Blog: Performance Bonds and the Free Lunch

Roddy Cormack
Roddy Cormack

Roddy Cormack asks whether performance bonds could mean that it is possible to have a risk free construction project.

I remember when I was a student, a group used to offer free lunches in a hall near the campus. You wouldn’t need to pay for the food; there was, however, an exchange. You couldn’t go for lunch there without accepting that someone was going to try and engage you in a deep philosophical discussion about the meaning of life and your place within it. No money may have exchanged hands but you were going to have to give away something. It wasn’t, therefore, a completely “free” lunch.

Just as there is probably no such thing as a completely free lunch, there is also probably no such thing as a completely risk free construction project.

Risk is inherent in construction; you can’t make it disappear - all you can do is transfer it. So, if you are wanting to have a risk free construction project experience, all you can do is transfer all conceivable risks on to the other party through the building contract.

Of course, having a building contract that transfers all risks on to another party only provides you with a bit of paper. That bit of paper may contain the most comprehensive of risk transfers but if the other party goes into insolvency (or otherwise disappears) it will be you that is sitting with all the risks.

We seem to be coming back round to a market where employers are looking to protect that “risk free” experience through the requirement for performance bonds (typically for 10 per cent of the contract sum). With a performance bond in place, the theory goes, you can protect yourself against the likely extra-over costs of getting an alternative contractor to complete the outstanding obligations under the original building contract.

Does the existence of performance bonds, therefore, mean that it is possible to have a risk free construction project – is that metaphorical free lunch possible?

Well, the first, obvious, point is that performance bonds cost money. You may, however, be an employer who is happy to pay a little bit more to get the comfort of a bond (in the same way that students might be happy to engage in philosophical chat to get a plate of tasty lentils). The price you pay may, therefore, not be a real sacrifice.

A more universal point is that a bond, at best, can only ever put you in the financial position you would have been but for the breach / insolvency by your original contractor. A bond can’t turn the clock back on a project that has gone into substantial delay. A bond can’t rebuild relationships with purchasers or tenants that had made plans around getting in to the completed project by a particular date. A bond (even an on demand bond) isn’t a magic wand that makes a project instantly start to get back on track with no effort on the part of the employer. Although a bond can, to an extent, manage financial risk, it can’t manage practical and relationship risks.

On that issue of the management of financial risk, a bond will generally only give you (at most) a pot worth 10 per cent of the contract sum. If you are looking at having an entire site condemned, therefore, your performance bond may not come anywhere near covering your actual extra-over costs to get to completion. Far from a free lunch, therefore – you may end up having to pay for your own lunch and everyone else’s.

Looking at things from the other side of the fence, performance bonds are not contractor friendly. If you get your performance bond from a bank, more than likely it will eat into your overdraft limit and therefore affect your working capital. If you get your performance bond from an insurance company, they may well want to take a fixed or a floating security over some (or all) of your assets which in turn can impact upon your business’s flexibility. Moreover, a call on a bond is generally not something a contractor can respond to and so the contractor can effectively lose control over the management of claims that are essentially building contract claims – claims the contractor will ultimately need to account to the bondsman for.

Don’t get me wrong. I think there can be a place for performance bonds. But they are not a universal tool for the management of risk in construction projects. Reliance solely on performance bonds for the management of risk is likely to catch an Employer out at some point. Pre-contract due diligence; allocation of risk to where it can be most appropriately managed; and, collaborative problem solving are going to help prevent risk events actually occurring. Prevention is generally better than cure. Relying on a performance bond is a bit like being the last one to leave the restaurant and hoping that your credit card has a high enough credit limit to cover the bill.

Now, about the meaning of life and my place within it …

  • Roddy Cormack is a construction and commercial contracts lawyer at Ledingham Chalmers Solicitors

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