When it comes to performance security in construction projects, employers require appropriate protection and recourse to mitigate risks associated with non-performance, ensuring that there are financial remedies available if the contractor fails to meet its obligations.

Conversely, contractors often seek to ensure that coverage is reasonable and proportionate to their liability, avoiding excessive financial strain and reducing exposure over the life of the project as milestones are achieved.

Finding balance between the need for security with the practicalities of project execution ensures that both employers and contractors are protected and can work collaboratively towards the successful completion of a construction project.  There are several different types of performance security that can be utilised in construction projects. In this article, we have considered some of the most common forms of performance security, the purposes they serve and key considerations to keep in mind:

Performance Bonds

• A performance bond can provide assurance to employers that projects will be completed notwithstanding contractor default or insolvency. If a contractor fails to perform, the bond provides some protection from the consequent damages if the contractor does not, or cannot, pay. The ability of a contractor to procure a performance bond can be a good indication of its financial standing. Depending on the particular project concerned and any lender requirements, a performance bond is typically procured as a form of a conditional guarantee or default bond (instead of an ‘on demand’ bond), meaning proof of loss is required. It will be based on a percentage value of the contract price, usually 10%, reducing by half on practical completion and running until at least the end of the defects liability period.   

• A claim under a performance bond is not fast access to cash and careful consideration should be given to the terms of a bond. Typically, a performance bond will include wording such that the bondsman promises to discharge losses and damages “as established and ascertained pursuant to and in accordance with the provisions of the building contract”. Recent case law in Ireland and England serves as a reminder that parties should be clear on what they mean by this language i.e. does it mean that a party is required to establish their losses and damages pursuant to the dispute resolution procedure under the construction contract before a claim can be made (as has been suggested by the Irish courts) or does it require an accounting exercise under the construction contract to determine damages (as has been suggested by the Technology and Construction Court in England). Often significant resources, both in terms of time and cost, will be required to pursue a claim against a bond issuer so it is worth having the drafting clear at the outset.

Advance Payment Bonds

• An advance payment bond (“APB”) is useful where a construction project involves more specialist subcontractor/supplier elements, or elements of a project where design and manufacture will be carried out offsite, requiring the employer to pay significant upfront costs at an early stage. APBs are typically on-demand in nature, meaning proof of liability, causation or loss is typically not required in order for a claim to be made. For instance, in a wind energy project, advance payment may be required to cover the costs of a turbine supplier for the procurement of critical components that can often have long lead times for delivery to site. An employer will typically be entitled to make a call on an APB where the equipment paid for does not arrive on site as required.

• As a form of ‘on demand’ bond, it may be an additional comfort to an employer if the APB is issued by banks who have a reputational interest in making payments very promptly and without challenge. We understand, however, that the bond market has tightened such that availability of on-demand bonds is increasingly limited.

• In certain circumstances, parties may agree to have sliding scale mechanisms whereby the APB reduces in value by reference to key milestones throughout projects to reflect advance payments recouped through the typical valuation process. Thought needs to be given to the fact that certain sub-contractors and main contractors may not be able to provide APBs for significant payments due to the financial standing and counter-indemnities required by the bondsman.

Parent Company Guarantee

• A parent company guarantee (“PCG”) is a performance guarantee given by a parent company to support the performance of a subsidiary entity who is a counterparty to a contract in a construction project. From an employer’s perspective, it is always worth considering as part of the due diligence process whether you are contracting with a parent entity or subsidiary. If the latter, they may have no assets or perhaps not have been in existence for very long. A parent entity will also likely have a better financial standing than the subsidiary entity and this will inform the need for a PCG to be provided.

• It is worth bearing in mind that an issue with a subsidiary (such as insolvency) is likely to affect the parent entity as well, potentially diminishing the value of the PCG. This will depend on the size and structure of the group.

Retention and Retention Bonds

• A sum of cash retention is often held back by the employer from the contract sum, usually between 3 and 5 %. This can provide the employer with security, particularly in terms of rectification of defects. The amount of retention needs to be a sum significant enough to incentivise the contractor to rectify the defects and thought needs to be given to the cost of administering retention release, particularly in the context of sectional completion as, if the sum is insignificant, the cost of administering its release may well exceed the sum.

• In larger projects, retention can amount to a significant portion of the contract sum and potentially impact on a contractor’s cash flow. An alternative to withholding of retention is to put in place a retention bond which is another form of on demand bond that will usually be triggered by a contractor failing to rectify defects. These will typically be on-demand in nature and, therefore, be more costly.

Collateral Warranties

• Collateral warranties are akin to direct agreements and aim to ensure that a beneficiary with an interest in the works (such as a lender or employer) has direct recourse against a third-party warrantor (such as a contractor and/or sub-contractor).  They are provided in addition to the primary agreement that is in place (namely the building contract or the sub-contract). The beneficiary will have a right to sue the warrantor in the event of any breach of the collateral warranty. Collateral warranties provide an important additional layer of protection against risks relating to performance (such as the insolvency of a main contractor), to ensure that contractual recourse is still available to a beneficiary.

Due Diligence

Recent events, such as the high-profile administration of ISG in the UK, offer a timely reminder for employers to consider the use of performance security in construction projects. Notably, there has been a significant increase in insolvencies in the Irish construction industry recently, with 89 insolvencies recorded in 2023, representing just over 13% of total insolvencies. This represents an increase of 62% when compared with 2022, when a total of 55 construction insolvencies were recorded. Of course, insolvency is just one of the many risks, including default, non-performance and termination, that impact on a contractor’s performance in a construction project and for which performance security offers protection to the employer.

It is important to remember that performance security is not a substitute for a robust due diligence process that should be carried out in the early stages of a construction project. Thorough due diligence on the financial strength, experience and track record of the contractor is always prudent to protect against risks impacting on performance and the overall success of a project.

While the size and duration of the project may well dictate how thorough this due diligence exercise will be, performance security should be viewed as an additional layer of protection to stakeholders looking to manage risk in a construction project.

Thompson Barry Doherty, Associate www.arthurcox.com

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