An introduction to performance bonds
1. Bonds are frequently used in commercial contracts to protect against non-performance by one party of their obligations under the contract. They should be distinguished from ‘bonds’ in the context of debt finance. Put simply, a bond enables a party to claim a sum of money from a third party who provided the bond, if the other party to the contract does something which causes the first party to suffer a loss (e.g. breach of contract).
2. The issuer of the bond (‘surety’) becomes responsible for the fulfilment of a contractual obligation owed by one party to the other, if the first party defaults. Performance bonds (‘PBs’) are issued by surety companies, insurance companies and banks. Their purpose is to support the performance of contracts, especially for the provision of construction services. This article will focus on PBs in the construction sector as this is where they are most common.
Structure of a performance bond
3. PBs create binding obligations between the parties and there are three main parties in a basic PB structure in the construction context. The employer in a construction project is the beneficiary of the bond. The building contractor (‘principal’) procures the bond from the issuer, and it is their primary obligations to the employer which are covered by the bond. The surety (or ‘bondsman’) is the third party who issues the bond in favour of the beneficiary on behalf of the principal.
4. There will often be a separate contract between the contractor and the surety, known as the ‘indemnity’. This obliges the contractor to repay the surety once the surety has paid the employer under the bond. However, an indemnity between the surety and contractor will be worthless if the reason for the contractor’s default was insolvency.
5. Thus, there are three main contracts in a typical PB arrangement. First, the underlying contract between the employer/beneficiary and contractor. Second, a bond between the surety/bondsman and the employer. Third, an indemnity between the contractor and the surety/bondsman.
Features of a performance bond
6. Bonds must be in writing to be enforceable under the Statute of Frauds 1677, section 4. This provides that for a “special promise” by one party to answer for the debt of another to be binding, it must be in writing and signed by or on behalf of that party.
7. The bond must set out when the employer can trigger it, i.e. when the surety will pay. It will also usually specify any formalities required, the form in which a claim should be made, and an expiry date. It will also set out the amount the beneficiary can recover under the bond, which is a percentage of the price stated in the underlying contract.
Types of performance bond
8. There are two types of PB: on-demand bonds and conditional bonds. Conditional bonds are more common in the UK construction market.
9. A conditional bond is one which pays out to the beneficiary only if certain conditions have been met, i.e. a default by the contractor and a loss to the employer. An on-demand bond is one which allows the beneficiary to simply tell the surety that an entitlement to a claim has arisen and to demand payment, without the need to prove any entitlement. This is as simple as the beneficiary writing to the surety and asking for payment.
10. In determining whether a bond is on-demand or conditional, courts will interpret the wording of the bond by applying Wood v Capita Insurance Services [2017] UKSC 24.
Enforcing a conditional performance bond
11. When the employer wishes to enforce the bond due to a default by the contractor, this is called ‘making a call on the bond’. This is usually where the contractor has committed a serious breach of contract, has gone insolvent, or both.
12. The ability to make a call on a conditional PB will depend on the precise wording of each bond. However, in practice, the main conditions are: (a) breach of the underlying contract by the contractor, and (b) damages must be proved.
13. Therefore, the contractor’s insolvency may constitute a breach in some conditional PBs but not in others. Where insolvency is not included within the definition of a breach of contract, it may still lead to another breach of contract indirectly, thereby enabling the beneficiary to make a call on the bond.
14. In some PBs, such as the Association of British Insurers’ (or ‘ABI’s’) model form, the loss needs to be “established and ascertained”. In Ziggurat (Claremont Place) LLP v HCC International Insurance Company PLC [2017] EWHC 3266 (TCC), a certificate issued in accordance with the underlying building contract was sufficient to ‘establish and ascertain’ damages for the purpose of making call under the PB. However, in Yuanda (UK) Company Ltd v Multiplex Construction Europe Ltd [2020] EWHC 468 (TCC), an employer/party issuing a certificate by themselves was not adequate. Rather, the decision of an adjudicator would lead to the sum being ‘established and ascertained’ for the purposes of the contract.
Michael Coumas will start his commercial chancery pupillage in 2025. He is a law tutor and was Called to the Bar in 2022.
