By Bryan Dayton and Samuel Song, Associates at Freshfields Bruckhaus Deringer, Dubai
Many construction contracts require the contractor to procure a performance bond to give the employer additional recourse should the contractor be delayed in performing, or fail to fully perform, its contractual obligations.
Depending on the type of performance bond, the employer may be entitled to call the bond for any failure of performance or any other breach of contract to indemnify of any loss suffered as a result of the failure or breach.
While many commentaries and cases have discussed instances where a bond is inappropriately or prematurely called, there have been far fewer discussions regarding instances where the release of a bond is improperly withheld or substantially delayed.
This post will delve into the following issues, particularly in respect of the 1987 FIDIC Redbook, which is the basis of many build-only construction contracts in the MENA region:
a) an overview of performance bonds in construction projects and the role they play;
b) how contracts generally deal with the release of performance bonds; and
c) how the release of the performance bond is sometimes (mis)used as a powerful bargaining chip.
A. The Basics of Performance Bonds in Construction Projects
In the context of construction projects, a performance bond is essentially a deed under which the issuer of the bond (i.e. the bank) promises payment to the holder of the bond (i.e. the employer) of an amount customarily equal to between 5% – 20% of the contract price, in the event of the default or failed performance of the principal (i.e. the contractor).
Performance bonds generally come in two types: “conditional” and “on-demand” bonds. The main difference between the two is that, for a conditional bond, the employer has to show the occurrence of a particular event (i.e. the contractor’s default, breach, or failed performance) to call upon the bond.
In contrast, on-demand bonds do not require the employer to prove anything in order to call on the bond. Generally, the employer needs only to prepare a written demand to the issuer and follow whatever limited procedures may be required by the bond.
Due to the less onerous requirements in calling on-demand bonds, contractors and banks are generally reluctant to provide them. Nevertheless, many contractors do agree to provide on-demand bonds, which are often a non-negotiable requirement by employers.
B. Releasing the Performance Bond
Outstanding performance bonds generally appear as an unsettled liability on a contractor’s books and, more importantly, will decrease a contractor’s ability to obtain further bonds for other projects as banks may not want to secure new bonds when the contractor has significant outstanding liabilities.
For these reasons, contractors will generally seek to have the employer release the performance bond as soon as possible. However, while most construction contracts provide seemingly clear contractual provisions in regard to the release of performance bonds, in practice, the release of these bonds may not be straight-forward.
The 1987 FIDIC Redbook deals with the release of performance securities in Sub-Clause 10.2, which states:
“The performance security shall be valid until the Contractor has executed and completed the Works and remedies any defects therein in accordance with the Contract. No claim shall be made against security after issue of the Defects Liability Certificate in accordance with Sub-Clause 62.1 and such security shall be returned to the Contractor within 14 days of the issue of the said Defects Liability Certificate.” [Emphasis added].
In turn, Sub-Clause 62.1 reads:
“The Contract shall not be considered as completed until a Defects Liability Certificate shall have been signed by the Engineer and delivered to the Employer, with a copy to the Contractor, stating the date on which the Contractor shall have completed his obligations to execute and complete the Works and remedy any defects therein to the Engineer’s satisfaction. The Defects Liability Certificate shall be given by the Engineer within 28 days after the expiration of the Defects Liability Period, or, if different defects liability periods shall become applicable to different Sections or parts of the Permanent Works, the expiration of the latest such period, or as soon thereafter as any works instructed, pursuant to Clause 59 and 50, have been completed to the satisfaction of the Engineer. Provided that the issue of the Defects Liability Certificate shall not be a condition precedent to payment to the Contractor of the second portion of the Retention Money in accordance with the conditions set out in Sub-Clause 60.3.” [Emphasis added].
The 1987 FIDIC Redbook empowers the engineer with significant discretion as to when to issue a Defects Liability Certificate and release the performance bond. Bidding contractors often agree to this provision without adequately considering the consequences. However, contractors should note at least the following when negotiating a construction contract that is based on the 1987 FIDIC Redbook:
1. There is a higher risk and uncertainty regarding the return of the performance bond compared to the release of the retention monies. Retention monies are generally owed at the end of the Defects Liability Period, regardless of whether a Defects Liability Certificate is issued.
2. Many construction contracts are silent as to what standard must be met or satisfied before the engineer is required to issue the Defects Liability Certificate. This uncertainty gives rise to a risk for the contractor, which is compounded by the fact that many construction contracts require the engineer to seek the employer’s approval for certain acts, including the issuance of final certificates.
So what is required of the contractor, in regard to addressing defects in order to satisfy the engineer (and the employer) enough to issue a Defects Liability Certificate? What constitutes a defect or, more specifically, a defect that must be rectified by the contractor? Are there additional unstated grounds for the engineer to refuse to certify the release of the performance bond, such as a determination that the contractor owes the employer money (e.g., the contractor owes liquidated damages or monies for overpayments)?
Defining a “defect” is no simple matter, giving rise to many disputes over whether a defect exists. Even if there is a defect, the cause (e.g. whether it resulted from a design issue within the employer’s responsibility or a construction issue with in the contractor’s responsibility) and the appropriate remedy (e.g. specific performance or damages) may be disputed.
C. Holding the Performance Bond
Regardless of the legal uncertainties as to employers’ contractual duties to release performance bonds, employers have an incentive to require that contractors maintain performance bonds until a final account has been agreed, in order to use the release of the performance bond as leverage in settlement discussions. It is not uncommon for employers to require contractors to maintain bonds for more than five years after the Defects Liability Period has ended.
Requiring that the contractor maintain the performance bond until a final account is agreed is not limited to the employer and main contractor relationship; it also arises between main contractors and subcontractors. While construction subcontracts are generally back-to-back with the main construction contract, the release of the performance bond can, again, be a very powerful bargaining chip for the holder (i.e. main contractor) to either favorably settle certain issues or to ensure a united effort in disputes between the contractors against the employer.
What the consequences of this positioning are or ought to be has not been developed in commentaries or cases. Thus, this is an area ripe for future debate and one that parties should consider when negotiating construction contracts.
Employers’ contractual obligations regarding the release of performance bonds – and the consequences of using it as strategic leverage – are not properly understood. Until it is, it remains an additional bargaining chip at the employers’ disposal, a tool that could be used with harmful consequences, unless contractors thoroughly consider or address this issue during contract negotiations.
Accordingly, contractors should take care during contract negotiations to have both their legal and commercial teams review provisions concerning the procurement and release of performance bonds. As it seems unlikely that there will be a trend to address this issue contractually in the near future, it will be the responsibility of disputes lawyers to navigate the shoals of this terrain in search of answers to the many questions that arise regarding these ambiguous contractual provisions.