The importance of bonds when insolvencies are rife

Kirsteen Milne is a partner at Brodies LLP

For the past few years the insurance and bonds market has been hardening, but the headlines in mid-June that QBE Europe has pulled out of the construction market is a blow to contractors. This follows other big surety providers pulling out of the market over the past couple of years.

“Some contractors have been struggling to obtain bonds, or certainly at acceptable costs”

It also comes as several recent construction company insolvencies have impacted clients and subcontractors. Those who have been stung by an insolvency without any potential recovery under a bond may be more likely to insist on a bond in future projects.

A closer look at the small print actually reveals that QBE will continue its partnership with Evo Surety to offer SME surety bonds of up to £1.5m. However, this will still have an impact and put pressure on the remaining bond providers. The maximum per bond is £1.5m as well as the maximum aggregate bond value that one party can bond with QBE over a number of bonds.

It is common for there to be a requirement in construction contracts for a performance bond. The bond is largely to provide cover in the event of insolvency of the contractor (although it will usually also cover any breach of the construction contract). This will usually be at 10 per cent of the contract sum and expire shortly after the issue of practical completion/completion certificate. Although we do still see the odd bond that endures during the defects liability period, they are often at a reduced level.

The most common form of bond is still a default bond, based on an Association of British Insurers form, with some amendments for an immediate demand in the event of insolvency and to allow it to be assigned to funders. We do sometimes see ‘on demand’ bonds from certain providers.

The impact of bond shortages

Recent press coverage has stated that a shortage of bond providers is threatening to delay project starts. For a while now we have been aware that some contractors have been struggling to obtain bonds, or certainly at acceptable costs. The irony is that the higher the cost of a bond the more likely it is that the client should be obtaining it as the cost will reflect the surety’s assessment of the risk of insolvency. However, it is often where the bond cost is higher than budgeted that clients decide it is not required.

Parties should discuss the requirement for a performance bond early in the procurement process, checking what is available, at what level, for what cost, and for whom. While there are new bond providers coming into the market, these may not meet contractual requirements if the contract states certain ratings that the provider needs to have, for example Moody’s or Dun & Bradstreet.

Both contractors and clients can consider whether there are alternatives that would provide comfort that there is cover in the event of an insolvency, for example parent company guarantees or increased retentions.

For those involved in housebuilding, some of the guarantees may also include insolvency cover. We have also seen an increased use of escrow accounts, where monies are transferred to a designated account. In the event of an insolvency, the client can require the transfer of the monies to it and on completion (assuming no insolvency) the monies will be released to the contractor.

It is better for all parties to have these discussions early on, especially if there are third parties such as funders who will be required to approve the terms of a bond, or if the procurement is subject to public procurement regulations where there may be other factors to consider.

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