My clients will often ask me, during the course of a standard sale and purchase of property or in relation to commencing works, “What are contract bonds?” and “How will they benefit me?”… Contract bonds are agreements made between three parties (the owner, the contractor and the contract bond surety – usually an insurance company), which guarantee that a contractor will fulfil its contractual obligations. Particularly in the construction industry, these bonds are often used as a way to ensure the supply of materials and services at the agreed price under the terms of the contract. The effect of the contract bonds is that material suppliers can seek recompense for unpaid materials, so that in effect there is a safety net for those in the build chain. Often this is better than relying on the provisions of a personal guarantee from the contractor down the line.
The significance of contractual bonds
Contract bonds are most common in the construction industry and have two main functions in that they: It is important to note that contract bonds should be examined closely with a clear understanding of their function and operation – the wrong contract bond, or an unintentional acceptance of less favourable terms, can be costly. In that regard it is important that a contractor who is required to provide a bond does so within their ability to source one and in a stream of finance which is in their control. It should be noted that penalties for non-compliance with contractual obligations, such as in respect of contract bonds, can be, and often are, harsh!
Often the contractor will appoint an insurance broker to negotiate the best deal possible with the surety provider. Contractual bonds create a safety net in favour of suppliers. The use of construction bonds creates a flow on effect to many others involved in the building industry and often it is material suppliers that are in the front row of the effects of supplier-contract bonds. Material suppliers can suffer huge repercussions where confirmation of a contract is deferred in favour of the receipt of a contract bond from a contractor.
As a contractual party, the supplier then adheres to the terms of the contract and when the contract is breached, often the supplier can be left out of pocket when seeking recompense from the contractor. In such a situation the supplier may be dealing with a reluctant contractor, and likely an insolvent contractor. The likely scenario is that the supplier will not be able to receive a contract bond from the contractor, and therefore the supplier should not enter into a contract unless there are appropriate assurances put in place. Often contract bonds are accompanied by indemnities from the contractor assuring the other contracting party that they will not only receive payment, but also that any contractual obligations will be complied with by the contractor. It is for this reason that material suppliers would be wise to require contract bonds with a cash cover or bank guarantees. Receivership situations do happen and it is during these stressful times that contract bonds serve the purposes for which they were intended.
Relation to large scale construction projects
Contract bonds are required of contractors before any party will work on a large scale construction project. Hong Kong’s MTRC West Island Line Extension project begins at Central Station (Hong Kong) and ends at Kennedy Town; it is currently going through a long construction period. The Hong Kong Government has released a document on the MTRC Website (8 Feb 2011) indicating that they intend to set up an Independent Monitoring Panel to oversee the completion of various large scale construction projects, including the MTRC West Island Line. The Panel Members are experts in their respective fields, including engineering, architecture, law, administration and manufacturing. It is a further example of how construction projects are overseen and why contract bonds are a prudent and responsible safeguard.
Contract bonds as a solution
It would be remiss of not mentioning, however, that home building material suppliers and others in the construction industry should also protect themselves and their businesses in other ways, such as:- With those points in mind it is clear that not only do contract bonds play an important role in Hong Kong with respect to large commercial construction projects but also they are an untapped resource for those in the building supply chain.
Conclusion
Suretyship as a concept dates back to antiquity while contract bonds have been applied for hundreds of years. The technology and complexities of modern life continue to increase, yet construction bonds remain a constant in Hong Kong.
For more information on contract bonds, you can visit Wikipedia.