How to negotiate a Performance Bond: 5 tips

The Performance Bond is a guarantee which secures the Employer from the risk of possible breaches by the Contractor during the execution of the works. It can be risky for the Contractor for several reasons and above all because it is a guarantee which remains in force for the entire life of the construction project.

This is why it is crucial to know what and how to negotiate a Performance Bond. 

In mid and big size projects, as it happens also for the other bonds commonly used in the construction industry, the Performance Bond is usually issued in the form of an on-demand bond by a bank upon request of the Contractor and it is issued together with other guarantees (such as the Advance Payment Bond and, at a later stage, the Warranty Bond).

A.      How it works

The mechanism is rather simple since it provides that the Performance Bond (in its entire amount or partially) is paid in favour of the beneficiary (the Employer) upon the non-performance (or alleged non-performance) of the Contractor.

As mentioned, the Performance Bond is often issued in the form of an on-demand bond which is a type of guarantee that can be called by the beneficiary without the need to prove the non-performance of the Contractor and upon simple request of the Employer (which usually has to simply 'declare' that the Contractor is in breach of certain provisions of the contract).

This is because an on-demand bond is virtually independent of the underlying contract and neither the bank nor the Contractor can raise objections based on the construction contract to prevent the payment of the bond (you can read also our article about the on-demand bond).

In this case, it is clear that the actual risk for the Contractor is that the Employer could virtually call the Performance Bond also in those situations where the latter is not legally entitled to obtain the payment from the bank, ie in all those situations where the Employer calls the bond in bad faith (it is generally said that the Employer calls the bond fraudulently), being well aware that he is not entitled to receive the amount of Performance Bond. 

B.      5 Tips to minimize the risks for the Contractor

If you are a Contractor, the following 5 tips will allow you reducing the risks and negotiating a more balanced Performance Bond:

• VERIFY first of all if the Performance Bond covers only the proper execution of the scope of works or if instead, it covers also the warranty period so that the Employer can call it also for defects which will occur during the warranty period. In such case, it is the same bond which changes 'function'. It is always better that Performance Bond covers only the breaches that might occur during the execution of the works and that the defects which may occur during the warranty period be covered by a specific and separate bond (the so-called Warranty Bond); 

• VERIFY if the Performance Bond is in the form of an on-demand bond;

• NEGOTIATE the bond in a way that the Employer can call it only upon presentation, at least, of a document issued by a third party (for example a technician appointed by the parties) who will ascertain the breach; in the alternative

• NEGOTIATE the bond so that the Employer has to detail the alleged defaults (such details will be then helpful to prove eventually the bad faith of the Employer either if you are seeking an injunction to restrain the payment of the bond or if you have started a legal action to recover what has been paid unlawfully to the Employer);

• NEGOTIATE the bond so that the Employer has to, at least, detail the damages suffered and that the amount that can be called from the bond be limited to the detailed damages;

C.      Conclusion 

The Performance Bond is a normal and rather standard form of protection for the Employer but it can be an extremely powerful weapon to put pressure (rightly or wrongly) on the Contractor especially if issued in the form of an on-demand bond. 

A careful review and negotiation of the terms and conditions of the text will allow to reach a fair compromise between the parties and to minimize the risk of unlawful calling by the Employer.

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"GUIDE ON BONDS IN INTERNATIONAL CONSTRUCTION CONTRACTS"