Carrying out construction projects can be a risky business. The project could be at risk of not getting completed due to contractor’s default or that the Employer could be confronted with multiple defects in a building that is supposed to be “completed”. In the unfortunate event that these risks materialised, the Employer often find it extremely challenging to recover financial remedy in a timely manner from the contractor in issue. This is because the contractor could have been financially insolvent or that the allegations of contractual breach are disputed by the contractor. It may take many months or even years before the disputes are resolved via any legal proceedings. To this end, bond is a financial instrument commonly used in the construction industry to mitigate these risks. Most construction contracts stipulate that the contractor is required to provide a bond issued by financial institution in favour of the Employer in an amount that is usually expressed as 10% of the contract sum. The bond shall remain valid and in force until the project achieves final completion. The Employer will therefore be able to call on such bond in case the contractor defaults. Depending on the wordings included in the bond, the financial institution responsible for issuing such bond is obliged to make payment. The main contractor usually passes such cashflow risk down the contractual supply chain by demanding a similar bond from its subcontractors based on sums proportional to the value of the respective subcontract works. 

This article examines the different types of bonds commonly used in the industry and the associated principles of risks allocation. Does the Employer have unfettered access to cash by calling on bonds issued in its favour? In more specific terms, does the Employer actually have the right to utilise the bond without proving that the contractor is actually in default? Even if proof is necessary, are the financial institutions issuing bonds in the best position to determine the merit of the disputes before fulfilling its payment obligations? These are all pertinent questions to be raised in order to have a comprehensive understanding of the effects of bond on allocation of risks. The principles of risk allocation can exhibit quite a different commercial characteristics depending on the purposes for which the bond is issued i.e. performance bond, retention bond, advance payment bond etc.

Basic Characteristics of Bonds in Construction Industry

There are usually three parties to a bond. First, the financial institution is the ‘issuer’. Second, the Employer under the main contract is the ‘beneficiary’ and third, the main contractor under the obligation for procuring such bond is the ‘obligor’. As regards bonds issued under subcontract, the beneficiary is the main contractor whilst the obligor is the subcontractor. 

The issuer’s obligation to pay is very much dependent on the legal characteristics of the bond. There are in general two types of bond namely ‘on-demand bond’ and ‘indemnity bond’. On-demand bonds are often described as cash equivalent due to its simplicity to gain access to payment. The issuer is obliged to pay upon a mere demand made by the beneficiary usually by presentation of compliant document of demand. The issuer is not required to consider whether the beneficiary is justified in demanding for payment or whether the beneficiary had suffered any damages as a result of breach by the obligor. Such low threshold of payment would mean that the issuer have access to obligor’s collateral for the purposes of security. On the other hand, indemnity bond has quite the opposite legal characteristics where the issuer only responds to demand for payment conditioned upon certain facts. In order to establish whether threshold of payment is fulfilled, the issuer may be required to get involved in determining the merit of the underlying disputes between the beneficiary and obligor. This naturally diminishes the beneficiary’s ability to gain access to payment but in turn becomes less financially risky and onerous for the issuer and obligor. There is also a question of how should an issuer actually determine the merit of the underlying dispute and what sort of proof is actually required. Is it a binding determination in the form of a state court judgment or an arbitral award or an admission of breach on the part of the obligor? These documentation proof may be overly onerous to be accepted for the purposes of a bond where the primary function is speedy access to financial remedy.

On-demand bond issued by banks that is also known as banker’s guarantee is quite commonly stipulated in standard forms of contract. As pointed out earlier, since the legal characteristics of an on-demand bond or indemnity bond is dependent on the wordings used, there are instances where parties dispute over the choice of words used in the process of negotiating bond submission. Therefore the banker’s guarantee template specimen is usually included in the contract appendix to ensure compliance by the obligor. In order to underscore the Employer’s desire for an unfettered access to security deposit, the relevant clauses in the standard form of contract usually stipulate the Employer’s acceptance of on-demand unconditional bond is an alternative to cash deposit. In other words, the primary intention is always for the contractor to provide cash deposit and the bond may be accepted provided its essence does not derogate significantly from the liquidity of cash. 

In the case of an indemnity bond, this can usually be procured from an insurance company instead of bank where it may cost the obligor anything between 1% to 5% of the underlying bond amount. This appears to be a more cost effective option than banker’s guarantee where the obligor is usually required to place in fixed deposit a sum equivalent to the bond amount.  This is in addition to the processing fee that the bank may charge. For a project with contract sum of $50million, the main contractor may have its cash amounting to $5million inaccessible for several years with the bank to serve as collateral until project achieves final completion. This can have a compromising cash flow effect even to established contractors. Therefore, indemnity bond issued by insurance companies appear to be a fairly cost effective alternative where the contractor may only be required to pay a fraction of the sum underlying the bond value. However, whether the insurance company may be comfortable issuing an on-demand bond without the extent of collateral typically required by bank may be a subject of negotiation and bargaining power. 

Performance Bond

Prior to commencement of any construction works, the contractor awarded with the project is usually required to provide a performance bond for a sum amounting to 10% of the initial contract value. This performance bond is required for the ‘due performance and observance by the contractor of all its obligations, responsibilities, and conditions stipulated under the contract’. Such requirement is intentionally worded in a very broad manner so that there are no restrictions imposed on the Employer on the permissible basis for any future calling of the performance bond. As pointed out in the beginning of this article, some of the common reasons that may initiate the calling of performance bond include contractor abandoning the project by its default, severe delay to project completion resulting in accumulation of excessive liquidated damages, unsatisfactory and defective works remained unresolved resulting in the need to engage third party contractors etc. Therefore such bond is meant to address situations where the contractor has issues with its contractual ‘performance’.

Some have argued whether there is a necessity for such performance bond given that most construction contract would ordinarily have retention sum amounting to 5% of the initial contract value simultaneously imposed on the contractor. It is also often argued that since the Employer only pays the contractor based on actual works done on site and not ahead of progress of works, its financial risk is minimised. Is performance bond a duplicative requirement considering the availability of retention sum? In fairness, there are certain differences in contractual treatment of retention sum as compared to performance bond. Firstly, retention monies are accumulated progressively by the Employer until it reaches 5% of the contract value based on incremental deductions from interim progress payments. In other words, the Employer would only have the full retention sum after multiples months of deductions made from interim progress payments to the contractor. Secondly, the first half of the retention monies are released to the contractor upon achievement of practical completion and the remaining second half is subsequently released upon final completion. By contrast the Employer would have access to the full performance bond prior to commencement of any construction works until the achievement of final completion. Secondly, there are still practical differences between bond and cash deposits. Even on the best case scenario of an on-demand bond, the Employer may be confronted with various legal resistance to payment such as grounds of unconscionability, which will be elaborated later in this article. On the other hand, retention sums are as reliable as cash deposits. Therefore having retention sums and performance bond simultaneously represents a mixed of financial guarantees available to the Employer.

Advance Payment Bond

As contractors retrospectively recovers payments after carrying out works on site, they are often out of pocket financially due its need to finance the project. The duration from the submission of monthly progress payment claim until the actual receipt of payment can take approximately two months or even longer. Therefore where the project involve early placement of order for costly long lead equipment or construction materials, contractors may request for advance payment from the Employer for a sum that depends on the initial capital outlay expected by the contractor. In return, it is common for the Employer to correspondingly require an advance payment bond from the contractor for such amount. 

The legal characteristics of advance payment bond is largely similar to that of performance bond discussed earlier. However the commercial treatments can be very different between these bonds. Firstly, the Employer usually stipulate in the contract for a progressive recovery of the advance amount paid via deductions from monthly progress payments. The mechanics behind such recovery is quite similar to that of retention sums. In essence, the Employer may stipulate that a certain percentage of monthly progress payments made to the contractor is subject to deduction until such time the advance amount is fully recovered. Such monthly deductions could be in addition to the retention sum deductions. The advance payment bond may be cancelled and return to the contractor once the recovery is completed. Such arrangement may not be appealing to certain contractors especially if the advance payment bond is in the form of banker’s guarantee where a fixed deposit collateral is required by the bank where such sum could have been used for the placement of advance orders. Further to that, the contractor is mathematically worse off than before upon the recovery of advance payment since it is confronted with both a reduced progress payment as well as the need to pay cost associated with the provision of a bond. 

From the Employer’s perspective, the practical advantage of an advance payment bond can be fairly limited particularly if there is a mechanism of recovery of advance payment through deduction of progress payments. It may not be worth the legal costs and hassle to call on the advance payment bond when the order is already placed and part of the advance amount has already been recovered. The Employer’s interest may be better served if certain contractual arrangements can be made to ensure that it has access to the title of ownership of such long lead equipment or material that are off site in case of contractor’s default.

Calling of Bond – Tips and Traps

Whilst on-demand bond often provide the veneer as an absolute financial guarantee for the beneficiary with unfettered access to payment, there are legal safeguards in place which may be construed as impediments or obstructions. These safeguards restrict payment where the calling of bond contains elements of fraud or unconscionability. The presence of these legal safeguards appears to be at odds with the wordings used in on-demand bond where the ‘issuer irrevocably and unconditionally undertakes to make payment immediately upon demand by the beneficiary without proof that there are entitlements due under the principle contract or that the obligor is in breach of its obligations’. In reality the legal safeguards are not in contradiction with the wordings of an on-demand bond. Whilst the issuer is typically under an obligation to pay upon demand, the obligor is also at liberty to contest such payment by applying for a court injunction. The wordings in such bonds only go in so far as addressing payment obligation of the issuer but not on the obligor’s rights to injunctive relief. As the courts in Singapore assess the merit of the obligor’s application for injunction based on grounds of fraud as well as unconscionability, the beneficiary ought to have these considerations in mind prior to calling on any bond in anticipation of any legal resistance.

Although the concept of fraud seems self explanatory, the types of conduct that may be deemed unconscionable is less straightforward. Fraud typically refers to conduct that is dishonest, morally reprehensible and lacks good faith but unconscionable is often associated with ‘unfairness’. The latter can be subjective and fact sensitive, making it difficult to breakdown its definition into discrete and definitive elements. There are however multiple case precedents on the matter of unconscionability as it relates to calling on bonds that may be instructive. In the case of Gammon Pte Limited v JBE Properties Pte Ltd [2010] SGHC 130, the main contractor applied for an injunction to restrain the Employer from receiving payment from the latter’s calling on a performance bond. The performance bond included a term which states amongst others that the issuer shall be obliged to effect payment within 30 business days of a claim and shall be under no duty to inquire into the reasons, circumstances or authenticity of the grounds for such claim or direction. The performance bond is therefore deemed an on-demand bond. The main contractor argued that it would be unconscionable for the Employer to call on the bond although it did not dispute the presence of outstanding defects in the concerned building. The bond amount is $1,151,500.00 and the Employer claimed that $1,820,198.59 is due and payable by the main contractor. The key issue relates to a figure of $2,200,800.00 included in the said $1,820,198.59 pertaining to an alleged rectification cost of aluminium cladding defects. What was before the judge in this instance was purely on the issue of unconscionability on the calling of bond. Therefore the only relevant question was whether there was a prima facie case of unfairness rather than the actual merit of the underlying substantive claims. The main contractor’s case was that original cost of the supply and installation of the entire curtain wall was only $1,690,000.00 of which the cost of the aluminium claddings that were in issue was only $371,664.00. Therefore the alleged rectification cost was six times the original cost of the said aluminium cladding. The Employer apparently awarded the rectification works to an entity which did not appear to have any expertise in design, fabrication and installation of cladding via a one page document with no scope of work detailed at all. Further, the total defects rectification cost amounted to more than 25% of the original contract sum to construct the entire building which curiously the architect had issued completion certificate for. The judge ordered the parties to provide quotations for cost comparison with the sum of $2,200,800.00 and were ultimately found to be significantly lower. The call on the bond was therefore ordered to be deferred by the judge, pending final resolution of all the issues between the parties.  

Given the above it appears that when determining whether it was unconscionable to call on a bond, the principle of unfairness is assessed based on proportionality of sum claimed relative to bond amount. Payment can be restrained if the figures reflected in the relevant paper work, even on a prima facie basis give rise to disproportionality. Therefore, some have argued that an on-demand bond is in reality comparable to an indemnity bond, except that the burden of assessment is shifted from the issuer to a court. The beneficiary therefore ought to satisfy itself prior to calling on any bond that it has a proper basis and documentation to support its claim, regardless of whether the issuer undertakes to pay upon demand without any requirement of delving into the merits of the underlying disputes.

If justification and proper basis are essential ingredients for any successful calling on bond, the primary function and purpose of bond as a risk allocation device ought to be reviewed and understood in perspective. Are bonds meant to prevent the beneficiary from being out of pocket financially whilst the disputes are pending determination? Or are bonds meant to be a security to an amount claimed such that it becomes available when the disputes are finally favourably determined? If it is meant to avoid an out of pocket situation, then beneficiary can technically demand for payment even with mere existence of disputes, regardless of the merits to the claim even on prima facie basis. Given these considerations, it would appear that having cash deposits is a lot more certain and straightforward than an on-demand bond at least from the beneficiary’s perspective. The differences between cash deposit and on-demand bond are not insignificant, both from the legal and commercial perspectives. 

Conclusion

There is no right or wrong on the question of whether a bond is payable on demand or payable on default. This issue is strictly speaking a matter of commercial bargain between business entities as part of its risk allocation assessment. Even when a bond’s security guarantee is ‘elevated’ from an indemnity bond to an on-demand bond, the practical difference may be limited. Therefore when making risk assessment, it may be advisable to pay attention to the details beyond just the label.




Koon Tak Hong Consulting Private Limited