their exposure by requiring ring-fenced monies – increasing the cost of bonds, reducing the contractor’s resources to carry out the project and making it more likely the contractor will become unable to pay its debts (ie insolvent).
  • Calls: The surety has plenty of defences ie reasons not to pay out on a claim. Examples include the employer used the wrong claim procedure, or the right procedure at the wrong time, the employer failed to prove breach/amount of losses/link between breach and loss, the contract was amended, the employer did not tell the surety of other minor defaults during the project and so on.

The employer already has lots of security including the retention fund, insurances such as latent defects insurance, and the fact that it pays for the goods, works and services in arrears (sometimes many months later).

Do we really need to keep demanding, securing, negotiating and signing yet more useless paper?

What should you do?

Do not assume that a bond is the best or even a sensible solution to the risk of a contractor defaulting on its obligations.

You should really understand the purpose of and problems with bonds before leaping on the ‘bondwagon’.

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