Understanding the use and benefit of performance bonds in NEC contracts

Key Points

• A client can ask its contractor to provide a performance bond as additional security against the contractor’s failure to perform.
• A performance bond can be included in an NEC contract via option X13 (or X4 for NEC4 ALC and NEC4 FMC).
• Clients need to decide on the form of the bond and include this in the scope, but they also need to balance the cost of providing the bond with the potentially limited security provided.

Clients rely on the performance of their contractors for successful delivery of construction projects. While good procurement practice and effective contract management can reduce the risk of non-performance, the risk may still persist. As such, clients on higher value contracts may choose to offset this risk by means of a performance bond.

A performance bond is effectively a way of insuring a contractor’s performance. The bond provider or ‘guarantor’ is normally a bank or insurer. It undertakes to make payment to the client or ‘beneficiary’ in the event the contractor or ‘principal’ breaches its contract. The obligation on a contractor to obtain a bond arises only when the requirement is stated in the underlying contract between the client and contractor.

Types of performance bond

Broadly, there are two types of performance bond: conditional (or guarantee) bonds, and on-demand bonds. Under a conditional bond, the guarantor becomes liable to the client only when the client has demonstrated the contractor has failed to comply with its obligations under the contract and that the client has, as a consequence, incurred loss. This means the guarantor may rely on the same rights and counter claims available to the contractor that exist under the contract to defend a claim made against the bond. Conditional bonds are the most commonly used in the UK.

On-demand bonds generally do not require the client 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. Not surprisingly, on-demand bonds are not favoured by either guarantors or contractors. Ultimately the question of whether a bond is classed as conditional or on-demand, or a hybrid of the two, depends on the actual words used in the bond.

Using a performance bond in NEC4

All long-form versions of NEC4 contracts allow for incorporating an obligation on the contractor to give a performance bond. With the exception of the NEC4 Alliance Contract (ALC) and NEC4 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 (though the Engineering and Construction Contract (ECC) project manager can give an instruction to the contractor which changes the scope via clause 14.3). The ALC and FMC use option 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 a standard form of performance bond and so the decision on what to use is left to the client. The Association of British Insurers provides a model form of guarantee bond for use in the UK construction industry. In addition, the bond amount required must be stated in contract data part one, normally expressed as a proportion (typically 10%) of the contract value. The bond amount should be replicated in the bond itself, but clients should be aware this is the maximum recoverable and not a guarantee that the full amount will be paid.

Neither clause X13 or the contract data include an entry for the expiry date of the bond, so the parties will need to ensure this matter is properly addressed in the bond itself. In the absence of an expiry date, liability usually exists until the end of the limitation period for breach of contract, which is commonly governed by the date of completion. Project managers should be aware of this implication when issuing a completion certificate.

The contractor is required to provide the bond to the client within 4 weeks of the contract starting. However, before doing so, the contractor has to obtain the project manager’s acceptance of the guarantor. Clause 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 a 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 4 weeks of the notice.

Cost of performance bonds

The cost of a performance bond depends on the type of bond, its amount and duration, and the guarantor’s assessment of the contractor’s standing. They are typically between 1% and 3% of the contract value. If amount of the bond become payable to the client, the guarantor may pursue the contractor 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 its tender price. Clients should consider this when asking for a performance bond.

Under ECC Option B (priced contract with bill of quantities), the performance bond will be a priced item in the bill of quantities. For ECC Option A (priced contract with activity schedule), if the client requires transparency of the cost, it will need to ensure the activity schedule includes a separate priced activity for the bond. The cost incurred by the contractor is not payable as defined cost and treated as included in the fee (clause 52.1). For ECC cost-reimbursable contracts (Options C, D, E or F), contractors should ensure their fee percentage is sufficient to cover the cost of the bond.

Conclusion and recommendations

Performance bonds can provide clients with a certain amount of additional security for their contractors’ performance. NEC contracts allow for the use of performance bonds, but clients will need to decide the form of the bond and then include it in the scope.

The form of bond dictates what level of security is provided and the ease by which a client can make claim against the bond. The cost of providing a performance bond can be expensive, so competent advice should always be sought by clients and their project managers deciding to ask for one.

Acknowledgement

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