Provision of a performance bond based on the MOC standard performance guarantee
Pett Yap Baker & McKenzie
More than five years have elapsed since the former Ministry of Construction ("MOC")［1］launched a suite of standard guarantee forms for a trial run on 18 May 2005, and one of the standard forms is a performance guarantee which a contractor has to furnish to the project owner. Although provision of a performance bond by Chinese contractors to project owners has become increasingly common in recent years, it does not appear that the MOC standard performance guarantee has gained popularity with local users. This article looks at the salient features of the MOC standard performance guarantee and examines the possible reasons underlying the reluctance of international project owners to use the MOC standard performance guarantee.
The provision of a performance bond by a contractor in favour of the employer is a deeply ingrained feature in most international construction projects. Performance bonds serve as security for the performance of the contract by the contractor. They are essentially an undertaking given by a bank, insurance company or other financial institution (a "guarantor") at the request of the contractor ("principal") in favour of the employer ("beneficiary").
The Ministry of Construction in China issued the Notice Regarding the Issuance of Standard Form Contracts for Bonds for Construction Projects on 18 May 2005. The Notice launched 10 standard guarantee forms for a trial run. The Notice remains in force and local construction authorities continue to promote the use of the standard bond forms. The standard form bonds include:
• bid bond from contractor to owner
• performance bond from contractor to owner
• payment security bond from owner to contractor
• payment security bond from contractor to subcontractor
• payment security bond from contractor to supplier
This article focuses on the standard performance bond and looks at why it has not gained popularity with international investors involved in construction projects in China.
The use of the standard bond forms is not mandatory. Whilst use of the MOC standard construction contract is also not mandatory, local construction authorities in certain localities may require the use of the MOC standard construction contract or its equivalent local form. In such a case, the owner would have no choice but to use the standard construction contract to ensure successful filing of the same so as to obtain the construction commencement permit. Currently performance bonds do not have to be filed, and as such they are not subject to the local construction authorities' intervention on the bond form to be adopted.
The notable elements of the standard performance bond are:
Performance bonds are either on-demand/unconditional or conditional/default in nature. On-demand bonds are akin to standby letters of credit. The guarantor is obliged to pay simply on demand by the beneficiary without proof of default by the performing party or conditions; hence it is independent of the underlying contract between the performing party and the beneficiary. Default bonds, on the other hand, require proof of breach of the underlying contract by the principal. An employer would have to establish that the principal is in breach of its obligations under the underlying contract. For this reason, default bonds are not favoured by owners in construction projects.
The common denominator of the standard forms of bond is that they are default bonds. The beneficiary has to provide proof of breach by the principal, and where quality issues are concerned the beneficiary has to produce a report from a licensed quality inspection agency. This process is likely to be time consuming and may lead to complications. The guarantor has a period of time to verify the evidence.
In addition to having to establish breach, the beneficiary has to prove the actual damages which he suffered by reason of that breach of the underlying contract. Thus, it appears that under the standard performance bond the beneficiary would first have to prove breach, and secondly actual damages. The time lag between a beneficiary's decision to call on the bond and decision of the guarantor whether to satisfy the claim may be lengthy and the lack of certainty in the outcome significantly weakens the value of the bond.
Validity of the Bond/Release
Generally, performance bonds will expire shortly after the completion of a project or defects warranty period. Likewise, the standard performance bond allows the parties to insert a cut-off time on the guarantor's obligations after the project completion. However, under the standard performance bond any change to the contractual completion date must be approved in writing by the guarantor. This imposes an onerous administrative burden on the employer since delays are a common occurrence in construction projects and introduces risk that the performance bond will lapse prior to the project completion.
It should be noted that where other standard performance forms provide that the obligations of the guarantor under the bond are discharged absolutely upon expiry (that is, the date defined in the bond) or payments made under the guarantee reach the cap specified in the guarantee before expiry, the standard performance bond prescribes that on occurrence of circumstances which justify the discharge of the bond the guarantor shall be released from its liability. The extent and scope of "circumstances which justify the discharge of the bond" is ambiguous and undefined. Arguably, an instruction by the owner to omit a sizeable part of the works with a consequent reduction of the contract price may be considered a significant variation of the contract terms and conditions and may therefore be categorized as circumstances which justify the discharge of the bond.
Exclusions from Liability/Release
The standard form expressly exempts the guarantor from the consequences of variations to the underlying contract that result in additional liabilities being imposed on the guarantor unless such variations have been approved in writing by the guarantor. By contrast, bonds used in international construction projects would normally provide that the surety's liability is not released as a result of any alteration to the underlying contract. This is because, in practice, invariably variations and allowances of time would arise in a construction project thereby varying the terms, conditions and provisions of the contract.
No Governing Law
The standard performance bond is silent on the governing law. A bond is a separate and distinct obligation and any choice of law in the underlying contract will not apply to the bond. If both the beneficiary and guarantor are PRC entities, the applicable law will be PRC law otherwise the beneficiary may be faced with the uncertainty of establishing the courts with jurisdiction and the governing law of the bond.
Construction contracts usually provide for disputes to be settled by arbitration. The settlement of disputes by litigation in the Chinese courts are unlikely to find favour with international investors. Most owners would prefer arbitration and as far as possible, the dispute resolution provision should be identical to that in the construction contract.
Project owners would not want to be put to the expense of proving default and justifying their right to be paid by reference to any actual loss. The banks may be unwilling to enter into obligations which require investigation into whether the underlying contract has in fact been breached and the call is justified. The standard performance form fails to provide project owners with a measure of protection that a justified call on the bond will be enforced. In the absence of legal reason requiring the use of the standard performance bond it is unlikely to be the preferred option of international investors.
［1］ The Ministry of Construction has been re-named the Ministry of Housing and Urban-Rural Development.
About the author
Pett Yap, Special Counsel, Baker & McKenzie. Ms. Yap's practice focuses on all agreements necessary for major infrastructure projects in the Asia Pacific region. She has been involved in several industry sectors and also has experience in contentious construction and general commercial arbitration and litigation.
Tel: +86 21 6105 8558 │ Email: email@example.com
Please note: The contents of this article are intended to provide a general guide to the subject matter only, and should not be treated as a substitute for specific advice concerning an individual situation.