A Performance bond (Also known as a contract bond) is commonly used in construction (not exclusively) as a way of satisfying the beneficiary that the contractor and any of their sub-contractors will fulfill their contractual obligations to the Obligee. This is a tripartite agreement. The parties are,
- The Principal, the party who has to get a bond
- The Obligee, the party who wants the bond or guarantee
- The Surety, the underwriter who issues the bond and goes guarantor for The Principal.
Performance bonds are mandatory for government and local autority projects. In the private sector, they are used quite alot and are becoming more and more prevalient in Ireland every year. There are two types of performance bonds, Conditional which is by far the majority and On-Demand Performance bonds. On-Demand bonds differ in that they will have to be paid immediately to the Employer(Obligee) once they are called.
Why would a surety go guarantor or underwrite these risks?
The surety will do so based on the client’s (The Principal) Bonding Capacity. Bonding capacity involves,
- Financial strenght of the company
- Financial Reporting
- Cash Flow
- Management team strenght.
In addition, to satisfying themselves that The Principal’s Bonding capacity is good enough to proceed, The Surety will require a Counter Indemnity legal document officiated over and agreed upon by The Principal.
Drilling down into the nuances, if the bond is called(meaning the Obligee asks for the bond to be paid), The Surety will then use their experienced team to promptly investigate the case (this is good for The Principal as they won’t just pay out they will make sure the Bonds terms have indeed been breached before doing so). Once The Surety has satisfied themselves that the Bond must be paid they will do so as soon as possible (this is great from a Obligee point of view, as they are legally guaranteed to be compensated by a objective party whom can pay straight away). Now that the bond has been paid, the Surety is out of pocket…No, remember that The Principal signed a Counter Indemnity document idemnifying (apart from a catasrophic financial failure by The Principal, the Surety will be able to reclaim, all funds paid out to the value of the bond), thereby mitagating almost all the risk.
The 3 parties entering into a Bond should all have the aim that it will never be called. The surety makes their money by facilitating The Principal’s ongoing free cash flow, not to ultimately pay a bond if you The Principal defaults or breaches the Bond terms. From the above explination one can see that all parties stand to gain from a clearly defined bond.