The Ever-Evolving Performance Security Market: A look at the P3 bond

Performance security on P3 projects in Canada has been rapidly evolving over the past few years.  In an attempt to respond to the growing use of letters of credit (“LOCs”) on many projects surety companies have put forward several new bond forms in order to address the liquidity that project stakeholders are looking for.

Traditionally Canadian P3 projects have had a mix of performance and labour & material bonds, subcontractor default insurance (“SDI”), parental company guaranties and letter of credits to support the general contractor.  The combination used is typically determined between the construction contractor, the developer and the lenders in an attempt to maximize the available recovery from a construction contractor in the event of the non-performance of the project.

Traditional performance bonds and labour & material bonds have unfortunately had a bad reputation in the infrastructure market due to their perceived lack of a timely response, which has left lenders and developers concerned about getting a project back on track. On a project where on-time delivery is essential the ability to continue to pay subcontractors in the event of default is vitally important for the lenders and developers.

The old adage of “cash is king” has provided a strong preference of lenders and rating agencies to look to letters of credit as more liquid forms of performance security.  In the world of contractor default – liquidity is key if one needs to think about replacing the construction contractor.

While cash in hand is a very tantalizing feature of an LOC one must look at how else the construction contractor is providing security over their performance.  Cash alone is often not enough to complete the job, which is why a combination of a various number of performance security options are utilized on large projects.

Sureties have taken notice to the preference for cash over traditional bonds and have responded by creating a unique suite of products known commonly as the P3 bonds.  The term P3 bond is a bit of a misnomer as there are several bond wordings that are available in the market to cover off different contract scenarios.  The key to the P3 bond is actually the fact that sureties have built in an “on demand” feature, which operates similar to a letter of credit. We reference these bonds as “on demand” bond forms.

This article attempts to look purely at the on demand feature or liquid component provided under the new bond forms.  INTECH’s next newsletter will deal with the various bond forms and the pros and cons of each.

How does the liquid component work?

Traditional LCs are very simple to trigger.  In the event the principal (usually project company or the developer) or the lenders feel there has been a default they are able to walk over to any Canadian bank and present the letter of credit for an on demand payment.  The bank cannot refuse to pay and the payment is unconditional, which means there is no requirement to prove default. LOCs used to range from 8-10% of the construction price and in recent years we have seen limits between 3-5% of the construction price.

The liquid component under the various demand bond forms emulates a letter of credit in the following ways:

• Up to 5% liquid amount available;
• Liquid component must be paid between 5 and 15 business days (depending on the bond form used).  All forms require a portion of the unconditional liquid amount to be paid within 5 business days;
• The liquid amount is unconditional – no proof of default is required.

The Pros and Cons

The liquid component of the bond is a major step forward for sureties in ensuring they are meeting the needs of their clients.  Some major benefits of the product are as follows:

• Traditional performance bonds and an “on-demand” bond are wrapped into one product;

• Surety products require an immense amount of due diligence in order for the surety to issue them and sureties are heavily invested into their contractor clients. This means that the sureties have an extremely good overview of the contractor’s business as whole since they provide a bonding facility over many projects;

• LOCs must be renewed annually.  The liquid component of the bond is guaranteed for the entire construction period plus the warranty period, which is typically 1-2 years beyond substantial completion;

• Construction contractors are able to use their bonding capacity to provide the liquid component rather than tying up their net working capital, as they need to with LOCs, which allows them to bid more jobs.

Of course, with every pro there must be a con.  In our opinion the major disadvantages to the liquid component are as follows:

• Construction contractors are able to use their bonding capacity!  While an advantage to the construction contractor, the lenders like the fact that LOCs limit the construction contractors net working capital as it acts as a risk control to ensure they don’t over extend themselves;

• Sureties, while attempting to be more responsive, are less responsive.  LOCs can be drawn immediately at any financial institution in Canada.  The current bond forms state that the liquid amount will be paid out within 5 business days, and on some forms, a portion will not be paid until 15 business days.  The bonds go a long way to improving their response time but ultimately, cannot complete with the liquidity on LOCs.

This article attempts to look purely at the on demand feature provided under the new bond forms.  It is essential to have proper due diligence on the various bond forms before accepting them blindly on trust.  The various P3 bond forms from the leading sureties are all different and not all are, in our opinion, created equally.  It is important for lenders and developers to make use of their technical advisors and insurance advisors to receive proper advice as to the efficacy of the bond form and to assist in the negotiation of the terms and conditions of the bond.

SARAH ROBERTS
President B.A. Hons, CRM, MBA
Global Practice Leader – PPP and Project Finance
Tel: +1-416-348-1365
Email: sroberts@intechrisk.com