Calls on Performance Bonds in Construction Disputes: What to Do

You may be a contractor who is entering or has entered into a performance bond with a developer. Here is a brief rundown of:

• What is a performance bond
• The types of performance bonds
• What to do should the developer decide to call on the performance bond

What is a Performance Bond?

Performance bonds are a type of security that are typically used in building and construction contracts. They are issued by an insurance company or a bank, to the developer, to guarantee the timely completion of a project by a contractor.  

If the contractor fails to complete the project or breaches any of the obligations under the contract with the developer, the developer can seek to recover any losses that he may have suffered from the breach of contract through calling on the performance bond (i.e. demanding payment of the bond amount).   

Types of Performance Bonds

There are two types of performance bonds: 

1. Unconditional or on-demand bonds; and
2. Conditional bonds. 

Unconditional/on-demand bonds 

Unconditional bonds, also known as on-demand bonds, are bonds where the developer can demand for payment from the third-party guarantor (an insurance company or bank) without having to prove that the contractor breached the contract.  

Unconditional bonds are usually a substitute for a cash deposit that the contractor would place with the developer to either secure the performance of the contractor, or to secure the advance payment that the developer has paid the contractor for the works (if applicable). 

Cash deposits are what some developers ask from contractors to ensure that they perform the obligations stated in the contract (else the contractor loses the cash deposit). However, cash deposits fell out of favour over time as they were damaging to the cash flows of the contractors.  

Therefore, performance bonds are used such that the contractors are able to use more cash for their projects and at the same time, developers can have a peace of mind that should the contractors default, they can still recover a sum of money from the bank/insurer.

Although the developer does not need to prove a breach of contract to call on the bond, the developer will not be allowed to call on the bond abusively.  

If the contractor can prove that the developer called on the bond abusively, he may resist the call on the bond (i.e. avoid paying the bond amount) on the grounds of either fraud or unconscionability, as will be elaborated on below.   

Conditional bonds 

Conditional bonds are where the developer is not entitled to call on the bond unless some event(s) previously agreed by both parties occurs. The event usually concerns the performance of the contract, such as if defects were to appear within a year of completing a construction project.

In deciding whether the developer is entitled to call on the bond, the court will look at whether the contract is being performed.

This type of performance bond is less often used as the developer must prove that there was a breach of the contract before being able to demand payment from the contractor, and the contractor can also defend himself against the claim by proving that there was no breach.

Value and Duration of a Performance Bond 

Performance bonds are usually for about 5 – 10% of the total contract sum, or for the amount that the developer is willing to accept as security.  

The exact terms of the bond may vary, and contractors are encouraged to look through these terms carefully, but the bond generally secures the entirety of the contract, from when the developer formally accepts the tender until the Final Completion Certificate is issued.  

A tender is accepted when a prospective contractor is selected by the developer to carry out the project. 

After construction works have been completed and the Defects Liability Period (the time period after completion of construction works where contractors are still liable for any defects in the works) has expired, the person or firm in charge of overseeing the project will issue a Final Completion Certificate.    

Resisting Calls on Unconditional Performance Bonds 

A contractor may attempt to apply to court for an injunction to resist a call on an unconditional bond by proving either fraud or unconscionability on the part of the developer. Fraud means that the developer did not honestly believe there had been a breach of contract when the call was made.  

On the other hand, unconscionability denotes elements of unfairness, reprehensible conduct or acts lacking in good faith such that the court would restrain the unfair party, i.e. the developer, from calling on the performance bond.  

If the court grants the injunction, the developer is stopped from calling on the performance bond. It is important to note that the matter of the performance bond is separate from the underlying contract for the project between the contractor and the developer. 

Therefore even if the developer is stopped from calling on the performance bond, it can still sue the contractor for breach of contract if the contractor has not completed the project as required under the terms of the contract.

In practice, unconscionability is more often argued than fraud as unconscionability is easier to prove. To prove unconscionability, there must be evidence pointing towards unfairness, abusive and/or dishonest conduct.

The High Court has stated that, even if the developer himself has breached the contract in other ways not related to calling on the bond, this fact itself may not be sufficient to prove unconscionability. However, whether the developer gave notice to the contractor before calling on the bond would be a relevant consideration for finding unconscionability.

Since the developer could have taken a cash deposit instead of a performance bond, the courts may be reluctant to allow a contractor to resist the call of an on-demand performance bond mutually agreed between the parties.

This is because a cash deposit provides more security to the developer as he can use the deposit to immediately offset himself against any losses caused by the contractor. But by agreeing to take a performance bond instead, not only does the developer not have any actual cash from the contractor on hand, but the contractor may also successfully be able to resist the call on the bond.

Therefore, the court may decide that the developer, who already agreed to take on more risk for the contractor to have more cash on hand to perform the contract, was not being unconscionable when he exercised his right to call on the performance bond.  

Tips When Entering into Contracts Containing Performance Bonds      

When entering into contracts containing performance bonds, contractors are advised to look through the contractual terms carefully, understand their consequences and pay attention to what was included or not included in the contract. The terms of the contract, specifically the clause(s) on the performance bond, would affect:

• The nature of the bond: namely conditional or unconditional, or whether the developer needs to prove breach of the contract before calling on the bond.
• The ability of the contractor to resist the call on the bond: some performance bonds will deliberately exclude resisting the bond on the grounds of unconscionability. If so, this makes it even harder for the contractor to resist the call on the bond if he had previously agreed to this arrangement. 

In a 2015 Court of Appeal case for example, the parties had agreed in the contract that the contractor cannot resist the calling on the performance bond except in the case of fraud. In other words, the contractor could not later argue unconscionability to resist a call on the performance bond. 

The Court of Appeal decided that a performance bond phrased this way were enforceable, as the parties had mutually agreed on it. Thus, as the contractor did not rely on fraud in its attempt to resist the developer’s call on the performance bond, its attempt failed and the developer was allowed to call on the bond.  

Hence, it is important at the contracting stage to keep in mind the nature and possible consequences of performance bond clauses in the contract and negotiate for more favourable terms if required. 

If you need legal assistance with these issues or have already agreed to a performance bond that the developer is threatening to call on, you may wish to consult a construction lawyer.