As part of the performance security package for construction projects, project finance lenders (as well as project owners, landlords and government authorities) often require performance bonds from the construction contractor as security for the performance of the contractor's obligations. However, certain misconceptions prevail about performance bonds among those outside the construction industry. In this bulletin, we highlight a few key issues that we have encountered on recent project finance transactions, including: failure to negotiate and modify the 'standard form' of bond, issues overlooked during construction, the surety's right to an investigation after a claim for default, cross-default scenarios and the requirement for lenders to 'step-in', the surety's options in curing a default, and limits to the scope of surety's obligations.
Negotiating the Form of Performance Bond
Performance Bonds are issued by sureties in favour of the project owner (called the obligee) to guarantee that the bonded contractor (called the principal) will perform its obligations under the construction contract in accordance with the contract's terms and conditions. To add project lenders as beneficiaries to the performance bond, a dual obligee rider or multiple obligee rider is often issued concurrently with the performance bond, naming the project lenders and providing them with the same rights as the project owner (the obligee). Although the performance bonds and obligee riders used in Canada are based on forms published by the Canadian Construction Documents Committee (CCDC) or the Surety Association of Canada it is important to note that these forms are negotiable and, particularly on large projects, often tweaked and modified to address specific concerns or add specific language.1
Issues to Consider During Construction
For a bonded project, if the terms of the construction contract are amended or varied, or the scope of work is expanded without the surety's knowledge, the surety can claim that such modifications were prejudicial to it. While it is common for owners and contractors to agree to change orders or variations over the course of a project, this can carry significant risks if the surety is not kept apprised of and does not consent to such modifications. If an obligee and principal vary the underlying contract without the surety's consent, the surety may be discharged from its obligations under the performance bond.
While older case law gave sureties significant power in determining whether a variation of a contract would discharge them, courts have since adopted a more balanced approach and taken a larger role in determining whether a surety should be discharged because of a variation. While there is no definitive test for materiality and prejudice, larger changes to a contract or any significant increase to a surety's risk may prompt a court to discharge the surety.2
Furthermore, some kinds of variations may be more problematic than others: significant increases to the scope of work, substantial changes to the nature of work, variations of the terms of payment, and extending deadlines and schedules may discharge a surety. For example, an extension may place the surety in a worse position to remedy the default because the...
