In international construction projects, it is rather standard that the Contractor starts the mobilisation/procurement just after an advance payment has been paid by the Employer. But how does it work and how can you negotiate it at your best?

The Advance Payment Bond is the guarantee which is issued upon instructions of the Contractor in favour of the Employer for an amount equal to the advance payment received -which is generally between 5% and 10% of the contract value (despite it can reach an amount between 10% and 20% for technological or power producing plants). This is only one of the various bonds used in international construction contracts.

A.      How it works

The mechanism is rather simple but it is essential to understand it so that it can be pretty clear what and how to negotiate an Advance Payment Bond.

The advance payment paid by the Employer is generally paid back by the Contract by way of deductions that the Employer will make on each interim payment.

Lets' take the following example:

• the contract price is equal to 1000;

• the advance payment is equal to 100 (ie 10% of the contract price);

• the payment of the contract price is made in 10 equal instalments (or interim payments);

• on each interim payment, the Employer shall deduct an amount equal to 10% (and accordingly will make each interim payment for an amount equal to 90 and not 100);

• at the completion of the works, the Employer will have recovered the advance payment in its entirety.

The rationale for the Advance Payment Bond is, therefore, that, if for any reason the Contractor will not complete the works (say, for instance, that the contract is terminated in advance) the Employer will be able to recover the amount of the advance payment (if not yet repaid back) simply by calling the bond. 

The Advance Payment Bond, therefore, secure the interest of the Employer in the case the works will not be completed despite the Contractor has received the advance payment on the entire contract price.

The Advance Payment Bond is a guarantee that (together with the Performance Bond) has to be carefully analysed since it is usually in the form of an on-demand guarantee  and it might happen that, in case of termination of the construction contract for the (alleged) Contractor's default, the Employer will call the Advance Payment Bond in its entirety (if not properly drafted), together with the Performance Bond, even in the case part of the advance payment has already been repaid back by the Contractor. 

B.      5 Tips to minimize the risks for the Contractor

Despite the mechanism of the Advance Payment Bond is rather simple, if it has been issued in the form of an on-demand guarantee (as it is often the case) it could be open to unlawful calling by the Employer, even in the case part of the advance payment has already been repaid back.

There are 5 basic suggestions that you can follow to minimise the risk of unlawful (or fraudulent) calling: 

• CHECK if it is an on-demand guarantee or instead of a conditional guarantee (read our article on how an on-demand bond works to understand how to recognise it);

• TRY TO OBTAIN, in case the bond is an on-demand guarantee, that the Employer will be entitled to call the amount upon presentation of a declaration from an independent third party who has ascertained, at least prima facie, (i) the default and therefore the non-repayment of part of the advance payment received by the Contractor and (ii) the amount still to be repaid;

• OBTAIN that the amount of the Advance Payment Bond is automatically reduced by the percentage of the advance payment already repaid by deductions applied to the interim payments (if for instance, you received an advance payment of 100 and have already repaid 20, the Advance Payment Bond must automatically be reduced to 80);

• VERIFY that there is an express wording which entitles the Employer to call the Advance Payment Bond only in the case the advance payment has not been repaid back and only for the amount not yet repaid; 

• VERIFY that the Advance Payment Bond has an expiry date (or an expire event) and that, further to that date or further to the occurrence of that event the Advance Payment Bond will no longer be valid and enforceable.

C.      Conclusion 

The Advance Payment Bond is a standard protection for the Employer who has paid a certain amount of the contract price in advance but can be also a weapon in the hands of the Employer who, in bad faith, wants simply to put pressure on the Contractor. 

The above tips should be followed not only to avoid the risks of an unlawful calling of the bond by the Employer but also to seek a more fair balance between the interests of the Employer and those of the Contractor.

IF YOU WISH TO READ MORE DOWNLOAD THE

"GUIDE ON BONDS IN INTERNATIONAL CONSTRUCTION CONTRACTS"