For those who do not live on the construction planet, a performance bond is a bank guarantee issued by a main contractor in favor of a project’s owner or employer. The bond is usually issued for 10% of the value of the construction contract. The construction industry, through a range of practices and contractual frameworks such as the FIDIC rules, invented the concept of performance bonds primarily to protect employers against contractors’ breaches.
With the performance bond usually being “unconditional” the idea is that an employer would have the ability to liquidate the bond at any given point of the contract’s lifespan should the contractor commit any qualifying breach. The bond also serves as a claw back tool that enables the employer to deduct any amounts due on account of defective works or snags that are not rectified by the contractor during the 12 months defect liability period.
This might sound like the perfect set up for employers right ? As an employer all you need to do is to monitor the monthly progress of construction, you usually have 30 to 45 days to make payment of payment applications certified by the Engineer, in case anything goes wrong, you either withhold payment or terminate the contract and call the bond or take any other appropriate measure.
The reality of managing a construction project is however far from perfect. A common theme that legal practitioners often see towards the end of each project is a game of who blinks first, played between contractors and employers. What commonly occurs during the last stretch of a project is a situation that can be summarized as follows:
- An employer who is keen to achieve the Building Completion Certificate to meet obligations towards buyers of off plan units, financing institutions or, in the case of build to lease projects, to kick start revenue generation;
- A contractor who has made several application for variations and/or extension (s) of time seeking to vary the contractual pricing and/or avoid penalties for delay;
Employers often tend to play a high stakes tactical game during this phase of the project. They know that if they push the Engineer to reject the contractor’s variation or extension of time applications this may lead to the contractor abandoning the project. The potential for this outcome is usually obvious because if the contractor sees that they will end up in a loss in any event, then it would be more practical to stop work and cap their losses at the 10% delay penalty applicable under the contract.
If this happens an employer would be faced with a disastrous situation where an alternative contractor must be engaged to complete the project. Any other contractor coming in at that late stage would likely charge more and take longer to mobilize on the site. To keep the current contractor going, employers would delay the determination of the contractor’s applications for as long as possible. This signals that the door remains open for the contractor to get paid more, whilst making no commitment to do so.
In turn, knowing that there is no guarantee that they will get the additional amounts they are seeking, contractors respond with covertly slowing down the rate of progress at site. From a contractor’s perspective once the Building Completion Certificate is issued, employers have the upper hand because they can start handing over their project as this certificate signifies the legal ability to occupy the building. So, whilst officially maintaining that they are working towards achieving the Building Completion Certificate, contractors start to take a position that certain works are delayed because of the employer or the project’s Engineer.
A very tense environment is then born. An anxious employer starts losing patience and develops the feeling that they are being held hostage. A contractor starts to slowly lose interest in the project as the mindset starts to shift towards damage control and preparations for potential legal proceedings. It is during this tense time when the role of the performance bond becomes most crucial. Bonds are often seen by employers as the nuclear option. They know that if this press this button there would cross the point of no return and hence they often only use it as a last resort.
The reason being that at such advanced stage of the project, a contractor is often in a delicate financial position. They would have one or more pending payment applications not certified yet or worse they would have received a negative certification i.e. that in the Engineer’s view the value of work they completed is less that the money they received from the employer. This is usually coupled with the fact that 5-10% of the contract’s value is also held by the employer as retention.
So in these circumstances if the employer liquidates the performance bond, the contractor faces immediately losing 10% of the contract’s value thereby directly affecting their cash flows and ability to borrow from banks for other projects. As such contractors try to maintain a balanced approach with employers to avoid a call on the bond.
With all of that said, contractors are not helpless. There is a well established practice adopted by most UAE courts which can provide interim relief to a contractor. If a contractor can demonstrate that they have achieved substantial completion or a Building Completion Certificate, courts would be willing to grant a precautionary attachment over the performance bond. Such attachment or freezing order would have the legal effect of preventing the issuing bank from liquidating the bond until the substantive dispute between the contractor and employer is resolved.
The downside of applying for such an attachment is that the UAE Civil Procedures Code requires a successful applicant to file a substantive claim against the opposing party within 8 days of the issuance of the attachment order. Failing which the attachment order automatically falls away. This places a contractor is a predicament. If they apply for the attachment prematurely, this might blow any chances of amicable resolution with the employer because it must be followed with a judicial or arbitral confrontation between the parties.
To avoid having to fire the first bullet, many contractors wait until the employer calls the performance bond to apply for the precautionary attachment. This way a contractor would be able to argue that they only did so to defend themselves against the employer’s action and potentially leave some room for a practical solution to be reached.
This is when the issuing bank’s role kicks in. A bank guarantee such as the performance bond is legally classified as a contract between the issuing bank and the beneficiary of the bond. It is an obligation to release the funds upon request without any need for further consent or intervention from the client who instructed the bank to issue the bond. Therefore from this perspective many practitioners take the view that the bond is a sacred document that plays a major role in transactions. From this point of view banks should not be permitted to do anything that jeopardizes the standing of bonds as this would lead to devaluing the very purposes of unconditional bonds.
What we see on the ground is that upon receiving a call on a performance bond, some banks immediately inform the issuing client. They then tell the beneficiary that the payment is under process while intentionally taking longer than needed to make the payment. This delay allows the contractor to go to court to obtain an attachment order prior to the completion of payment “processing” .
So the question becomes can a bank be liable to a beneficiary for such delay in processing the liquidation of the bond ?
This question was recently alive in a claim before a UAE court. The main legal question at the core of the proceedings was whether there is a specific timeline during which banks must process requests to liquidate bonds or bank guarantees. The court appointed banking expert concluded that the UAE Central Bank’s directions impose a 5 days processing period for such applications. Therefore it follows that if a bank exceeds this period it would be in regulatory breach which in turn could open up liability for compensation. That is of course in addition to liability that could arise from any deliberate collusion with the issuer of the bond to cause further delay through using tactics such as sending unnecessary document requests to the beneficiary of the bond.
This shows that the courts in the UAE are willing to entertain claims for this type of liability against banks if such conduct takes place. Therefore banks should be more attentive to this aspect of their activities and monitor the conduct of their relationship managers very closely in these circumstances.
In normal circumstances, the preparation, filing and registration of a precautionary attachment application would take any party more than 5 days. Once registered decisions are made within 2-4 days. As such, if banks are held accountable for the said 5 days time time this could practically lead to the end of the route of obtaining precautionary attachments as a response to liquidation calls on construction performance bonds.