Performance security is a prominent feature of construction projects and is used as a means of protection for the Employer against the non-performance of the Contractor. The advantage to the beneficiary of the bond (i.e. the Employer) is that a third party surety (often an insurance company or bank/funding institution) agrees to fulfil the Contractor’s obligations under the underlying construction contract or to pay a sum of money that was advanced to the Contractor by the Employer. Bonds issued by a robust and reputable bond provider with a strong credit rating certainly provide comfort to the Employer in the event of default, insolvency or termination of the Contractor. Further, in the development finance context, its lender will also seek to ensure such performance security is in place to protect the Employer’s interest in such scenarios and protect the lender’s interest in an enforcement/step-in scenario.
The term “performance security” captures all types of third party security instruments. The most commonly used in the construction context are performance bonds and advance payment bonds. Whilst often referred to interchangeably (and both do fall under the umbrella of “performance security”), these instruments serve different purposes and often include different trigger events that allow the Employer to call on the bond.
What’s the difference between an advance payment bond and a performance bond?
Advance payment bond
An advance payment bond (APB) is often used in the construction and engineering industry in circumstances where an Employer has agreed to make a payment to the Contractor prior to the Contractor fulfilling its obligation for that payment. For example, it can provide the Contractor with funds for site mobilisation or the purchase of key materials or equipment manufactured off site. The concern on the Employer side is failure by the Contractor to fulfil obligations for which the Employer is already out of pocket. As a means of protection against this, the Employer may require the Contractor to provide an APB that provides that, once called upon by the Employer in accordance with its terms, the issuer will refund the advance payment or the “unperformed” element of the advance payment to the Employer.
Key features of an APB:
- The issuer has an independent, primary obligation to pay the bond amount under the APB to the beneficiary on receipt of a demand that has been properly issued in accordance with the terms of the APB.
- As APBs are regarded as a substitute for cash, they are usually on demand rather than on default based instruments.
- The issuer is often a bank rather than an insurance company.
- APBs usually cover the entire of the advance payments made to the Contractor, whereas a performance bond is often a percentage of the overall contract sum.
- The issuer will usually seek evidence that the advance payment has been made to the Contractor prior to its obligations under the APB taking effect (for example by way of copy of a SWIFT transfer of the bond amount to the Contractor by the Employer).
- The bond amount may increase to cover further advance payments made under the underlying contract or decrease as the obligations under the underlying contract are fulfilled e.g. an advance payment of 10% is made for the order and delivery of equipment and the bond value decreases by 10% when such equipment is delivered to site and approved by the Employer.
- An APB will often have a fixed expiry date with mechanics under the underlying contract for the Employer to seek an extension to the existing APB or replacement APB if the relevant obligations relating to the advance payment have not been fulfilled prior to such fixed date.
The clue is in the name – a performance bond is security for the Employer for the performance by the Contractor of its obligations under the contract. If the Contractor fails to fulfil its obligation under the contract, for example due to insolvency, the Employer will suffer a loss . In such circumstances the Contractor needs to be terminated and replaced and the Employer will need to procure a replacement contractor (potentially at a premium price) in order to try to make up the lost time and complete the works.
Key features of a performance bond:
- Can be on demand or on default but are usually on default based instruments meaning that the issuer has secondary obligation to the beneficiary that is contingent on failure by the Contractor to fulfil its primary obligation to the Employer under the contract – trigger events typically include breach of the contract, insolvency or termination for contractor default.
- The issuer is often a bank or insurance company.
- Performance bonds usually cover the risk of the Contractor’s default or insolvency up to an agreed limit (in the Irish market, usually 10% of the contract sum under the relevant construction contract, often reducing to 5% on practical completion of the works).
- Performance bonds do not usually have a fixed expiry date but rather remain in place until the end of the defects liability period or a minimum period of time following practical completion (in the Irish market, usually 12 – 15 months).
- Performance bonds often provide that the Employer is entitled to recover amounts that are “established and ascertained” under the performance bond. Following the decision of the Irish case Clarington Developments Limited v HCC International Insurance Company, such words were interpreted by the courts as the Employer having to first exhaust the dispute resolution procedures under the relevant construction contract to crystallise the amount to which the Employer was entitled.
It is worth noting that, while performance bonds can help the Employer recover some of the costs incurred in finishing out the works in an insolvency/default/termination scenario, the Employer would first need to complete the works. Thereafter they can attempt to recover costs under the bond, however this may be challenged by the bondsman particularly in a difficult economic climate. In this sense, performance bonds are a means of recovering costs post completion and not a liquid instrument to fund completion of a project in a default scenario.
Recent Trends in Irish Market
The Irish market has seen an increased use of APBs in recent years. This is primarily being driven by the current delays and shortages in supply chains that is being experienced globally because of the aftermath of Covid-19 and the effects of the on-going conflict between Russia and Ukraine. Such delays and shortages have led to continued surges in prices of fuel and materials in particular. According to the latest Construction Industry Federation Economic Outlook research, 96% of construction companies have reported a rise in the cost of building materials between June and August 2022, with 85% expecting cost rises to continue to year end. The increasing cost of materials was cited as the top concern for companies over the next three to six months (86%). In response, many Employers are asking Contractors to place orders at an early stage in order to lock in prices and production/factory slots for key materials and equipment. Consequently, Employers are increasingly seeking APBs as security for such advance payments. This can pose a challenge to subcontractors and some smaller main contractors who may not have a sufficiently strong balance sheet or credit rating to facilitate the issue of performance security. Employers should carry out detailed analysis and due diligence of the supply chain to identify the pinch points and where performance security can assist. Employers should also work closely with their insurance advisors to map an overall realistic and achievable plan for performance security for the project, in the context of the current market and the financial strength and credit rating of the relevant contractors and subcontractors.
For further information in relation to this topic, please contact Siobhan Kearney, Senior Associate, Clare McAdam, Lawyer or any member of A&L Goodbody’s Construction and Engineering team.