What are they?
Most parties to construction contracts are familiar with performance bonds but few will know that these evolved from legal agreements that have been used since before Roman times. Those same principles that were applied by the Romans still exist today.
A performance bond, in the construction industry, is a financial tool most commonly used by developers to provide security for satisfactory completion of a project by a contractor. Issued by a bank rather than the contractor itself the developer relies on the financial standing of the bank to guarantee that compensation will be readily available for any monetary loss up to the amount of the performance bond. In return the bank receives a fee from the contractor at whose request the bond is issued.
In some parts of the world similar forms of security are also available from the insurance industry, though these products differ in some key respects from the bank bonds that are invariably required by developers in Qatar and beyond. Specifically, the products offered by insurers are more akin to a surety or guarantee and, therefore, subject to a significant number of hurdles to a successful claim. Nevertheless, insurance products are widely acceptable elsewhere and provide a valuable form of security for developers in lieu of bank bonds.
Conditional and Unconditional Bonds
Performance bonds can either be “conditional” ie certain conditions are required to be fulfilled before a claim or demand can be made under the bond or, more commonly in this region, “unconditional” or “on-demand”. The grounds under which a demand can be made under the bond are set out in the in the bond itself, though in many cases a construction contract will also require that notice is given by the beneficiary prior to a demand. Conditions range from a simple requirement that the demand is signed by a director of the developer to the more onerous requirement for evidence of default such as a court judgment or arbitration award.
In the case of an unconditional bond, a written demand, up to the sum of the performance bond, will be sufficient. Such unconditional bonds usually explicitly require the guarantor, ie the Bank, to pay to the employer the sum of the performance bond, despite any objection or contest to the same by the contractor.
Problems caused to Contractors
A demand under a performance bond can wreak havoc with a contractor’s cash flow and financial standing. Depending on the type of financing arrangements used to secure the bond a demand when met, results in the sum under the performance bond being converted to a loan on terms that are generally disadvantageous. Moreover, the credit facility can be adversely affected making it difficult for a contractor to obtain additional bonds that are needed to bid for new work or to finance existing projects.
A demand can also adversely affect a contractor’s standing in the market and has usually has the affect of driving the parties into a formal dispute process. For these reasons, demands under performance bonds are often considered a last resort.
Contractor protection
- Employer’s Indemnity
In some contracts, employers are obliged to indemnify the contractor where it is determined (at a later stage by a court or arbitration panel) that a wrongful demand has been made under a performance bond.
An example of this type of clause can be found at clause 4.2 of the FIDIC Conditions of Contract for Plant and Design Build and the Conditions of Contract for Construction (First Edition 1999). Clause 4.2 states:
“The Employer shall indemnify and hold the contractor harmless against and from all damages, losses and expenses (including legal fees and expenses) resulting from a claim under the performance security to the extent to which the Employer was not entitled to make the claim.”
Whilst this may act as a deterrent to an employer wishing to make a demand under a performance bond, less sophisticated contracts often do not contain such a clause and where a FIDIC 1999 standard form, is provided at tender by an employer, this provision is often deleted.
- Notice
Sometimes, the performance bond or contract may contain a notice provision where the employer is required to give notice to the contractor that it intends to make a demand under a performance bond. This gives the contractor the opportunity to attempt to remedy its default or failing this, to alert the bank in an effort to limit the damage or consequences to the banking relationship.
- Legal Action
Where there is no notice provision in a contract, as above, the time between a demand under a performance bond by an employer and payment by the guarantor bank is often only a matter of a few days.
Often, the only way for the contractor to attempt to stop the payment by the Bank to the employer is by way of injunctive proceedings through the local courts. In Qatar, this would involve an urgent (known as “Summary”) application to the local courts for injunctive proceedings to be issued on the Bank to stop such payment. In this case, the contractor may be required to give an undertaking in damages (that is a payment into court) to cover costs if at a later stage the court determines that the employer did have valid grounds to make the demand under the performance bond.
- Expiry
The best protection for a contractor is not to have a performance bond at all or failing this to make the bond conditional. However, if, as is often the case an unconditional bond is required a fixed expiry date provides some measure of protection against the common peril of a perpetual bond. Bonds that are stated to expire on the issuance of a defects liability certificate or the like expose contractors to the risk of an enduring exposure and additional cost that is best avoided.