Construction projects are inherently risky and clients rely heavily on the performance of their contractors for the successful delivery of projects. Due diligence and good procurement practice can reduce the risk of non-performance but not eliminate it. On higher value contracts clients may choose to offset some of the risks to a third party by means of a performance bond. This article will explain what a performance bond is, the different types available and how it can be incorporated into an NEC contract.

What is a performance bond?

 A performance bond is used by clients as security for a contractor’s performance. The bond provider, known as the “guarantor” undertakes to make payment to the client in the event that the contractor breaches its contract with the client.  The bond, normally provided by a bank or insurance company, is executed by the contractor (the principal) and the guarantor and given in favour of the client “the beneficiary”. The obligation on the contractor to obtain a bond arises when there is an express requirement stated to do so in the underlying contract between the client and supplier.

Performance bonds are the most common form of security of performance on engineering and construction projects. A performance bond is not the same as insurance although it does share some similarities in the sense that a bond provides the means of financial recovery should a certain risk event occur. Other types of bond are available for use with the NEC forms, for example; an advanced payment bond (X14) and retentions bonds (X16) but discussion on these are outside the scope of this article.

Types of performance bond

There are, broadly, two types of performance bond; conditional and on-demand bonds.  A conditional bond is sometimes referred to as a guarantee bond.

Under a conditional bond, the guarantor becomes liable to the beneficiary only when the beneficiary has demonstrated that the contractor has failed to comply with its obligations under the construction contract and that the client has, as a consequence, incurred loss. This means the guarantor may rely on the same rights and counterclaims available to the contractor that exist under the construction contract in order to defend a claim made against the bond.

The guarantor’s liability to the beneficiary will also be subject to any amounts that are payable by the contractor to the client under the construction contract. For example: under clause 46 of the NEC4 Engineering and Construction Contract the project manager may certify an amount to be paid by the contractor to the client for an uncorrected defect. The application of delay damages (X7) and low performance damages are other examples.

On-demand bonds, generally, do not require the beneficiary to provide evidence of the contractor’s default or the loss incurred. In practice there will often be some conditions, such as the giving of a notice with details of the amount claimed, that will need to be satisfied before liability arises.

Conditional bonds are most commonly used in the UK. On-demand bonds, unsurprisingly, are not favoured by surety providers or contractors and their use is more prevalent on international projects.  Ultimately the question of whether a bond is classed as conditional or on-demand, or a hybrid of the two, is a matter of the precise words used.

Using a performance bond with NEC4 contracts

 All of the long-form versions of the NEC4 contracts allow for incorporating an obligation on the contractor to give a performance bond. With the exception of the Alliance Contract (ALC) and the Facilities Management Contract (FMC) the obligation is effected by including secondary Option X13 which requires the form of the bond to be set out in the scope.  If the bond is not included in the scope the client may find it difficult to enforce the obligation.

The ALC and FMC use X4: performance guarantee, which includes the option of an ultimate holding guarantee or performance bond (not both) if stated in the contract data.

NEC contracts do not provide for a standard form of performance bond and so the decision on what to use is left to the client. The use of the term performance bond in X13 may indicate that the contract drafters intended it to be of the conditional type.  The Association of British Insurers (ABI) provides a model form of guarantee bond (a type of conditional performance bond) for use in the UK construction industry which has been adopted by the National Joint Consultative Committee for Building. However, some clients seek to amend the ABI model form to include the act of insolvency as a reason allowing a call on the bond as insolvency may not directly constitute a breach of the underlying contract^[1] and as a consequence, a valid call on the bond is delayed until it is established there is an unpaid debt.

Notably, the project manager (ECC) has the power to give an instruction to the contractor which changes the scope (clause 14.3). However, it is recommended that project managers act only on instruction from the client and that competent legal advice is obtained before any such instructions are given.

The bond amount required by the client must be stated in contract data part one; this is normally expressed as a proportion (typically 10%) of the tendered total of the prices (the contract value). Alternatively, the bond amount may be expressed as a fixed sum. Whichever approach is adopted clients should ensure the amount stated in contract data is replicated in the form of the bond provided in the scope.  Client’s should be aware that the bond amount is the maximum that could be recovered and is not a guarantee that the full amount of the bond is payable by the guarantor.

X13 nor the contract data provide for stating the date of expiry of the performance bond.  The parties will need to ensure this matter is properly addressed in the bond. In the absence of an expiry date, liability under a guarantee bond may subsist until the end of the limitation period for the breach of the underlying contract.  It is common practice for the expiry date for the bond to be governed by the date of completion. Project managers should be aware of this implication when issuing the completion certificate.

If the performance bond is not in place before the parties enter into the contract, the contractor is required to give the bond no later than four weeks after the date on which the construction contract comes into existence (contract date). Before giving the bond to the client, the contractor has to obtain the project manager’s acceptance of the guarantor. X13 states, “A reason for not accepting the bank or insurer is that its commercial position is not strong enough to carry the bond.” It is recommended that project managers refer to the client or seek competent advice on such matters.

The contractor’s failure to give the bond is a reason for which the client may terminate the contractor’s obligation to provide the works (clause 91.2 - R12). The client’s right of termination is subject to a notice of the default first being served by the project manager and subsequent failure by the contractor to put matters right within four weeks of the notice.   In Liberty v Mercian (2020) the court decided that the requirement to give a performance bond was a “self standing, independent obligation”. Further, that the obligation to give a performance bond was “procedural and collateral or ancillary to the subject matter of the contract” and as a consequence, the court held that the obligation to give a performance bond survived termination of the contractor’s obligation to provide the works.^[2]

The cost of a performance bond varies depending on the type of bond, amount, duration and the guarantor’s assessment of the contractor’s standing. Costs typically range between 1 and 3% of the contract value. The contractor pays the guarantor a non-refundable fee for providing the bond. The guarantor may also seek additional collateral in cash.  If amounts become payable to the client the guarantor may pursue the principal for recovery of its loss under any rights of subrogation that exist. Ultimately, the obligation to give a bond increases the contractor’s risk profile which will need to be reflected in the contractor’s price for the construction contract. Client’s should consider this when deciding to ask for a performance bond. 

Under main Option B the standard method of measurement (for example CESMM) will include the performance bond as a priced item in the bill of quantities. For main Option A, if the client requires transparency of the cost, it will need to ensure the activity schedule includes a separate priced activity.  The cost incurred by the contractor is not a defined cost and is treated as included in the fee (clause 52.1). Contractors pricing any one of the cost reimbursable contracts (C, D, E or F) will need to ensure their fee percentage is sufficient to cover the cost of the performance bond.

Conclusion and recommendations

1. A performance bond provides the client with limited security for the contractor's performance.

2. NEC contracts allow for the use of performance bonds but the client will need to decide the form of the bond and include it in the scope.

3. The form of bond will dictate what level of security is provided and the ease by which a client may make claim against the bond.

4. Competent advice should always be sought by clients and project managers.

David Hunter

Daniel Contract Management Services Ltd

January 2022

The author acknowledges the assistance of Patrick Waterhouse in the writing of this article.

An edited version of this article was first published in the NEC User Group newsletter Issue No. 116 January 2022 and can be downloaded here.

^[1] Perar BV v General Surety and Guarantee Co Ltd (1994) 66 BLR 72

^[2] Liberty Mercian Ltd v Cuddy Civil Engineering Ltd [2013] EWHC 2688 (TCC), 192-199