Construction Post looks at the thorny issue of on-demand bonds
It’s a subject that has had contractors and project owners at loggerheads for as along as anyone can remember, the performance bond on a project.
The Construction Industry Council recently put its foot forward with a proposal to further study the issue to establish some common ground.
According to the minutes of a meeting held by the council’s committee on procurement in September, a special group would be formed to “deliberate on the issues and to undertake drafting of the guidance notes”.
The group would also review whether it was appropriate and necessary to commission a research study on performance bonds.
The committee’s move comes after an earlier meeting held in June 2013 where members were briefed on the types of performance bonds used in the construction industry and representatives from contractors and project owners made their views known on the matter.
“No consensus could be reached amongst members on the way forward,” was the dry conclusion of the discussion in the minutes of the June meeting.
What was clear though from the minutes was that contractors detested performance bonds while the project owners regarded them as a vital part of risk management.
Performance bonds are surety bonds issued by banks or insurance companies to guarantee satisfactory completion of a project.
In the construction industry, there are type types of bond, the default bond and the on-demand bond.
Asked to comment, a company boss at a listed contractor said contractors generally did not want to see on-demand bonds.
The cost of the bond, at about 1.5 percent per year for the bond amount for the contractor concerned, was not the main reason for not liking them but the fact that the bonds were literally “on-demand”.
“The most worrisome [thing] is some of the private clients use this as a threat to the contractor to accept unreasonable requests. This is very damaging to contractors,” the boss said.
For example, one well-known client here in Hong Kong has been known to threaten to call an on-demand bond if a contractor started the dispute resolution process.
Some project owners, especially the MTR Corporation (0066) and the Airport Authority Hong Kong, were more reasonable on the matter of bonds, according to the company boss.
A veteran industry consultant said he could understand the reasoning of both contractors and project owners on performance bonds.
For project owners, retention money held by them was part and parcel of risk management for a project but sometimes it could take time to use the money in the event of a contractor going bust.
This was because the project owners could be bogged down in dispute over who owns the retention money with the receivers appointed for the contractor.
That left performance bonds as the other viable tool to manage risk.
Unlike default bonds where a third party had to certify default by the contractor, on-demand bonds could be called anytime without giving any reason at all.
“With a lot the wordings here, the developer can wake up and say, ‘Christ, I’ve got a hangover, I’ll call that bastard’s performance bond’,” the consultant said.
However there has been legal precedent regarding the unreasonable calling of on-demand bonds so the contractor can always dispute such calls but that takes time.
“So you have this situation where the project owners like on-demand bonds because they feel that gives them the biggest possible stick that they can threaten the contractor with,” the consultant added.
The problem of on-demand bonds for contractors was if the bond was called, the bond amount came straight out of the contractor’s overdraft facility, as contractors generally financed their operations with overdrafts.
For example an overdraft of HK$10 million would instantly be halved if a bond of HK$5 million was called.
“So if contractors have a lot of bonds out there, that can pose a quite a problem for them,” the consultant said.
Another aspect of getting a bond was that there are banks and and there are banks.
The consultant pointed out that the international contractors had an easier time if they maintained good business relationships with the banks in their home markets.
As such, they could get bonds at a much cheaper rate.
For the others who have to rely on local banks, it could get expensive.
“Especially if you are a Hong Kong-based contractor,” the consultant said.
The bond document itself could be problematic with the bond document being issued as part of the tender documents to contractors.
A successful contractor would take the bond document to a financial institution and arrange for a performance bond.
Unfortunately the bond documents were usually written by the project owner’s solicitors and made use of archaic forms of wording.
“For the average [project quantity surveyor], it’s just gobbledygook,” the consultant said.
Not only was the wording difficult to understand, the bonds sometimes had no expiry date which is a big no-no for the financial institutions.
“Banks here in Hong Kong hate that,” the consultant added.
According to the June meeting minutes, 80 percent of the MTRC’s bonds have an expiry date specified by an event with the remaining 20 percent have a specified fixed date.
The Airport Authority previously used bonds without expiry date but has recently revised its practice and stipulated a fixed expiry date as well as reducing the bond amount.
For government contracts, performance bonds have been waived since 1997 except on projects with tight programmes, high risks or co-funding with China.
The willingness of a financial institution to issue a performance bond was also affected by its own internal limits on financial exposure to its various business sectors.
To reconcile the opposing views on on-demand bonds, the consultant suggested that perhaps a hybrid bond of default and on-demand could be used.
The bond, with an expiry date, could be called immediately if the contractor went bust or had made a financial arrangement with its creditors.
If there was a default by the contractor, an independent third party would have to certify the default first before the money can be released.
The third party would have to be truly independent and as such the architect, being employed by the project owner, could not be considered independent.
“The solution lies between the two,” the consultant said.
On-demand bonds – the view from the insurance industry
Construction Post talks to a source in the insurance industry on performance on-demand bonds.
CP: Construction Post
S: Source in the insurance industry
CP: Is the issue of on-demand bonds as controversial an issue as it is made out to be in the discussion [in the June minutes]?
S: They are controversial from the aspect that contractors simply don’t like a bond that can get called for reason at all compared to say a default bond where there has to be grounds to call the bond. Although the fine print of the contract and/or required bond wording needs to be looked at closely as often, a default bond may effectively be an on-demand bond.
Ultimately, it is of course the contractor’s money as whether they source the surety by way of bank guarantee from their bank or a surety bond from an insurer, the contractor will have to reimburse the bank or insurer.
Regarding the insurer’s surety that we deal with, the contractor signs a deed of indemnity to repay to the insurer any bond amounts that are called. In the case of the bank issued [bonds], it will be debt.
CP: And with the current boom in the industry, will the premium for on-demand bonds go up or are they already going up? The [June meeting] minutes seem to hint at this.
S: [I’m] not sure whether the on-demand rates are going up. Banks provided a large amount of bank guarantee/surety to contractors currently and their pricing is typically lower as they do not require collateral as such – they use an existing credit line.
Insurers typically will not require collateral, they just rely on the deed of indemnity and accordingly their rates are usually higher than a bank.
The premium for on-demand bonds can be a bit higher than the usual performance bond required by the likes of MTRC who are a huge entity requiring many bonds for their Hong Kong projects.
Some insurers charge the same rate for the bond whether default or on-demand.
CP: Are contractors paying more for bonds now say in 2008 when the [construction] market was down? What is the going rate for the premium for on-demand bond as percentage of the bond amount for building or civils works?
S: The cost that a bank or insurer may charge for a bond is typically 0.5 to 1 percent of the bond amount per annum. So it all depends on how long the bond is required for.
MTRC bonds are often seven years but they recently reduced their required bond amount from 10 percent to three percent of contract value.
A major factor is also the balance sheet of the contractor. The stronger the balance sheet, theoretically the lower the rate. Whether rates are higher now than 2008, it’s probably not. But it would depend on individual cases.