Retention bonds

Paul Cowan considers retention bonds

Most forms of standard contract and sub-contract allow the employer under a contract or a main contractor under a sub-contract to retain part of the amounts due to the contractor or sub-contractor to protect against the possibility of default (usually insolvency) by the contractor or sub-contractor prior to the completion of the works. The traditional way in which this is effected is by means of "cash retention", whereby a percentage (usually between 3-5%) of the contract price for the works is retained by the employer or contractor. The retention is usually released in two tranches, the first at practical completion and the second when the works are completed and the defects liability period has expired. If the contractor or sub-contractor is in breach of contract (for example due to insolvency) then the employer or contractor has a readily available fund which can be applied to completing the works with another contractor or sub-contractor or remedying any uncorrected defects.

Cash retentions are increasingly unpopular with the supply side of the industry, especially sub-contractors. Principally, their objection is based on the impact that is caused to their cash-flows by having to wait until the final completion of the works before they receive retained sums. Consequently, there is a developing trend for sub-contractors, and sometimes main contractors, to demand the replacement of cash retention with retention bonds.

In essence, retention bonds are provided to the employer or contractor by a third party who acts as a guarantor of the contractor's or sub-contractor's due performance of his obligations. It is argued by those seeking to replace cash retentions with retention bonds that the provision of such bonds will result in lower tenders. The fundamental question is, however, whether the bonds, whilst solving cash-flow problems for contractors or sub-contractors, will give a similar level of security to the employer or main contractor as they had under the cash retention system.

Developments within the industry

Sir Michael Latham in his report "Constructing the Team" (HMSO 1994) suggested that retention bonds are a "better option" than the continued use of cash retentions (see paragraph 11.1).

Leading on from this, as has recently been reported in the construction press, a number of specialist contractor associations have formulated standard terms under which, if adopted, their members will only offer retention bonds, not cash retentions. It is understood that these associations include the British Constructional Steelwork Association, the Lift and Escalator Industry Association and the Federation of Piling Specialists. Since these associations form cartels amongst their members within the meaning of the Restrictive Practices Act, their retention bond agreements have been registered with the Office of Fair Trading.

Whilst it is arguable that a well-drafted retention bond can offer as effective a level of security for employers and main contractors as a cash retention, this very much depends on the terms and conditions of the bond.

The key distinction

Retention bonds are either drafted to be "on demand" or "conditional".

As the name suggests, "on demand" bonds allow the beneficiary to enforce the bond without having to prove (whether in court or before an adjudicator etc.) that the contractor or sub-contractor is in default. Consequently, these bonds can provide an effective substitute for cash retentions - they both afford the beneficiary with instant access to a fund where it is perceived (rather than proven) that there has been a breach. Typically, the obligation on the bondsman to make payment is triggered by the beneficiary presenting him with a statement that an amount equal to the demand is due and owing by the contractor or sub-contractor, notwithstanding any dispute or objection which he may have.

There are, however, concerns that the "on demand" method may put the employer or main contractor in a better position than they would have been in had they made a simple cash retention. Standard contracts and sub-contracts often provide that the employer or main contractor keep retained sums on trust for the contractor or sub-contractor and in a separate bank account and only permit the employer or main contractor to make use of the retained sums after, for example, the issue of a certificate of delay by the architect. Without adjustment, an "on demand" bond would allow the employer or main contractor to obtain the use of the money without these restrictions. In order to facilitate agreement from contractors or sub-contractors, this could be avoided by obliging the beneficiary to submit such an architect's certificate before a valid call under the bond can be made.

• "Conditional" retention bonds are perceived as much less effective for beneficiaries. For example, in order to enforce the BCSA's draft retention bond the beneficiary must prove that:
• the sub-contractor is in default of his obligations;
• the beneficiary has actually sustained damage; and
• that such damage has been reasonably sustained.

In fact, the only protection that such a conditional bond offers the beneficiary (beyond that which he could get by simply suing the contractor or sub-contractor) is in the event of the contractor's insolvency. Where employers or main contractors wish to have ready access to a fund in relation to any other breach of contract, a conditional retention bond is unlikely to offer much comfort.

The terms of the Retention Bond

Whether the parties agree to proceed by way of an "on demand" bond or a conditional bond, they should ensure that a number of key provisions are included.

1. The principal purpose of bonds in general (including retention bonds) is to provide security for the beneficiary against the contractor's or sub-contractor's insolvency. As a result of the Court of Appeal's judgment in Perar BV -v- General Surety (1994) 66 BLR 72, any bond must make it clear that it covers default and/or termination of the underlying contract caused by insolvency - otherwise no call can be made on the bond in the event of insolvency. It is noteworthy that many retention bonds, including the BCSA's draft bond, do not include such a provision.
2. The bond should provide that it is payable in respect of the contractor's failure to perform any of his obligations. The BCSA bond, in contrast, only guarantees the performance of the sub-contractor's obligations in relation to the defects liability/maintenance period. Bearing in mind that this bond is for a maximum sum of 3% of the contract price, reduced to 1.5% after practical completion, the effect of the limitation to defects liability is that the maximum sum claimable under the bond will be 1.5%.
3. There will be provision for the beneficiary's right to claim under the bond to end at some point. It is important that the employer makes sure that the bond does not expire until full compliance by the contractor has been provided - i.e. after completion of the works and the correction of defects.
4. Where the "conditional" format is adopted, the bond should include clear provision as to how the conditions are to be proved. For example, the BCSA bond states that the sub-contractor's default is to be proved by a letter from him admitting that he is in default (unlikely!) or by a certified decision of the sub-contract adjudicator that he is in default. However, there must be provision for all of the conditions to be proved. In addition to default, the BCSA bond requires the contractor to show that damage has been reasonably sustained. There is no provision for how this condition is to be proved. Presumably, the contractor will have to prove that condition in court when he attempts to recover under the bond.

In summary, retention bonds can be used by employers and main contractors to provide a similar level of security as that traditionally offered by cash retentions. However, only "on demand" bonds put them in a comparable position as they would have enjoyed by holding on to a cash retention. Conditional bonds, as are (unsurprisingly) being adopted by the specialist contractors associations, are no substitute for cash retention - in reality they are only of any use if and when the contractor becomes insolvent, and only then if they include a Perar clause.

What is certain is that as the specialist contractors associations urge their members to adopt their sub-contractor-friendly draft bonds, so main contractors will increasingly seek to pass on the same lack of protection to their employers. Employers and main contractors should monitor these developments with concern.

Main contractors may be particularly vulnerable to these changes. For example, the employer may insist on a cash retention which, during the course of the works, is expended by a sub-contractor's defaults. If that sub-contractor has only granted the main contractor a weak conditional retention bond, the main contractor may find himself in the invidious position of being unable to pass on his loss to the sub-contractor. The main contractor's objective should, therefore, be to achieve parity in the terms which he agrees with his employer and those which he requires of his sub-contractors.

Overall, the increasing use of retention bonds may provide employers, main contractors, and sub-contractors with an effective alternative to cash retentions. The resulting benefits may be seen in improved cash-flows for contractors and sub-contractors, and perhaps in lower tender prices. The parties accepting such bonds must, however, remain vigilant that their security is maintained.