Understanding Performance Bonds

Dafydd Huw Davies
Performance bonds are widely used in the Middle East construction industry, as a means of encouraging contractors to deliver their obligations to the required standard. Given the popularity and significance of performance bonds, it’s useful to understand their key principles.

Clarity of Content

Performance bonds may simply stipulate 'we acknowledge paying xxxx to you or your representative at the first request without consideration to any objection from the contracting party'. Careful structuring is needed however, as a contracting party’s signature can, depending on the precise phrasing, give rise to an unconditional obligation.

If both parties are to benefit from a performance bond, they need to understand and, importantly, have confidence in, when it’s appropriate for a performance bond to be called on. Where possible, a performance bond should stipulate the precise context in which it may be called on, as this provides clarity on fiscal exposure for the contracting parties and any third party financiers. Knowing the contractual parameters allows each party to establish internal escalation procedures to 'control the controllables' and avoid the dreaded notification from the other party or the bond underwriter.

Time Limited or an Indefinite Bond?

A performance bond should mirror the contract’s duration or conclude at a fixed date thereafter, avoiding an indefinite liability. A fixed deadline means the contractor need not chase for the return of a bond’s certificate and can manage financial exposure more effectively. This also avoids the difficulties arising when an employer organisation loses the bond or, for some other reason, cannot return it.

A performance bond should mirror the contract’s duration or conclude at a fixed date thereafter, avoiding an indefinite liability.

To Call on or Not?

Possession of a bond does not necessarily mean an employer should call on it. Doing so can negatively impact both employer and contractor. An employer’s reputation for exercising bond rights can make contractors nervous and less willing to work for them. An employer’s 'high risk' reputation may also lead to higher quotes in future, as the propensity to draw down bonds will be factored into the contractor’s submissions.

One-time Bond?

How specific is the contract? Does it include a specific performance bond or can it be interpreted as a one-time bond? Traditionally the calling of a performance bond coincides with the contractual termination - but this may not always be the case.

If the bond’s purpose is to ensure satisfactory completion of the contracted work, the calling of a single bond may not achieve this objective.

If the bond’s purpose is to ensure satisfactory completion of the contracted work, the calling of a single bond may not achieve this objective. It may well be in the employer’s interests to insist that the contract is continued, especially if the contractor is providing a specialist service.

The contractual terms should therefore be carefully considered during pre-contract negotiation. The contract should clearly prescribe whether the employer can draw down one or more bonds and whether the drawing down of the bond terminates the contractual arrangement and the parties’ liabilities to one another. The contractor may also apportion an element of the performance bond to a specific contractual failure, as a means of managing financial exposure.

Jurisdiction and Resolution

The performance bond is a separate legal document with its own unique obligations. The appropriate legal jurisdiction is best prescribed within the document, removing any doubts.

Any disagreement or preventative measures may need to be referred to the prescribed jurisdiction’s publically accessible courts. However, the emphasis is now on achieving resolution by consensual and private alternative dispute means, assisted by a neutral third party. Several international organisations help disputing construction parties, e.g. the Qatar Financial Centre or the Dubai International Arbitration Centre.

Know When to use it

Performance bonds are a costly mechanism imposed by the employer to ensure that the contractual obligations are achieved. From a contractor’s perspective, the key is to identify and limit financial exposure.

While performance bonds have undoubtedly earned their place in the contract management toolkit, the employer’s challenge is to know when to draw on the bond...

While performance bonds have undoubtedly earned their place in the contract management toolkit, the employer’s challenge is to know when to draw on the bond and to appreciate the consequences of doing so.

Faithful+Gould has extensive experience in advising clients on performance bonds. We advise not only in relation to their procurement, but also on ways of resolving disputes so as to avoid calling on bonds.

Written by