Practical Law

This post considers whether a performance bond:

• Is triggered by the insolvency of the principal contractor.
• Will respond if the principal contractor becomes insolvent.

If you are still misunderstanding the implications of the decision in Perar BV v General Surety & Guarantee Co Ltd then you are not alone. Many well regarded law firms also misunderstand it. There is a misconception that it means that an employer (beneficiary) cannot bring a claim under a performance bond based on the contractor’s insolvency or that the bond is not triggered by and payable following the insolvency of the contractor. 

If that were true, it would be concerning because bonds are usually obtained by the employer to protect against precisely that risk – the possibility of the contractor becoming insolvent.

As a result it has become fairly common practice for employers to seek an amendment to the standard bond wording to include an express statement that the insolvency of the contractor is a breach for the purposes of the bond. Is this really necessary? The answer in my view is no.

I say that because the possibility of the insolvency of the contractor is something which parties to the standard form construction contracts address their minds to when negotiating and entering into the contract. As such, it might accurately be characterised as “an event” which the parties have wisely contemplated and provided for.

Standard wording in the construction industry

The construction industry is fortunate in that it has a standard form of bond which is succinct and in plain English. This is thanks to the Surety Bond Panel of the ABI, which crafted that wording following judicial criticism of the use of archaic bond wordings in Trafalgar House Construction (Regions) Ltd v General Surety & Guarantee Co Ltd.

The industry also benefits from resources such as the standard form contracts published by the JCT and other bodies, which contain detailed provisions including those that specify what is to happen in the event of the insolvency of the contractor. They will usually either provide that the employment of the contractor is automatically determined or that the employer may opt to serve notice determining the contractor’s employment. The contract then goes on to set out the consequences of that determination.

In the normal course, the employer is not obliged to pay any further sums to the contractor; and the employer may use materials on site and engage a completion contractor to carry out and complete the remaining contract works. Following completion, an accounting process is undertaken to calculate the ultimate net loss that the employer has suffered as a result of the original contractor failing to complete the works as originally contracted for.

The employer will undoubtedly be holding funds due to the original contractor – in retention, money certified but not paid, and the value of work done and materials supplied but not yet certified or paid for. On the other hand, the employer will have incurred costs in having the works completed by the completion contractor over and above those costs which it would have expected to pay to the original contractor. The employer may well have incurred additional expenses such as those relating to securing the site following the demise of the original contractor.

Thus, the contract sets out what is to happen and once the final account has been drawn up, any balance due from the original contractor is a debt. The employer can then demand payment of that debt from the original contractor. When the insolvent contractor fails to pay that debt once it has fallen due, then that may be characterised as a breach.

Accordingly, the insolvency of the contractor is not a “breach” of the contract. The standard form contracts do not categorise insolvency type events as a breach of contract. Contrast the position in relation to other occurrences such as a failure to proceed regularly and diligently with the works.

The employer needs to analyse the contract provisions to ascertain what the consequences of insolvency are and to identify the subsisting obligations of the now insolvent contractor. The contract has not been brought to an end; it is the contractor’s employment that has been determined. This is an important distinction. The contractor is relieved of the obligation to carry out and complete the work from the point of termination, but it is not relieved of all its contractual obligations, some of which will remain extant.

What then is the effect of stating in the bond that the insolvency of the contractor is a breach for the purposes of the bond?

The decision of the House of Lords in the Trafalgar House case is the leading case in relation to conditional performance bonds and the court made it clear what a claimant needed to establish in order to bring a successful claim. The two elements are that:

• The contractor is in breach of contract.
• The employer has suffered net loss as a result of that breach, which it needs to prove and evidence that it has sustained.

In amending the wording of the standard bond such as that published by the ABI, the employer has established one key element that it needs to prove in order to bring a claim under a bond, namely, the breach. “Good” the employers and their lawyers may say, “Let’s include that wording then – that’s good for us isn’t it?”. Well, maybe, maybe not. What you have done is to create a mismatch between the bond wording and the contract.

The amended bond wording now provides that the insolvency of the contractor is a breach, but doesn’t specify the consequences. The contract contains consequences for breach, but insolvency is not a breach. It is a moot point what loss has been suffered under the contract “thereby” when “thereby” means as a result of the breach of contract relied upon .

The second element is that the employer has suffered loss and damage as a result of that breach. This means that the net loss and damage has been sustained and ascertained in accordance with the contract. This can only be established after the works have been completed by the new completion contractor and the accounting exercise contemplated by the contract has been undertaken.

So what happened in Perar?

Perar contained a bond wording which was quite specific and relatively unusual. It is rarely, if ever, in use in projects today. It contained a condition precedent requiring the employer to notify the surety within a specified timescale if the contractor was in breach of contract. The employer notified the surety that the contractor was insolvent and therefore, in breach of contract. It was expressly stated in the bond that failure to comply with the condition precedent meant that no recovery could be made.

Of course, becoming insolvent is not in itself a breach of contract. So the employer notified an event, insolvency, which was not a breach and having set off down the wrong path, and based its case entirely on the wrong basis, the employer’s claim failed.

You may think that seems unfair, that there was a technical defence when the contractor had become insolvent and the employer had to engage someone else to complete the work. Well, don’t rush to judgment unless you know all the facts. Remember that only the parties themselves know the factual matrix unless and until there is a full trial with witness, expert and documentary evidence being fully canvassed. That never happened in Perar so only the parties and their advisers are in possession of the full facts and know the underlying merits of the claim.

Will the performance bond respond if the principal contractor becomes insolvent?

The answer to this question is: yes. It remains “yes” without the amendments to refer to insolvency which employers often request.

A performance bond is not, as some mistakenly think, a lump sum amount that can be called upon to be available immediately on insolvency. By securing a performance bond, the employer is not obtaining a guarantee for payment of a lump sum payment on insolvency, which may – or may not – reflect the employer’s actual loss. Rather, a performance bond is a guarantee of the ultimate net loss that the employer may suffer if things go wrong and the original contractor does not carry out and complete the works in accordance with the contract.