Performance bond – default insurance

Performance Bonds – Some Questions

We have received a lot of questions lately about Performance Bonds.  Specifically, we keep getting asked about performance bonds in the international arena and whether we can write a bond for some sort of international deal.  So, let’s discuss this here.

What is a Performance Bond?

A performance bond is a type of a surety bond.  This type of bond is unlike the standard type of bond, which most people think is a type of financing.  Instead, a performance bond is more like insurance.  It is a three party contract.  The three parties are:

Surety – This is the party that is guaranteeing the actions of another (the obligor)

Obligor – The obligor (or principal) is the party that is doing the work pursuant to the terms of a contract or agreement

Obligee – This is the party that is demanding a guarantee on behalf of the principal (obligor)

Here’s a short example of a performance bond

Let’s assume that the obligor is a concrete company.  They get a job on a large construction project, like laying down all of the foundation and parking lots for a new shopping mall.  The concrete contractor has done this work many times in the past and is a fairly stable company.  However, the general contractor requires the concrete company to get a performance bond.  The performance bond provides that the concrete company will perform the work on the shopping mall in a timely manner and for the prices quoted.

What is a performance bond?

So, the concrete company goes and gets a performance bond in the amount of the contract.  This bond obligates the surety to guarantee that the concrete company will perform the job according to the terms of the construction agreement.  If they don’t, then the surety will find another company to finish the job (or pay damages to the general contractor).  Finally, most performance bonds have a provision that the job that was completed will be effective for a certain time period, such as a year (this is called the maintenance provision – it just guarantees that the work performed was done in a good manner).

What are the different types of Performance Bonds?

First, there is the standard type of contract performance bond, also known as a default performance bond.  That type of bond is the one described above.  It provides that there must be some triggering event – such as the default on a contract – before the performance bond can be called.  Once a default is claimed by the obligee, then the surety will investigate that claim and then make sure that it is a valid claim (and not just a standard construction dispute).  The, and only then, will the surety make sure that the contract is fulfilled according to its terms.

Construction performance bond

There is also another type of bond that is pretty concurrent with a demand performance bond.  That is a payment bond.  A payment bond makes sure that the contractor pays all of their material providers in a timely manner and in full.  Further, a payment bond verifies that the contractor pays all of their subcontractors in a full and timely manner.

The third type of performance bond is the one that we’ve been getting a lot of questions on lately.  And that’s a demand performance bond.

Demand Performance Bond

A demand performance bond is utilized pretty regularly in the Middle East.  It actually spawns from London and the attorneys that practice there.  Unfortunately, it is completely unlike the typical performance bond.  A demand performance bond is just that – when the obligee makes a demand for payment, then the surety must pay the bond.  This is really just a financial guarantee.  There doesn’t have to be any sort of demand or any investigation by the surety.  Quite frankly, the obligor doesn’t even have to have done any wrong.  It’s all about the demand.

types of performance bond

It is extraordinarily difficult to get a demand performance bond.

Conclusion

There are three main types of performance bonds, a performance bond that comes due only when there has been a claim made under a contract.  The next type is a payment bond, which makes sure that all material vendors and subcontractors are paid.  Finally, there is a demand performance bond, which is normally only used in international situations.  It’s paid when a demand is made and there does not have to be shown a problem.