What is a Performance Bond?

A performance bond acts as a financial assurance to one party within a contract, safeguarding against the potential failure of the other party to fulfill its contractual duties. It is typically issued by a bank or an insurance company to ensure the completion of specified projects by a contractor.

Performance bonds are widely used within the Malaysian construction industry where construction contracts often require the contractor to secure a performance bond, usually in the form of a bank guarantee which covers a percentage of the contract value. The employer is allowed to call upon the performance bond up to the specified maximum limit in the event of the contractor’s breach of contract.

A performance bond represents an independent agreement between three (3) parties, i.e. (1) the principal (usually the contractor), (2) the obligee (usually the employer or project owner) and (3) the surety (usually the bank or other financial institution who provides a performance bond to guarantee that the principal will complete their work).

Why the Need for a Performance Bond?

Performance bonds serve to mitigate the risk for the employer by guaranteeing the contractor’s compliance with the terms and conditions in the contract, and offering financial protection in case of default by the contractor on their obligations. This protection includes reimbursement for financial losses incurred due to delays or substandard work.

It also has the added effect of motivating contractors to maintain high standards of workmanship to avoid triggering the bond, encouraging adherence to timelines, specifications and quality standards outlined in the contract, thereby promoting performance quality.

Ultimately, it is a remedy for the employer dealing with a defaulting contractor, establishing a clear mechanism for recourse through legal channels.

Key Terms to Pay Attention to

Some key terms of a performance bond are as follows:

a. Scope and Amount: The scope of coverage and the maximum claimable amount are primary considerations when establishing a performance bond. Typically, the coverage amount is capped at a fixed percentage of the contract value, commonly around 5% to 10%. However, this figure may vary depending on the size and complexity of the project.

b. Validity Period: One of the common terms found in a performance bond is the specification of the validity period, i.e. the effective start date and expiry date of the performance bond. The effective start date marks the commencement of the coverage of the performance bond, often corresponding with the initiation of the construction project or the signing of the contract and the end date indicates when the performance bond will expire and no longer be enforceable. The validity period of the performance bond may be subject to extension or renewal under certain circumstances as agreed by the parties.

c. Events Triggering Call: Another crucial term is the event that triggers the call of the performance bond. This event could be the contractor’s failure to meet contractual obligations within a specified timeframe, such as delays in project completion or substandard workmanship.

Calling on a Performance Bond

The circumstances in which an employer can call on a performance bond depend on the triggering event specified within the terms and conditions of the document. This triggering event may include instances such as the contractor’s failure to meet contractual obligations within a specified timeframe or non-compliance with quality standards.

However, failure to adhere to any requirements stated in the performance bond by the employer before calling on the performance bond may lead to the contractor challenging the validity and enforceability of such a call. If the employer’s call is found to be invalid, any payment that has been made under the performance bond by the bank in such circumstances will also be considered invalid and should be returned accordingly.

There are two (2) types of performance bonds, i.e. unconditional / on-demand and conditional performance bond.

a. Unconditional / On-Demand Performance Bond

This is a situation where only a mere written demand is required by the employer to call on the performance bond. An example can be seen in the case of Esso Petroleum Malaysia Inc v Kago Petroleum Sdn Bhd [1995] 1 MLJ 149 where the performance bond was worded as follows:

“… we hereby unconditionally and irrevocably guarantee the payment to EPMI, the ringgit equivalent of the sum of DM466,562…”

The then Supreme Court held that this performance bond was, on a true construction, a pure on-demand guarantee and all that was required to trigger it was a demand in writing. It would not be dependent or conditional on the production of a document and there is no need for the bank to inquire into any breach between the parties.

b. Conditional Performance Bond

i. Demand Must Assert a Failure

This is a situation where the employer is required to state the basis for its claim and failure to do so will render the demand invalid. An example can be seen in the case of Teknik Cekap Sdn Bhd v Public Bank Bhd [1995] 3 MLJ 449 where the performance bond was worded as follows:

“If the sub-contractor (unless relieved from the performance of any clause of the contract or by statute or by the decision of a tribunal of competent jurisdiction) shall in any respect fail to execute the contract or commit any breach of his obligations thereunder then the guarantor shall pay to the contractor up to and not exceeding the sum of RM422,000…”

The Court of Appeal held in the above instance that since the liability of the guarantor only arises in the event there is a failure by the sub-contractor to execute the contract or commit any breach, the employer must state the basis of its claim in substance in the letter of demand.

ii. Proof and Not Mere Assertion

This is a situation where proof and evidence of the contractor’s breach of contract are required. An example can be seen in the case of Kining Exeton Sdn Bhd v Majlis Perbandaran Kuantan & Anor [2020] MLJU 343 where the performance bond was worded as follows:

“The Guarantor further covenants and agrees that the Guarantor shall pay, to the Employer on demand such sum as the Employer may certify being indemnification against any loss, damage, costs or expenses incurred by the Employer by reason of any default or breach on the part of the Contractor of his obligations under the Contract provided always that the total of such sums so demanded shall not exceed the sum of…”

The High Court held that as the performance bond is conditional, the defendant is required to assert that the plaintiff has failed to execute the contract or commit any breach and additionally certify the sum of the loss, damage, cost or expense incurred by the defendant in making the demand.

Restraining a Call on a Performance Bond

If the contractor intends to challenge the employer’s call on the performance bond, the contractor may apply to the Court for an injunction. This injunction would have to expressly restrain the employer from making a demand on the performance bond and/or to restrain the bank / surety from releasing funds to the employer.

Following the case of American Cyanamid Co v Ethicon Ltd [1975] 1 All ER 504, an injunction will only be granted by the Courts if the following requirements have been fulfilled:

a. there is a serious question to be tried;

b. the balance of convenience lies in favour of the applicant; and

c. damages is not an adequate remedy.

In addition to the above requirements, to injunct a performance bond, the Federal Court in the case of Sumatec Engineering and Construction Sdn Bhd v Malaysian Refining Co Sdn Bhd [2012] 4 MLJ 1 at 36 held that the Courts must be satisfied that either there is an element of fraud involved or that the calling of the performance bond is unconscionable.

a. Fraud

The Court in the case of LEC Contractors (M) Sdn Bhd (formerly known as Lotteworld Engineering & Construction Sdn Bhd) v Castle Inn Sdn Bhd & Anor [2000] 3 MLJ 339 held that in order to justify any injunction to stop payment, there must be clear evidence of fraud and fraud must be specifically pleaded. In this case, the disputes between the parties do not amount to fraud and must be settled between the parties, which would not affect the performance bond.

b. Unconscionability

The High Court in the case of Kejuruteraan Bintai Kindenko Sdn Bhd v Nam Fatt Construction Sdn Bhd [2010] MLJU 1869 held that the circumstances of unconscionability are “unfairness, as distinct from dishonesty or fraud, or conduct of a kind so reprehensible or lacking in good faith that a court of conscience would either restrain the party or refuse to assist the party. Mere breaches of contract would not by themselves be unconscionable (Royal Design Studio). It concerns abusive calls on the Guarantees or Bonds which warrants court intervention without necessarily prejudicing the integrity of the security.”

An example of unconscionable conduct can be seen in the Court of Appeal case of Target Resources Sdn Bhd v Thp Bina Sdn Bhd [2019] 6 MLJ 116 where the plaintiff had breached its obligation to renew the bank guarantee within the stipulated time thereby entitling the defendant to call on the bank guarantee. The defendant then indicated a willingness to grant the plaintiff extension of time to renew the bank guarantee, but after the plaintiff renewed the same the defendant then proceeded to call on the bank guarantee. The Court of Appeal held that this could be construed as unconscionable.

Potential Complications with Performance Bonds

a.  Attempt to Deny Payment

At times, the surety may seek to deny payment on a performance bond, particularly if they believe that the obligee’s claim does not align with the conditions outlined in the bond agreement. This can precipitate disputes between the obligee and the surety, leading to delays in receiving compensation for damages arising from the contractor’s non-performance. The obligee may encounter difficulties in persuading the surety of the validity of their claim, necessitating thorough documentation and evidence to bolster their case. These disputes can prolong legal proceedings, impose administrative burdens and incur additional costs for the obligee, exacerbating the financial and operational impacts of the contractor’s default.

b. Underestimation of Cost

If the obligee underestimates the potential costs associated with the contractor’s non-performance when setting the performance bond amount, they risk being unable to immediately recover expenses that exceed the bond coverage. For instance, if the expenses for completing the project or addressing deficiencies exceed the performance bond amount, the obligee may need to cover the shortfall with their own funds. This scenario can strain the obligee’s budget, disrupt project timelines and impede the project’s successful completion.

Conclusion

In essence, performance bonds are indispensable in construction projects, ensuring the contractor’s satisfactory performance and safeguarding the employer’s interests. This need is especially evident in large-scale local authority construction endeavors, where significant investments and public finances are at stake. Given the inherent risks in construction projects, performance bonds are increasingly favored as a protective measure against potential non-performance by the contractor.

However, although performance bonds are intended to be a speedy mechanism for dealing with defaulting contractors, various complications can hinder the process as outlined above. It is thus crucial that the rights and responsibilities of all parties involved are clearly outlined within the performance bond along with any specific conditions or procedures for triggering a call, and that any written demand calling on the bond is carefully crafted to minimize room for dispute.

Get in touch with us if you have any questions on the topic! We regularly advise both international and domestic clients on all matters regarding Construction Performance Bonds.