In Short
- Performance security protects principals by ensuring contractors meet their obligations and complete projects as agreed.
- The two main types are retention moneys (withheld from payments) and unconditional undertakings (bank guarantees or insurance bonds).
- Security release terms should be clearly defined to prevent disputes and ensure fairness for both parties.
Tips for Businesses
Before agreeing to performance security, assess its impact on cash flow and risk. Contractors should negotiate staged releases to free up funds, while principals should ensure security provisions cover potential defects or disputes. Clear contract terms on retention and release prevent conflicts and support smooth project completion.
Construction projects are inherently risky endeavours, fraught with uncertainties that can derail even the most meticulously planned projects. To mitigate these risks and safeguard the interests of all parties involved, performance security measures are employed. These measures encompass a range of instruments and agreements designed to provide financial protection and assurance, ensuring the successful completion of construction projects. This article explains the concept of performance security and its critical role within the construction industry.
What is Security?
Principals often require security from head contractors, and head contractors often require security from subcontractors. Security ensures the contractor properly does their contractual work. The circumstances where security may be called will usually be set out in the contract.
Some common circumstances include where:
- a party fails to pay a debt due under the contract;
- the contractor can no longer perform the contract;
- there are defects or issues with the work that the contractor fails to fix; or
- the contractor does not have enough financial resources to cover potential problems.
Types of Performance Security
The type of security provided often depends on the size and scope of the contract. However, the two most common forms of performance security in construction contracts are:
1. Retention Moneys (Cash Retention)
This is the simplest form of security. A percentage of each progress claim (such as 10%) is retained by the principal until a certain capped amount is reached (such as 5% of the total contract sum).
This form comes with its advantages and disadvantages, as outlined below.
| Advantages | Disadvantages |
| Contractors avoid costs associated with bank guarantees. Principals have immediate access to the funds. | Initially, contractors have a limited cash flow. There is a risk of non-payment at the completion of the project if the principal faces financial difficulties. |
2. Unconditional Undertakings
This category includes bank guarantees and insurance bonds. These instruments involve a third party (usually a bank or insurance company) promising to pay the principal a specified amount on demand.
Key features include no upfront cash payment required from the contractor. The paying party must honour the demand without questioning the principal’s entitlement. These guarantees are often issued as two separate undertakings, each covering 2.5% of the contract sum, allowing for easier partial return at practical completion.
Advantages and disadvantages of unconditional undertakings include:
| Advantages | Disadvantages |
| They free up cash for contractors. The principal has access to readily accessible security. | Banks may require collateral or charges on the contractor’s assets. Reviewing and preparing bank guarantees may result in higher administrative and legal costs. |
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This manual aims to help business owners, financial controllers and credit managers best manage and recover their debt.
Release and Retention of Security
The release of performance security is a critical aspect of the contract lifecycle that requires careful consideration and explicit contractual provisions. While the specific terms may vary, there are several common scenarios and considerations to keep in mind:
Contractor’s Perspective
Contractors should negotiate for transparent and fair terms regarding the release of security. Key points to consider include:
- Staged Release: Typically, a portion of the security is released at practical completion, with the remainder held until the end of the defects liability period. This staged approach balances the principal’s need for ongoing protection with the contractor’s desire to reclaim their assets.
- Principal’s Breach or Insolvency: Contractors may seek provisions that require the release of security if the contract is terminated due to the principal’s breach or insolvency. This protects the contractor from having their security unfairly retained in situations where the principal is at fault. However, note that such positions are rarely accepted by experienced principals.
- Timely Release: Contracts should specify clear timelines and processes for releasing security to prevent unnecessary delays or disputes.
Principal’s Perspective
From the principal’s standpoint, retaining security is a crucial safeguard against potential issues. Key considerations include:
- Defects Liability Period: Principals often require the right to retain security if defects have been notified during the defects liability period and remain unresolved. This incentivises prompt rectification of issues and provides financial protection for the principal.
- Unresolved Disputes: In cases with ongoing disputes or unresolved claims, principals may seek to retain security until these matters are settled. This helps ensure that funds are available to cover potential liabilities or compensations.
- Graduated Release: Principals might negotiate for a graduated release of security, tied to specific milestones or the resolution of key project phases, to maintain protection throughout the project lifecycle.
Key Takeaways
Performance security is an essential element in modern construction contracts, serving as a financial safeguard for all parties involved. The two most common forms are:
- Retention Moneys: A percentage of payments held by the principal to cover defects or non-performance.
- Unconditional Undertakings: Bank guarantees or insurance bonds providing security without upfront cash payments from contractors.
The release of security should be clearly defined in contracts to avoid disputes. Transparent, fair and well-negotiated terms regarding the provision, retention and release of security are essential for maintaining a balance between risk protection and practical business operations.
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Frequently Asked Questions
Performance security is typically in construction contracts when a principal wants assurance that a contractor will complete their work as per the agreement between them. It may be necessary where the contractor fails to meet contractual obligations, such as not completing work, failing to fix defects or experiencing financial difficulties.
Retention moneys involve withholding a percentage of progress payments until project completion, providing immediate funds to the principal. Unconditional undertakings, such as bank guarantees, do not require upfront cash from the contractor but may involve additional costs and collateral requirements. Each has advantages depending on the contract’s structure and financial arrangements.
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