When an Employer awards a construction contract to an agency, it is indispensable for them to have the commitment from the Contractor. Here, ‘Commitment of the Contractor’ means delivery of the project on time, with all the functionalities and quality as per the contract. For big projects, where the stake is higher, the higher the risk for the client or Employer. Any delay in delivery of the contract due to the non-performance or negligence of the Contract will attract financial losses for the Employer. Performance bank guarantee, also knows as Performance Security comes into play under this situation.

Table of Content

• Definition of Performance Guarantee with Example
• Who Can Issue a Performance Security?
• Performance Bank Guarantee Charges
• On Invocation of Performance Bank Guarantee
• Types of Performance Bank Guarantee
• Performance Bank Guarantee Rules and Regulations
• Performance Bank Guarantee Sample Format

Definition of Performance Guarantee with Example

Performance Guarantee, or Performance Security means a security in any form, including Bank guarantees, cash, bond, or letter of credit, that the party who is obligated to perform under a contract, submits to the other party who forms and awards the contract to the former, to cover the anticipated financial losses of the later. Bank Guarantees, when used as an instrument for the above purpose, is defined as a Performance Bank Guarantee.

Example: Consider a healthcare organization awards the construction of a new hospital to a contractor in a location where there is no such facility available to the local people. The contractor does not perform and delays the delivery of the project. This will lead to monetary loss of the Employer and also the healthcare services may not be available to people. Similarly, delay in the completion of an important sports stadium may lead to delay of an important tournament like the Olympics or the World Cup, resulting face loss of a Government. Hence, for a large project, the firmness of the commitment from the contractor is of utmost importance. Performance bank guarantee or PBG serves this purpose to some extent. Why ‘to some extent’ only, we will discuss shortly.

Let’s elaborate a little on this.

Who Can Issue a Performance Security?

A performance security or a performance bank guarantee is a guarantee that a bank issues on behalf of the contractor, to the Employer to protect the Employer’s interest. In any case, if the Contractor evades the project, or by any other means does not fulfill its obligations under the contract, the Employer can get monetary compensation to the extent as mentioned in the contract.

Banks issue the performance security (in the form of a Bank Guarantee) as per the terms and draft detailed in the contract documents. This is usually pinted on stamp papers and under the signatures of the bank officials assuring to compensate the beneficiary, i.e. the employer, to the extent of the amount specified. On award of the contract, this is the most important job of the contractor. There are some time limits specified in the contract within which the contractor needs to get the PBG from the Bank and submit it to client. Employers, on receipt of the PBG, officially verifies it with the banks and further processes of the contract starts.

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Performance Bank Guarantee Charges

While Banks issues the guarantees or securities on behalf of a contractor, it charges a certain amount to them. This is valid for not only Performance guarantees, but also for any other bank guarantees meant for securing the advances given to the contractor, or use of any high-value materials. The charges of bank guarantee varies from 0.50% to 2%, or even higher, depending on the financial credentials of the Contractor and the policies of the banks. Banks generally charge this commission to the companies availing the facility on a quarterly or half-year basis. The credential of the contractor means their liquidity, asset, current liabilities in the market, loan repayment history, and financial performances in terms of revenue & profit margin in the recent past.

On Invocation of Performance Bank Guarantee

Contract conditions must describe the performance parameters of the Contractor in a contract. Usually, those for which the Contractor would provide the Contract Performance bank guarantee, are in the Notice Inviting Tender (NIT), under the performance bank guarantee clause. The tender document mentions the performance parameters leads to penalty for the Contractor. The tender also specifiess the format for the PBG. Hence, the tender specifies the obligations of a Contractor under a contract.

When we say ‘Obligations of the contractor’ it means time, quality of work, functionalities of the project, and any other deliverables of the Contractor that they have agreed to while signing the contract. Failing to execute such requirements by a Contractor will empower the Employer to exercise their power to invoke the guarantee. Hence, Performance bank guarantees protect the interest of an Employer by obligating the Contractor to deliver their commitments under the contract.

To invoke a performance guarantee, the beneficiary, means the Employer should declare in writing to the bank that the Contractor did not fulfil their contractual obligations in some way or the other.

Types of Performance Bank Guarantee

Principly, performance guarantees are of two types:

• Payment guarantee: When a party in the contract is obliged to pay some amount to the other party in the contract, and fails to do so, the other party can invoke the guarantee to compensate.
• Bid bond guarantee: When a party in the contract (generally the contractor) is obligated to perform as per certain conditions of the contract. When they fails to perform in line with the same, the other party has the option to invoke the guarantee to cover their financial losses due to such non-performances.

Example: Agency A has awarded a project to agency B of a certain amount. Now, there could be certain conditions post-award that B aprehends about their profit margin, may be due to wrong calculations or changed market conditions. If there is no obligation, B has always a choice to abandon the project and fly away, leading to delay in the project completion, as the selection of the next contractor will take considerable time.

Now, if performance security is mentioned in the tender and agency B provides it to the agency A, then the former is obligated to perform as other wise they will loose the money (along with reputation) as specified in the performance security.

In exeptional cases, contractors abandon projects in spite of existence of a performance security in effect. This is the case when the Contractor anticipates a loss in the project much higher than the performance bank guarantee amount, or becomes utterly unstable in financial condition.

Performance Bank Guarantee Rules and Regulations

In the regular construction project contracts, the value of the Contract Performance bank guarantee (also known as performance security of the contract) varies from 3% to 10% of the contract value. The percentage generally depends on the type of the contract, severety of the breach, if any, and the Employer drafting the contract. After the outbreak of COVID-19 many of the countries has reduced the percentage of the performance securities, in a view to reduce the bank charges overburden for the contractors.

Following are the general rules for a Performance Security:

• Amount of the Bank guarantee
• Date of effect of the bank guarantee
• Validity period of the guarantee and date of expiry
• Date of claim to lodge if the contractor is on default
• Conditions under which the beneficiary can demand invocation

Generally, the contractor cannot stop the Employers to invoke on the Performance guarantee if they intend to do so. But, of course, they can deal the matter contractually and get their money back if proved that the Employer has invoked encashment of the performance securities by wrong means.

Performance Bank Guarantees Sample Format

Here we provide a sample format of Performance bank guarantee of a Government contract. This may vary with the contract conditions and the party drafting the contract. However, this is a general format from where you can take reference for learning about performance bank guarantees.

Further Reading

You may refer to the post by the Reserve Bank of India regarding the conduct of guarantee business by banks here: Reserve Bank of India – Notifications (rbi.org.in) You will find the performance bank guarantee rbi guidelines in 2022 in this article.

If you have any further query or need clarification on the subject discussed above, please comment below.