Expedited Performance Bonds: A new type of performance security hits the US P3 market

In March 2015, the Pennsylvania Rapid Bridge Replacement Project reached financial close, and broke records as the largest private activity bond financing of a P3 in US history (US$721.5m) and the largest road project in Pennsylvania’s history.

A less well-publicized fact is that the project was the first to use a type of performance bond that had not previously been used in the US P3 market – what the American insurance company Travelers call “Expedited Dispute Resolution Performance Bonds”. This type of performance bond enables a much quicker and more well-defined resolution from the surety than the traditional performance bonds, and is therefore treated as a more credible form of performance security by lenders and ratings agencies.

This article briefly explains the general use of performance security in construction projects and discusses what Expedited Dispute Resolution Performance Bonds (referred to hereafter as EDR Bonds) are, why they may be attractive for developers and contractors to include in a performance security package, and the use of similar performance bond products in other markets.

An introduction to performance security

Before going into detail on EDR Bonds, it is worth briefly explaining the purpose of performance security in a construction project, and the manner in which performance bonds fit into this framework. The purpose of performance security is to give the awarding authority, project company and lenders comfort that they will have recourse following default by the contractor, particularly if direct action against the contractor may not be practical because the contractor has a low credit strength or may be insolvent. See the box on the next page for further details.

The structure of a performance security package will be driven by a number of factors and will vary from project to project. In some jurisdictions, legislation requires that contractors provide performance bonds in relation to certain government construction projects. In the US, the Miller Act mandates that prime contractors involved in the construction of any large federal public works project post both payment bonds (which ensure the subcontractors and material suppliers will be paid) and performance bonds. The Little Miller Act refers to state statutes that require prime contractors on certain types of state government contracts to satisfy conditions similar to those set out in the Miller Act.

In addition, project finance and P3 lenders and ratings agencies will also have certain requirements for the performance security package which will primarily focus on the ability of the performance security to cover debt service and other project costs during a delay period or (in a worst-case scenario) during the replacement of the contractor. Therefore, creditors will be more interested in liquid forms of security such as letters of credit and retention security. The credit strength of the contractor and its parent company guarantor is an important factor in the structuring of performance security for the lending community because a contractor or guarantor with a strong credit rating is better equipped to fund and resolve a potential default scenario.

A critical consideration in the structuring of a performance security package is that different forms of performance security will come with different costs, and the cost of the performance security package will be passed down to the project company through the cost of the construction contract. As such, the more efficiently the performance security package can be structured, the cheaper the cost of construction will be.

In the US market, the performance security package for a project will typically consist of a combination of the following:

• Performance bonds – this is a guarantee given by a surety of the contractor’s obligations under a construction contract. The surety will be required to have a strong credit rating. (As noted below, the term “performance bond” can have a different meaning and format in other markets, such as in the UK.)
• Parent Company Guarantee (PCG) – this is a guarantee of the contractor’s obligations under a construction contract, granted by the contractor’s parent company. The parent company will be an entity with a stronger credit rating than the subsidiary contractor.
• Letter of Credit (LC) or Demand Guarantee – these are on-demand instruments which can be drawn down promptly following any non-payment by the contractor (e.g. non-payment of liquidated damages under a construction contract). This type of security is more expensive than performance bonds or PCGs, and a contractor will also be more limited in its ability to raise LCs/demand guarantees than performance bonds.
• Retention security – this is a cash retention withheld (or retained) from the payment due to the contractor which acts as security in the event of a default or non-payment by the contractor. The retention amount will be released to the contractor following expiry of the construction and/or warranty period.
• Subcontractor Default Insurance (SDI) – this is an insurance policy which specifies that the insurer will compensate the developer for losses resulting from a subcontractor’s default, and also provides coverage for indirect losses that result from a default, such as liquidated damages. However, SDI has deductibles and therefore may not be used in P3 projects as it fails to satisfy the requirements of the Miller Act and the Little Miller Act (see further below).

Performance bonds, letters of credit and “on-demand” instruments in the US market

Having discussed performance security generally, it is also worth focusing in more detail on the difference between performance bonds and on-demand guarantees/letters of credit. This distinction can be confusing because the terms are not used consistently across markets and industries, and different terms can have the same implications in practice.

In the US market, the key distinction between these types of instruments is that a performance bond will guarantee the performance obligations of the contractor and is a secondary obligation – meaning that the surety will perform or pay under the performance bond only if the surety has investigated the default claim and validated that the contractor is in default. An “on-demand” instrument, such as a letter of credit or bank guarantee, is a primary obligation and the bank does not require proof of the contractor’s breach: the only requirement for payment of an on-demand instrument is that a compliant demand is made in accordance with the terms of the instrument. A typical performance bond, on the other hand, may entail protracted litigation if parties disagree, and the surety is entitled to assert numerous defenses including those available to the contractor. Therefore, from a beneficiary’s perspective, the critical difference between letters of credit and performance bonds is the ease and speed with which the beneficiary can resolve a claim for an amount due by the contractor under the construction contract.

On-demand instruments are also known as bank guarantees, letters of credit, on-demand guarantees, and on-demand bonds. Secondary obligation- style instruments are also known as conditional bonds, surety bonds, completion guarantees, completion bonds, etc. Terminology differs across markets and industry sectors. In practice, it will be necessary to check the instruments’ terms to determine the type of performance security. In this article, we refer to “letters of credit” or “LCs” when we mean an on- demand/primary obligation performance security, and to “performance bonds” when we mean a guarantee/secondary obligation performance security.

What is an Expedited Dispute Resolution Performance Bond?

In the US market, an EDR Bond is a performance bond with a contractually determined maximum period for resolution of any dispute in the event the surety contests the contracting entity’s call of default before the surety is obliged to perform or pay under the bond. Setting a maximum period of resolution adds certainty and timeliness to the bond, providing comfort to the beneficiaries that the surety will perform its obligations (including payment obligations) under the EDR Bond within the agreed period of time. Therefore, EDR Bonds are seen by creditors as a more beneficial form of performance security – a hybrid solution sitting between letters of credit and a typical performance bond. Even though the concept of an EDR Bond has been under discussion in the US P3 market for several years, the Pennsylvania Rapid Bridge Replacement Project was the first P3 project to successfully utilize EDR Bonds, which were developed by Travelers and The Walsh Group, in co-operation with Granite.

The length of the expedited dispute resolution procedure referred to in the bond may vary from transaction to transaction. On the Pennsylvania Bridges Project, the maximum period was 82 days (see the box on the next page for further details) and the terms of the dispute procedure were set out in the EDR Bond itself (although the bond could alternatively refer to an expedited dispute resolution procedure set out in the construction contract or elsewhere). If the contractor or the surety want to appeal the decision following the conclusion of the expedited dispute procedure, then they can do so, but the surety is obliged to perform or pay under the bond in accordance with the adjudication decision notwithstanding that an appeal may be contemplated.

Also of note is that Travelers issued a letter to Standard & Poor’s regarding EDR Bonds, confirming that they would treat the obligation to pay in accordance with the decision reached through the dispute resolution as a hard obligation crystalizing at the end of the 82-day period (and thereby acknowledging that failure to pay could have an impact on the surety’s own rating).

Liquid security and the benefits of Expedited Dispute Resolution Performance Bonds

Creditors, ratings agencies and LTAs will examine the liquid security available under the performance security package and will want to see sufficient liquidity to cover debt service and project costs in the event that construction is delayed and/or the contractor is replaced. The aggregate liquid security requirement varies from project to project depending on the type and complexity of the specific project.

In the case of Standard & Poor’s, the liquid security requirement is determined through an analysis of the likely downside scenario, and with reference to the creditworthiness of the contractor or its guarantor compared to the construction rating of the project. In sizing the liquid security amount, Standard & Poor’s will consider contractor replacement only if the creditworthiness of the contractor is lower than the preliminary construction phase stand-alone credit profile (also known as “construction rating”). If sufficient liquid security is not available for contractor replacement (if applicable), then the project credit rating will be capped at the rating of the contractor (or its guarantor). Standard & Poor’s will count any cash reserves or LCs as liquid security but do not give any credit to typical performance bonds because there is no certainty as to how quickly they will pay out.

On the Pennsylvania Rapid Bridge Replacement Project, Standard & Poor’s gave the EDR Bond ten per cent credit as liquidity security following the expiration of the maximum dispute resolution procedure period. The EDR Bond accounted for 100 per cent of the construction contract value (US$899m) and Standard & Poor’s assessed that there would be US$89.9m of liquid security available after 82 days of delay. Therefore, the project structured the transaction such that LCs and cash covered only the first 82 days of delay.

There are two key benefits of EDR Bonds. Firstly, they can enable the performance security package to be structured more efficiently while still satisfying the requirements of project creditors and the public sector; secondly, they can marginally reduce the LC requirements for the project which thereby frees up the contractor’s LC capacity to be used elsewhere in its business (and, in some cases, will allow contractors to bid for projects from which they would otherwise be precluded due to limited LC capacity – most US contractors will have a much larger surety capacity than LC capacity).

In the US market, although EDR Bonds are typically more expensive than traditional performance bonds, they are significantly cheaper than LCs and can be utilized separately from the limited line of credit a contractor has in providing LCs. Therefore, on the Pennsylvania Bridges Project, it was economical for the sponsors and the contractors to include an EDR Bond in the performance security package, as it marginally reduced the overall LC requirement and enabled the contractor to provide a robust and affordable security package to support an investment-grade rating from Standard & Poor’s.

EDR Bonds have the additional benefit of balancing the need of the contractor for protection against the beneficiary’s potential abuse of letters of credit, on the one hand, and the rating agencies and creditors’ requirements for assured liquidity on the other hand: for this reason, using EDR Bonds will be more attractive to contractors, compared to providing liquid security with only cash and LCs. This is particularly relevant in the US P3 market, where international contractors are often supported by large lines of credit from foreign banks, compared to domestic contractors who do not have as significant a line of credit for LCs.

Although some states have excluded P3 projects from the requirements of the Little Miller Act on the basis that private sector creditors will require a robust performance security package, EDR Bonds would still satisfy this legal requirement to post bonds if these requirements were to apply to a project. This would prevent potentially overlapping performance bonds and large amounts of additional liquid performance security from increasing the cost of the performance security package.

Use of EDR Bonds in other markets

In the UK, the concept of an EDR Bond has been around for some time and these bonds are known as “adjudication bonds”. In the UK projects market, it is quite common for an adjudication bond to be used as a compromise between a more liquid “on-demand” bond and a simple guarantee, which is drafted as a secondary obligation. Adjudication bonds are typically structured as an on-demand bond where the only condition is that a compliant demand is made in accordance with the terms of the instrument. Usually the instrument will require a demand to contain an adjudicator’s decision confirming that the contractor is in breach of the underlying construction contract. Another feature of UK adjudication bonds is that, typically, in the event of the contactor’s insolvency, they will become truly “on-demand”, as the instrument will not require an adjudicator’s decision in order to make a compliant demand.

The popularity of adjudication bonds in the UK is linked to the UK Housing Grants, Construction and Regeneration Act 1996 (the Act). Under the Act (with limited exceptions), parties to all contracts for the carrying out of construction operations or for the provision of professional services in respect of such operations have a statutory right to refer disputes under the contract to adjudication, and the Act requires that the adjudicator’s decision be made within 28 days of referral. Therefore, the speed with which a UK adjudication bond may be called will typically be driven by this statutory 28-day period but may be longer depending on the agreed procedure for making compliant demands under the bond. This statutory period can provide beneficiaries with more certainty as to the potential time delay for calling on a bond.

In South East Asia, the use of EDR Bonds or adjudication bonds is not common, and instead it is more typical for performance security to be provided in the form of on-demand bonds. Both Australian and Middle Eastern P3 markets utilize performance bonds without the expedited dispute resolution process.

The authors would like to thank Walsh Investors, Kiewit Development, Aon Risk Solutions (Grace Hartman) and Standard & Poor’s for their time discussing the content of this article, and also the Ashurst infrastructure teams in London, Sydney, Singapore, Tokyo and Dubai.

This article is part of our InfraRead (Issue 7) released in March 2016. To download the full PDF publication, please click here.