ON-DEMAND PERFORMANCE BONDS ARE COMMONLY USED IN INTERNATIONAL ENERGY CONSTRUCTION PROJECTS . THEY TAKE THE FORM OF AN UNDERTAKING BY AN ISSUING BANK OR FINANCIAL INSTITUTION , ON BEHALF OF AN OBLIGOR , TYPICALLY THE CONTRACTOR , TO PAY ON DEMAND A SPECIFIED AMOUNT TO A NAMED BENEFICIARY , TYPICALLY THE EMPLOYER . BY ROBERT MEADE , PARTNER , AND ALISTAIR CALVERT , PARTNER , AT BRACEWELL ( UK ) LLP , AND TOM SWARBRICK , PARTNER , AT BRACEWELL DUBAI

Performance bonds are intended to guarantee a contractor ’ s satisfactory and timely completion of a project . There is no need for the employer to establish or prove that the contractor has defaulted on its obligations prior to making the call . For that reason , enforcing a performance bond is often seen by employers as an attractive option : it can be a means of obtaining a quick cash return , which could alleviate any cashflow pressures that threaten the viability of the project .

Historically , calling an on-demand performance bond has always been seen as the exception , rather than the rule . They were a form of security that was often required , but that was only reluctantly enforced . However , the political and economic shocks felt around the globe since 2020 have started to change this perception .

Supply chain issues , increased costs and insolvency risks have led to employers being more willing than ever to call performance bonds , and we have seen a number of calls being made in the last two years . But experience shows that making a call is never as straightforward as the employer expects . There is often disagreement as to where fault lies and , occasionally , around the bond call procedure itself . The decision to call a performance bond should , therefore , be exercised with caution and only once full thought has been given to the process and potential outcomes . We set out below some of the factors that an employer should consider when deciding whether to call a bond .

The impact on the commercial relationship Calling on a bond should not be looked upon in isolation but in the context of broader commercial relationships .

Facing a demand on a bond is likely to cause damage to a contractor ’ s banking relationships . The contractor will generally have provided collateral to the bond provider to support the performance bond . Any call will most likely cause the contractor to lose its collateral and will affect its subsequent ability to obtain performance bonds or access finance . This could correspondingly impact its ability to bid for and win future projects .

For that reason , employers should be aware that enforcing a bond is very likely to jeopardise the relationship between employer and contractor . If the parties ’ goal to complete a project remains aligned , a bond call may not be appropriate despite the contractor ’ s defaults . However , the severe impact on the contractor can also provide the employer with leverage . We have recently advised on a number of projects where calling a bond ( or at least threatening to do so ) was enough to get the parties to seriously focus on settling their issues and completing the project .

Calling a performance bond can also have negative reputational impacts for the employer . If it becomes common knowledge that a certain employer frequently resorts to making calls on bonds , this could drive up the price at which contractors are willing to do business with that employer in the future and make it harder to obtain similar security .

Requirements of the bond The cardinal rule is that an issuer of a bond will only pay out under the bond if it is presented with a valid demand . The employer will need to make sure that the demand takes the correct form and is accompanied by the correct documents . It will also need to ensure the demand is served at the right place and by the right method . Employers should ensure they comply strictly with these requirements . Failure to do so will result in the demand not being effective .

Because of this , it is sometimes prudent to liaise with the issuer of the bond before the call is made to ensure that all necessary requirements will be fulfilled . This introduces the risk that the contractor becomes aware of the proposed bond call ( and therefore provides it with an opportunity to take preventative action ), but it also significantly reduces the risk that the issuer of the bond will reject the form of the demand for being non-compliant .

Finally , the employer should ensure that the correct party is making the demand under the bond . Remember that in a project finance context , security will often have been taken over the bond proceeds . The employer should check the security and assignment documents to ensure the right party is making the demand . Is it the employer ? Or is it the bank that has taken security over the bond ?.

Project Finance International January 11 2023 49