Contract Bonds

What are Contract Bonds?

Like Bank Guarantees, Contract Bonds are a financial instrument, rather than a financial product, and is a three-party contract.

Contract Bonds are part of the broader Surety Bond range and provide protection for the principal/project owner against the default or non-performance of the contractor for a particular contract.

The Contract Bond is issued by an insurer (Party 1) in favour of the principal/project owner (Party 2) undertaking that part or all of the bond amount will be paid to the principal/project owner in the event the nominated contractor (Party 3) does not perform in accordance with the terms and conditions of the contract awarded.

Similar to a bank guarantee, the contractor requests that the Contract Bond is issued in favour of the principal/project owner. Whilst the contractor pays for the Contract Bond, the principal/project owner is the beneficiary in the event that the Contract Bond is called.

Contract Bonds carry the same wording as a bank guarantee and follow the Australian Standards template (such as AS2124, which requires an unconditional and on demand undertaking) and carry exactly the same obligations at law as a bank guarantee. Insurers are not able to call their offering a bank guarantee, as they are not a registered bank. Otherwise the offerings are identical.

Like bank guarantees, payment must be made by the insurer on demand, unless the bond specifically states otherwise and without any assessment as to the amount to be paid. The only assessment occurring is to ensure the claim is made in terms of the Contract Bond itself - a process identical to the payment of a bank guarantee.

Surety Bonds, which include Contract Bonds, have been part of the Australian market for over 60 years and are widely accepted by the private sector and Commonwealth, State and Local Government Authorities and Agencies.

Some self-interested parties push the line that Surety Bonds issued by insurers are not as secure as bank guarantees. The recent global financial crisis pretty well pushes that misconception out of the equation.

The reality is that the major international insurers, which include Lloyds of London, have credit ratings equal or greater than most global financial institutions.

One key aspect often overlooked is that Surety Bonds fall outside the Bankruptcy Act in Australia, therefore, in the event of the liquidation of a contractor, the principal/project owners aren’t impacted as their call is against the insurer and not as an unsecured creditor as is the case with a bank guarantee.   


What’s the role of Contract Bonds?

Contract Bonds are an integral part of the construction process, providing protection to the principal/project owner against the default or non-performance of a contractor.

In difference to bank guarantees and from a principal’s/property owner’s perspective, there’s the added advantage that the contractor's performance ability has been independently assessed by the insurer who holds valuable knowledge about the contractor’s involvement in other projects and their performance and claim’s history.

Before agreeing to issue a Contract Bond, a comprehensive review of the contractor's performance is undertaken, which includes an assessment of the contractor's financial status, management strength and past performance record with respect to prior contracts.

From a contractor’s perspective, their bank credit facilities are totally or partially freed of bank guarantees, thus delivering greater financial leverage from their asset base and freeing up working capital and cash flow. This allows for increased growth opportunities.

Typically, standard contracts require the contractor to offer some form of surety to the principal/project owner which is 5% to 15% of the total contract value. The percentage may be tiered depending on the stages and timeframe of the relevant project.

Contract Bonds are issued prior to commencement of the contract and expire on achievement of a specified milestone, such as the issuance by the principal/project owner of a Certificate of Practical/ Final Completion (after the maintenance/ latent defects period), Handover Certificate or equivalent.

Contract Bonds cater for a number of stages in the life of a project.

  • Bid/Tender Bonds secure a contractor's obligations to proceed with a contract upon successfully being awarded the project.
  • Off-site materials bonds secure the principal client's position where progress payments to the contractor has been made, but delivery of the goods has not occurred because engineering and manufacturing contract items are constructed off-site and delivered to site at a later date.
  • Performance bonds cover the obligation of the contractor to complete the contract works in accordance with the project specifications and typically extends through to practical completion.
  • Maintenance bonds secure the contractor's post-completion obligations to attend to any defects or remedial works following practical completion. It’s possible that the contractor has ongoing maintenance obligations such as lifts, air conditioning systems, etc.
  • Advance payment bonds allow pre-payments by the principal/project owners to the contractor to mobilise the project; pre-purchase plant and equipment; or order specialist building products or finishes. These bonds provide the principal/project owner security for funds advanced to the contractor.
  • Retention release bonds allow the principal/project owner to release full progress payments to the contractor which enhances the contractor’s ability to perform.


How are Contract Bonds offered & priced?

Typically, contractors are involved with an ongoing number of existing and new projects, so we establish a ‘multi-bond facility’. Not dissimilar to an approved line of credit with a financial institution that can be drawn down/used/reused as required.

If a project is of sufficient size, we will look at ‘one-off’ risks.

Because of the assessment work involved, plus upfront costs to undertake various statutory checks and searches, a non-refundable application fee of $1000+GST applies.

The pricing of Contract Bonds depends upon the risk profile of the contractor; the Contract Bond amount required; the duration of the particular project; specialist aspects of the particular project; and any other relevant information. The determined premium must be paid in full prior to the Contract Bond being released to the nominated party.


What occurs if the principal/project owner makes a call on a Contract Bond?

This will only occur if the contractor has defaulted or has not performed in accordance with the particular contract.

If the principal/project owner seeks a payout under the Contract Bond, the insurer will pay the principal/project owner and then immediately seek recovery of the claimed amount from the contractor.

The recovery is either against the operating entity or the director’s personal guarantees.


What’s the application process?

This is a recently new facility and the insurer is proceeding with caution and is being selective.

Contractors (applicants) must be able to demonstrate that they:

  • be contracting to a project with either a Government Agency or Tier 1 construction firm
  • operate a well-developed business
  • have a solid track record
  • have professional financial and operational management
  • consistently retain capital within the business
  • possess proven technical ability to deliver on all contractual requirements
  • have control over exposure to existing projects
Clear documentary proof of the above, in addition to the require application documents; will ensure that Contract Bond applications are approved in a timely fashion.

Contractors seeking a Contract Bond facility must meet the following criteria:
  • Bond amounts from $10,000 to $2,500,000 anyone bond and maximum $5,000,000 in the aggregate.
  • The maximum contract term is 24 months.
  • Net equity or shareholders funds must be a minimum of two (2) times the amount of the bond required or of the overall annual facility pre-approved.
  • Require two (2) years company financials, plus YTD management accounts and full year forecasts. If a larger company, the financials must be audited.
  • Where company financials don’t meet the acceptance criteria, director’s personal guarantees are likely to be sought.
  • As there are costs incurred to both assess applications and obtain various statutory reports, a non-refundable application fee* of $600 + GST applies. Where a facility is approved, 50% of the non-refundable fee will be refunded.
  • Where an annual facility is pre-approved, a holding fee of 1% applies and is deducted from the standard rate as repeat bonds are approved.