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Securing Contractual Obligations: An analysis of Construction Bonds from an Employer’s perspective

By Solape Peters and Oluwatobiloba Akinyede

Introduction

A bond is a promise by deed, where the person giving the promise (the “Obligor”) promises to pay another person (the “Obligee”), a sum of money.[1] In the construction industry, the most common kind of bond is a performance bond entered into by a bank or insurance company at the behest of the contractor, in favour of the employer.[2]

In construction contracts, bonds are mechanisms implemented as a means to secure contractual obligations between an employer, who instructs works to be undertaken and a contractor, who carries out the works. They generally protect the interests of the contracting parties, i.e., the employer, contractor, and by extension the subcontractors and suppliers, as well as indemnify them, should the need arise, by ensuring the smooth completion of projects. In addition, these security mechanisms ensure the performance of contractual obligations in construction projects such as payment obligations, compliance with some specific and limited obligations (as seen in bid bonds), compliance with due and comprehensive performance by the contractor of all of his various contractual obligations owed in return for the contract price[3]. In essence, one of the commercial reasons understood in the construction industry, for requesting bonds from contractors or subcontractors, is the need by employers or main contractors to be assured of the ultimate financial ability to meet its contractual obligations.

The underlying requirement which determines what type of bond is taken out by either the employer or the contractor is predicated on the appropriate balance of risks and the party best placed to manage and bear such risks.

Methods of securing contractual obligations

Contractual obligations are secured by being included as a term in the contract, i.e., liquidated damages, or by a separate security agreement, i.e., bonds.[4] Bonds can be of a conditional nature, or an on-demand bond. A conditional bond is one which is expressed and conditioned upon a particular event or events and commonly upon the satisfactory performance of the contractor. The employer’s right to recover is dependent on the construction of the bond; thus, if the bond guarantees the contractor’s performance, the employer has to establish damages occasioned by the breach of the contractor’s obligations. On the other hand, on-demand bonds are unconditional bonds obliging payment simply on demand.

      Types of Bonds

The various type of bonds in a construction project also include:

  • Bid bond:

This is required to be submitted along with a bid for a contract. The primary aim is to ensure that interested pre-qualified applicants stay committed to the bidding process. It ensures that where a bidder withdraws, after being chosen as the preferred bidder, the bidder either executes the contract or the employer claims against the bid bond, which would cover a re-tender or subsequent award to another bidder.[5]

  • Performance bond:

This form of security ensures that the contract will reach the completion stage, in accordance with the obligations agreed upon in the contract. The performance bond protects the employer from loss if the contractor defaults on performance obligations. Where there is a default in completion of the contract, the contractor pays the employer the amount agreed upon in the performance bond for the specified period of time.[6]

  • Payment bond:  

This is a form of security is usually obtained by the contractor, guaranteeing payment to subcontractors and suppliers which the contractor engages on the project. This bond is taken out pursuant to subcontracts and agreements between the contractor and subcontractors or suppliers. This form of security protects the employer from financial liability and liens over the property, which may arise from the failure of the contractor to pay for goods and services from material suppliers or subcontractors. The bond is primarily to protect the employer; however, it extends to protect the interests of suppliers and subcontractors. It ensures payment by the policyholder, the contractor, and where the contractor fails to pay, a claim can be made against the payment bond. [7]

Payment bonds can also be taken out by the employer, in favour of the contractor, as a means of ensuring payment of all agreed sums in the contract to the contractor.

  • Maintenance/Warranty bond:

This serves as an assurance of the quality of work done. They guarantee that there will be no structural fault or defect for a fixed period of time. Where there is, the employer can claim against the bond.

  • Retention bond:

These are bonds that protect the employer even after the completion of the project. A percentage of each payment of the contract sum is withheld till the completion of the project, to ensure that it is completed up to standard. Where they are not, it ensures that any defect or fault is rectified by the contractor.[8]

  • Adjudication Bond:

Adjudication bonds are conditional bonds that have emerged on PFI/PPP projects and are payable on an adjudicator's decision. Adjudication bonds are most suitable when the adjudicator’s decision is final and binding. If this is not the case (i.e., the adjudicator’s decision is an interim one), complex procedures are necessary to balance payments if subsequent dispute resolution procedures reach different decisions.

Liquidated Damages

Liquidated damages are pre-determined damages, set at the time that a contract is executed, based on a calculation of the actual loss the client is likely to incur if the contractor fails to meet the completion date. Liquidated damages are not solely applicable to delay related breaches, they could also be compensations for failure to meet specific performance targets. What is crucial is that the parties have agreed at the outset that the value of liquidated damages is a genuine pre-estimate of loss that either party would suffer. Therefore, if the contractor fails to fulfil his obligations as it relates to time for completion, he is in breach of the contract and liable to damages.

In construction projects, time is of the essence in ensuring prompt completion and as such, contracts should contain suitable provisions regarding the time for completion, how request for any extension of time should be treated and how progress is assessed and monitored and what is regarded as failure to proceed diligently.

Parties would typically agree that a liquidated sum of which same has been fixed and agreed, would be paid as damages for  breach of contract.[9] A typical clause would require, that if the contractor fails to complete works by the date stipulated in the contract, or any extended date, he shall be liable to pay or allow the employer to deduct liquidated damages per day or per week at a rate earlier agreed and for the period which the works remain uncompleted, up to a maximum percentage of the value of the contract.

A liquidated damages clause saves considerable costs and time, because whilst there may be damage on account of a delay in completion, proof of same may require the appointment of legal representation and court proceedings, which could further complicate things. The agreement on liquidated damages in the initial stages saves on the time and cost of legal representation and court proceedings.

It is important to note that, where the liquidated damages, is assessed as being a penalty of any sort, it will not be enforced by the Courts.[10] In addition, where there is an express or implied waiver of the liquidated damages by the employer, same will not be enforced irrespective of whether the employer received consideration for such waiver. Also, where the employer prevents the completion of works in any way, the general rule is that he loses the right to claim liquidated damages and cannot insist on a condition, if it is his fault that the condition has not been fulfilled.[11]

Validity of Bonds, how they operate and lapse.

Construction projects require substantial investments, and as such, employers cannot afford to shoulder all the risks associated with the project. Consequently, bonds are important for various reasons, which include:

  • Performance guarantee:

Various factors could make completion of a project impossible after its commencement. Bankruptcy of the contractor or lack of commitment of the contractor are some of the reasons why a project might fail. Bonds provide a form of guaranty that the project will be completed based on the agreed terms, and if it is not completed, the employer is entitled to make a claim against the bond and be compensated. This protects the employer from being at a complete loss.

  • Payment guarantee:

In the course of construction, the contractor purchases material to work with and more often than not engages subcontractors, either as domestic or nominated subcontractors, to carry out certain works on the project. Payment bonds ensure payment for all goods and services utilized during the project, and where the contractor defaults on payment, the sub-contractors and suppliers can claim against the bond.

  • Protection from liens:

The existence of a payment bond, obtained by the contractor, being the policyholder, protects the employer from financial liability and subsequent liens being brought against the property, where the contractor has transacted with third parties in the cause of construction and failed to perform his obligations to them. An example of this would be where the contractor fails to pay subcontractors and suppliers for their work and materials.

  • Time Saving:

By providing a readily available source of funds that can be claimed against, should the contractor fail to fulfil his contractual obligations., as opposed to having to bring an action against the contractor after breach, the process of compensation is sped up.

The expiration of a bond would depend on the type of bond it is and what obligation it is attached to.

Performance bonds ensure the performance of the contract in its entirety, according to the contract terms. They become operative once the condition precedents have been met and the contractor has access to the site to begin the works. Typically, conditions precedent may include obtaining regulatory approvals, requisite notices, the acquisition of a bank guarantee, creation of a Special Purpose Vehicle (“SPV”). Hence, these bonds would typically expire when the contract has reached its completion stage, or, when the contract ceases to exist.

Payment bonds are attached to the contractor’s obligation to pay for all goods and services, utilized in the actualization of the project. These also become operative when the contract is signed and payment is due. As such, it ceases to exist when all debts have been paid by the contractor, and the employer can no longer be liable for the debts. Payment bonds on the other hand, where taken out by the employer, depending on whether the construction contract is standardized or not, could either be tied to milestones in the construction projects or the entirety of the project. Thus, where the payment bonds are tied to milestones, as each milestone is reached, bond should reduce, so as to reduce the cost of taking out these bonds on the employer.

Bid bonds create an obligation on the bidder/contractor not to withdraw his bid after being chosen as preferred bidder and perform the contract. The employer would be compensated with the bond where he fails to do so, saving him the cost of a subsequent bidding process. These are usually involved during the procurement stage and will typically fall away once a preferred bidder has been appointed.

Maintenance/Warranty bonds are attached to the quality assurance obligation, and as such, a time frame is fixed, within which the employer can claim against the bond, where there are structural defects or faults. While these may be procured during the performance period, they usually become operative during the defects liability period. Warranty bonds can be used to ensure that the contractor continues to provide services, rectifying defects that become apparent after practical completion has been certified. This is generally an on-demand bond that may be required on projects where there are no remaining payments to be made, or other security such as retention, after practical completion.[12]

A retention bond is also for a fixed time frame, as such, it will expire when the time frame elapses.  The purpose of retention is to ensure the contractor properly completes the activities required of them under the contract. Half of the amount retained is released on certification of practical completion and the remainder is released upon certification of making good defects.

Negotiating Bonds on behalf of the Employer

An employer would negotiate construction bonds, as well as liquidated damages, in order to ensure that the construction project progresses without undue delays. In the course of negotiation, a key consideration would be the allocation and balance of risks. The essence of negotiation for the employer would be to ensure that the employer is protected throughout the duration of the project and does not shoulder all the risk alone. The following are key points to be considered when negotiating bonds by the employer:

  1. The Overall Cost of the Project

The cost of procuring these security instruments is a critical factor which most contractors consider in relation to the overall cost estimate of a project. An employer should therefore ensure that the overall cost of the project is manageable, as the cost of the project also directly affects the cost of obtaining a payment bond by the employer. The higher the value of the contract, the greater the likelihood that the employer would spend more on procuring a payment bond. As such, the employer must factor this in when negotiating and agreeing to a contract price.

2. Risk Balance and Allocation

Construction projects are high risk projects, primarily due to the quantum of loss each party is potentially exposed to. The fair apportionment and balance of risk between parties in construction agreements is an effective means of facilitating sustainable construction projects. The level of risk borne by each party is determined by the structure and term of use of the type of performance security utilized.[13] Therefore, the parties must consider the risks of each project and ensure that these are efficiently balanced between the parties.

Proper contracts administration is essential to ensure that there is a mechanism to monitor the expiration of bonds as well as the renewal and replacement of same throughout the duration of the project. This effectively guarantees that the interests of the employer are protected at all times, till the eventual completion of the project to the required standards.

3. Performance Obligations

The purpose of the bonds is primarily to ensure the performance of the contractor throughout the duration of the contract. The major benefit the employer derives, in addition to ensuring the project is completed on time and ensuring the contractors perform well, is the financial protection in the case of a contractor default. In such cases where a contractor defaults, the institution that issued the bond is required to compensate the employer for any amount outstanding on the bond.  In effect, the employer’s exposure will be limited under each stage of the project, whether for performance, retention, warranty, or advanced payment. Considering the fact that the employer’s exposure following the default by the contractor is limited, the contractor would be more inclined to complete the project to ensure it is fully paid as agreed and the bonds returned.

  • Conclusion

Bonds are an essential requirement in construction projects and ensure that parties are adequately protected and compensated where defaults occur. Notwithstanding the fact that contractors are obligated to see construction projects to completion, there is need for security for the employer because of the protection against losses resulting from the Contactor’s contractual failure. Executing a construction contract without a form of security could see the employer unable to recoup its losses. Employers must therefore insist that contractors provide the various bonds discussed above, in order to ensure that at each stage of the project, the employer is protected and the project is completed in a timely and satisfactory manner.

 

[1] Anthony May (1995) Keating on Building Contracts. London: Sweet & Maxwell at p273.

[2] ibid

[3] I.N Wallace (1995) Hudson’s Building & Engineering Contracts. London: Sweet & Maxwell at p1496.

[4] Gould N, “Project Security: Bonds and Guarantees - Fenwick Elliott” (Fenwick Elliott) at p1. https://www.fenwickelliott.com/sites/default/files/nick_gould_-_project_security_bonds_and_gurantees_paper_for_university_of_vienna.indd_.pdf; accessed March 15, 2023

[5] Collum J, “4 Main Types of Construction Bonds Explained” (FCA Insurance December 12, 2022) https://fcainsurance.com/blog/the-4-main-types-of-construction-bonds-explained/; accessed March 14, 2023

[6] “What Is a Construction Bond?” (What is a Construction Bond: Construction Bonds Explained | Viking Bond Service) https://www.performancesuretybonds.com/contract/what-is-a-construction-bond/; accessed March 14, 2023

[7] Killough D, “A Contractor's Guide to Construction Bonds” (Procore March 9, 2023) https://www.procore.com/library/construction-bonds-guide; accessed March 13, 2023

[8] “Retention Bonds: Find the Best Deal & Cover” (Surety BondsMay 12, 2020) https://suretybonds.ie/retention-bond-ireland/#:~:text=In%20the%20case%20of%20the,full%20payment%20has%20been%20made).; accessed March 16, 2023

[9] ibid

[10] Watts, Watts & Co. Ltd v. Mitsui & Co Ltd [1917] AC 227(HL)

[11] Amalgamated Building Contractors v. Waltham Holy Cross U.D.C [1952] 1 All ER. 452

[12]“Bonds in Construction Contracts” (Bonds in construction contracts - Designing Buildings) https://www.designingbuildings.co.uk/wiki/Bonds_in_construction_contracts#:~:text=The%20defects%20liability%20period%20(now,become%20apparent%20in%20the%20works. accessed March 20, 2023

[13] Oke, Ayodeji & Ogunsemi, Deji & Ogunlana, Stephen & Aje, I.O.. (2016). Evaluation of risks associated with bonds and guarantees in construction projects. https://www.researchgate.net/publication/313850784_Evaluation_of_risks_associated_with_bonds_and_guarantees_in_construction_projects accessed March 15, 2023

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