Performance Bonds in Construction - The Ascertainment Conundrum

PUBLISHED: 12th April 2023

Bonds creating security for contractor performance are typically seen forming part of the contractual framework underpinning a construction project.

A performance bond is one such type of bond, essentially amounting to a contract of guarantee entered into between the two parties to an underlying construction contract - generally referred to as the “Employer” and the “Contractor” - and a third-party surety, whereby the surety agrees to pay a sum of money to the Employer in the event of breach of the underlying construction contract by the Contractor.

Every bond is different and any assessment of what should be paid to the Employer in these circumstances will depend on analysis of the bond wording itself. Generally speaking, a surety is required (subject to a specified monetary cap) to reimburse losses and/or damages sustained by the Employer that are attributable to breach of the underlying contract by the Contractor, having regard to any sums due (or to become due) to the Contractor. As such, when assessing whether a surety is required to make payment pursuant to a performance bond, it is usually necessary to examine the terms of the underlying construction contract.

In this regard, it is common for performance bonds - in both Ireland and the UK - to stipulate that losses and/or damages sustained by an Employer should be “established and ascertained” pursuant to the terms of the underlying construction contract. Naturally, terms will vary from contract to contract and there is no conclusive answer to the question of what it means to establish and ascertain losses and/or damages in this context. However, there has arguably been a divergence in approach when this issue has been considered by the respective courts of the UK and Ireland. We consider these contrasting approaches next.

Technology and Construction Court (TCC) - The “Commercial Purpose” of the Bond

In Ziggurat (Claremont Place) LLP v HCC International Insurance Company PLC (2017) EWHC 3286 (TCC), the Technology and Construction Court (TCC) was required to interpret the provisions of a performance bond in circumstances where a demand made upon the performance bond in question was being resisted by the Defendant surety.

The Claimant in question was the Employer under a construction contract relating to student studios in the UK. The Contractor's appointment under the construction contract was terminated following suspension of work by that Contractor due to financial difficulties. The Claimant engaged another party to complete the outstanding work and following completion, the Claimant made a demand under the performance bond in place.

The relevant clause of the performance bond in question provided as follows:

“The Guarantor [the defendant] guarantees to the Employer [the claimant] that in the event of a breach of Contract by the Contractor [County] the Guarantor shall subject to the provisions of this Guarantee Bond satisfy and discharge the losses and damages sustained by the Employer as established and ascertained pursuant to and in accordance with the provision of or by reference to the Contract and taking into account all sums due or to become due to the Contractor.” [Emphasis added]

The basis for the demand made under the performance bond was an account prepared by the Claimant's contract administrator and served upon the Contractor which set out, pursuant to Clause 8.7 of the construction contract, “the amount of expenses properly incurred by the Employer…for which the Contractor is liable, whether arising as a result of the termination or otherwise;” following completion of the works. The sum arrived at amounted to the cost incurred by the Employer in having the works completed by a new contractor, which when added to the total sum of payments made to the terminated contractor, exceeded the total amount which would have been payable for the works if the termination had not occurred.

The Claimant asserted that the carrying out of this accounting exercise was sufficient to establish the losses and damages sustained by the Claimant for the purposes of making a demand under the bond and sought a declaration from the TCC to this effect.

The Defendant asserted that it was required to be proven that a breach of contract had taken place and that losses had been incurred as a result of that breach, and that no payment was due until a “formal decision” had been reached as to whether the Contractor had breached the underlying construction contract.

The TCC refuted any suggestion that the Claimant needed to obtain judgment against the Contractor before a demand could be made under the bond and found that once the process described under the operative provisions of the construction contract (Clause 8.7) had been concluded, the Claimant could seek payment from the Defendant under the bond. In this regard, the TCC noted the following:

“Any other result would destroy the commercial value and purpose of the Bond. The Bond is required to provide the claimant with the ability to recover at least some of its losses against a solvent party. It would circumvent that commercial purpose if the claimant was then required to issue separate proceedings against that insolvent party (and get the necessary permission to do so) and/or to reach an agreement with the insolvent party, in order to establish either liability or quantum under the Bond.”

However, the TCC did emphasise that any sums asserted as payable by the Contractor to the Claimant following completion of the Clause 8.7 calculation exercise could not necessarily be considered a conclusive debt.

The Irish High Court - “Incorporating” Dispute Resolution Mechanisms

In Clarington Developments Limited v HCC International Insurance Company Plc (2019) IEHC 630, the Irish High Court interpreted the meaning of the phrase “established and ascertained pursuant to and in accordance with the provisions of the Contract” in circumstances where the Plaintiff, an Employer under a construction contract who asserted that works were carried out defectively by the Contractor, sought to issue proceedings against the surety under the relevant performance bond, seeking to recover damages. It was contented by the Plaintiff that damages could be assessed by the High Court in proceedings taken against the Defendant surety. However, the Defendant asserted that the underlying construction contract contained a dispute resolution mechanism whereby disputes arising between the Plaintiff and the Contractor were required to be referred to conciliation - and failing that, arbitration - and accordingly, it was a “ condition precedent” that damages be ascertained by way of conciliation or arbitration and therefore, the Plaintiff was not entitled to look to have damages quantified by the High Court in this manner.

The relevant clause of the performance bond provided as follows:

“The Contractor and the Surety are hereby jointly and severally bound to the Employer in the sum of €1,200,000.00 (one million two hundred thousand euro) [hereinafter called ‘the Bond Amount’] provided that if the Contractor shall subject to Clause 3 hereof duly perform and observe all the terms, conditions, stipulations and provisions contained or referred to in the said Contract which are to be performed or observed by the Contractor or if on default by the Contractor the Surety shall satisfy and discharge the damages sustained by the Employer as established and ascertained pursuant to and in accordance with the provisions of the said Contract and taking into account all sums due or to become due to the Contractor thereunder and all retention monies held thereby up to the amount of this Bond then this agreement shall be of no effect but otherwise shall remain in full force and effect. The Bond Amount shall automatically reduce by half upon the issue of the Certificate of Practical Completion of the said Works.” [Emphasis added]

The Court placed emphasis on the actual language used in the clause, noting that the reference to “the provisions of” of the construction contract in question “captures all of the provisions without distinction”. Ultimately, the Court summarised its position as follows:

“In summary, the language used under clause 1 has the effect of ensuring that all of the provisions of the building contract, including the dispute resolution mechanisms, must be complied with. The contractual requirement that the quantum of the damages sustained be “established” pursuant to and in accordance with the provisions of the building contract can only properly be understood as having this effect. Both the procedural and substantive provisions of the building contract must be complied with.” [Emphasis added].

The Implications of Clarington

Neither of the parties in Clarington referred to the Ziggurat decision. While Ziggurat is not binding on Irish Courts, it nevertheless raises important considerations for Employers assessing their ability to make a demand under a performance bond at any given time. The implications of the Court's finding in Clarington -- that the quantification of damages in a manner conforming with “the contract” imported the requirement to have recourse to the dispute resolution mechanisms thereunder - evidently creates an inconvenient hurdle for Employers seeking to recover losses.

It is not uncommon for construction contracts used in Ireland to contain provisions similar to Clause 8.7 of the underlying construction contract in Ziggurat, whereby additional costs incurred by Employers in terminating a Contractor's appointment and having works completed by a new party are treated, upon certification, as a debt payable by the terminated Contractor to the Employer. In contrast to the very literal interpretation of the bond provisions in Clarington, the TCC's rationale was that the “commercial purpose” of the performance bond must be taken into account, such that the certification of sums payable by the Contractor to the Employer pursuant to the terms of the construction contract should be considered sufficient for the purposes of making a demand on a bond, notwithstanding the fact that such sums do not constitute a conclusive debt.

It remains to be seen whether Clarington will be followed in future decisions of the Irish Courts, or if the Irish Courts will deploy the TCC's more nuanced analysis to the issue of establishing and ascertaining losses and/or damages.

Set-Off and Retention

Performance bonds in Ireland and the UK will often contain a proviso asserting that in calculating losses and damages established and ascertained in accordance with the underlying construction contract, all sums due - or to become due - to the Contractor must be taken into account. This is indicative of a requirement to set-off such sums against the gross calculation of losses and/or damages.

The wording “or to become due” is a standard inclusion which can be understood as a means of ensuring that a future release of retention monies to a Contractor must be taken into account in circumstances where a demand on a performance bond is being made by an Employer who at that time, holds certain sums in the form of retention.

Conclusion

The question of what Employers need to do in order to validly make a demand on a performance bond is shrouded in uncertainty. While the performance bonds used in both the Irish and UK markets tend to contain broadly similar provisions, careful consideration needs to be given to the provisions of the performance bond. Where quantification of damages is required to be carried out in accordance with the underlying construction contract, detailed analysis needs to be carried out in turn, of the provisions therein.

The Clarington decision affirms the need to examine the provisions of the underlying construction contract carefully to ensure that a call on a performance bond is not invalidated by a failure to comply with any such provisions. Employers should also be mindful of the need to have regard to any retention held, which may come into play in ascertaining the net amount potentially payable by a surety pursuant to a performance bond.

This article was first published in the Construction, Engineering and Energy Law Journal, authored by Cian O’Lionaird and Cori Gormley.