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Performance bonds and parent company guarantees

View profile for Derryn Rolfe
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Performance bonds and/or PCGs are often required of the contractor in building and engineering projects as a means of securing the purchaser’s position, and limiting their losses, in the event of the contractor’s default. But what’s the difference?

A performance bond is an insurance policy. The contractor takes out the policy with the bondsman – either their own bank or an insurance company – that will, subject to the provisions of the bond, pay to the purchaser a sum of money to offset its losses. The wording of performance bonds varies dramatically, with certain phases being key to how easy it is for the purchaser to call upon it. Over the last 20 years the market has hardened considerably, in common with most insurances, so that the classic “on demand” bond is now rarely available. This type, as the name suggests, means that the purchaser simply must demand payment from the bondsman: clearly a high risk for the bondsman, and the reason why most bonds now require the purchaser’s losses to be proven one way or another. Exactly what level of proof is required is the point of debate between those giving and those receiving the bond. The normal wording now is “established and ascertained”, which is based on the procedures and mechanisms of the underlying contract.

Similarly important is the co-existence of liability with the contractor and the bondsman; the Association of British Insurers (ABI) commonly-used model form of bond doesn’t include this, but the purchaser may well want to do so to avoid the necessity of pursuing the contractor for its losses as a condition precedent to going after the bondsman. The contractor, on the other hand, would wish to avoid this as a co-obligor clause may make the bond more difficult – or expensive – to obtain.

Assignment clauses are another point of negotiation, and whether the ability of the purchaser to assign the bond without the prior consent of the guarantor and contractor is important usually depends on whether or not there is an external funder for the project. A funder will always want the bond to be assignable and will often hold an executed but undated deed if assignment in escrow as part of its security package.

The ability of the purchaser to call in the bond upon the insolvency of the contractor is usually key: it is, sadly, the most common reason for needing to do so. There is still debate about the effect of a 1994 case called Perar BV v General Surety and Guarantee Co Ltd in which the Court of Appeal confirmed that insolvency is not necessarily a breach of a building contract and therefore not covered by the bond. Standard and model form contracts so usually include insolvency as a breach of the contract, but there is still a debate about the timelines of making a claim under a JCT in particular, so it is worth ensuring that it is explicitly covered.

But regardless of the details of the drafting, the point of a performance bond is to provide cash; a parent company guarantee, however, could instead (or, indeed, also) be used to require the contractor’s parent company to step in and compete the performance of the contractor’s obligations in the event of their default.

PCGs rise and fall in popularity and use, although the first requirement is, of course, that the contractor has a parent company. If it does, it is normal for the guarantee to be from the ultimate parent company, as complicated corporate structures could mean that the purchaser is holding a guarantee from a shell company with no assets. Some contractors prefer a PCG because it doesn’t affect their credit rating in the same way as a performance bond and can come at zero cost. It does sit as a liability on the books of the parent company, though, so company policy may mean that PCGs are not always free. As with performance bonds, the detail of the drafting is key to the ease with which the purchaser can get recompense. Many of the same issues apply as with bonds, but whereas bonds tend to be for a percentage of the contract sum PCGs tend to be for the entirety of it. The most important provision for the purchaser is to ensure that the guarantor cannot act against the contractor for its own losses whilst the guarantor’s liabilities to the purchaser are unsatisfied.

So which is best? Neither: they both have their place. If the purchaser definitely wants the project completed with single-point design or workmanship liability, or if time for completion is the critical issue, then a PCG is the only option. If they want cash, then a bond is probably the answer – an independent bond is safer than one from a parent company which may also go into insolvency. Asking for both is, except for major projects, probably overkill.

If you have any questions on Performance bonds or parent company guarantees, our Construction and Engineering team will be happy to help. Please get in touch for further information