Performance bonds vs. Letters of Credit

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Performance bonds and letters of credit play an important role in protecting municipalities against potential contract defaults. Understanding when and how to use these tools is more important than ever before. Performance bonds are similar to insurance policies. They are typically issued by a bond surety company to the municipality (i.e., the bond holder) in case the contractor fails to perform the obligations established in the contract. Generally, in case of a default, the bond surety company would be required:

  • to assist the contractor to complete the work; or,
  • complete the work themselves; or,
  • assign a new contractor to complete the work; or,
  • pay an agreed amount to that the municipality in the event of an unresolved contract default. [1]

A letter of credit is effectively a promissory note to pay a specified amount of money to a designated person (i.e., usually the municipality) upon receipt of a demand upon occurrence of an event specified in the letter.” [2]

Contract

Key Considerations

 Letter of CreditPerformance Bond
SecurityIf irrevocable, a letter of credit is, generally, a secure guarantee. In the event of a default on the contract, the issuing bank will provide the municipality with access to the funds secured by the letter of credit upon submission of the agreed to documentation.[3] There is no discussion about the contract and/or the event(s) giving rise to the breach.By comparison, a performance bond may be secure, but surety companies are unlikely to assume an unconditional obligation to make payment in the event of a breach and will take steps to investigate and discuss the breach prior to making any payment to the Owner.
CostIrrevocable letters of credit are usually more expensive as they typically represent an unconditional obligation and as a result represents a greater risk to the issuing bank. The issuing bank would normally require that the contractor provide the bank with sufficient collateral worth at least the same amount of the letter of credit thereby negatively affecting a contractor’s borrowing capacity and potentially compromising their ability to bid on a job.[4]While surety companies are unlikely to assume unconditional obligations, their product—performance bonds—are generally a lower cost to the contractor than a letter of credit.[5]
Potential to litigationIn general, there is limited room for litigation when it comes to an irrevocable letter of credit.[6] This is due to the Principle of  Autonomy Documentary Credits.[7] The Principle states that regardless of any dispute in the contract, upon presentation of the documentation specified in the letter of credit, the issuing bank must pay the amount promised.[8]With performance bonds, there is more room for discussion. For instance, there may be disputes regarding whether a contractor indeed defaulted in its obligations, or whether the owner has fulfilled all its obligations so that it may make a claim on the performance bond.
CoverageGeneral practice is that a letter of credit be obtained for 10 to 25% of the value of the project.Performance bonds, by comparison are often obtained for up to 50% of the total value of the project. Thus, while compensation is more easily recovered through a letter of credit, the coverage can often be lower.

The choice between the two options often comes down to appetite of the municipality to go to litigation to secure the higher compensation normally available through a bond. In the case of service contracts such as waste collection, the value of the bond is normally set as a percentage of the annual net worth of the contract.

Whether a bond or letter of credit is used to secure a contract, it is always important to ensure qualified legal counsel is involved in their development and negotiation.

Common questions about performance bonds

A precise answer to this question requires a financial and economic analysis of the project and the specific performance bond in question. How much performance bond coverage to require is a difficult question because the cost of the coverage is ultimately passed on to those contracting for the specific work or service (the “Owners”). Therefore, in general, the greater the coverage being sought against a contractors’ default the higher the cost will be to provide the service.

As a general guideline, the following points should be taken into consideration when negotiating the amount of the performance bond being requested:

  • Generally, surety bond companies secure up to 50% of the value of the project. While it is possible to negotiate to have the project up to 100% secured by a surety company[9] this results in higher premiums.
  • Typically, in Canada, the cost of performance bonds ranges from 1 to 3% of the total cost of the work.[10] [11] However, this depends on the contractor and for some contractors the cost of the performance bond may be between 5 to 20% of the total cost of the project.[12]
  • It is important to note that bids that are high do not provide more protection to the Owner. In fact, the opposite may occur. The surety company may perceive that specific contractor as risky and require a higher cost for the performance bonds.

The final decision for this question is a business decision that should involve professionals knowledgeable with the specific industry and service being provided.

To determine the trustworthiness of surety bond companies, an accountant should be consulted. There are a few tools that can assist in a preliminary analysis. A complete list of surety companies that the Canadian Federal Government accepts to do business with is available online (scroll down and click on “Appendix L – Acceptable Bonding Companies”).[13] An Owner may want to require that the surety company be one of those that is accepted by the Federal Government. Being accepted by the Federal Government is a sign that the surety company is reliable.[14] Another tool available is the AM Best-Canada website.[15] AM Best is one of the largest credit rating agencies in the world. It is specialized in the insurance industry and often issues performance bonds.[16] Owners can see how AM Best rates certain companies in the Canadian market. Some companies in the performance bond industry suggest that the rating of a surety company should be at least an “A-”.[17] Owners can sign up for free and search a company on the AM Best website.

It is recommended that any contract allow for the Owner to have final determination over the acceptance of the performance bond, acting reasonably.

Enforcing performance bonds

In the context of COVID-19 a number of companies involved in municipal construction and service contracts have had to default on the contract or declare force majeure. How can you enforce a performance bond in either case? [18].

The default of a contractor to perform and/or meet the terms and conditions of a contract and declaring a force majeure event in order to not perform its obligations under a contract are two distinct scenarios.

In general, surety companies require that a contractor defaults prior to allowing a claim to enforce a performance bond.[19] The idea is that a party contracting to have the construction or agreed upon service completed (the “Owner”) should have access to the guarantee—performance bond—only in circumstances where the contractor cannot perform its obligations due to the contractor’s own fault. On the other hand, generally, a force majeure clause excuses both parties in a contract from non-performance upon the occurrence of a certain event.[20]

The words in a force majeure clause may prevent the parties from recovering damages or relying on any sort of performance bond.[21] For example, the performance bond itself may include language exempting either party from liability for loss or damage to the other party as a result of a force majeure. The contract entered into between the parties may also include language exempting either party from any obligation in the contract due to a termination as a result of a force majeure. It is important that the words in the force majeure clause and in the contract be closely scrutinized and analyzed by legal counsel.

There are a few steps that are important in order to avoid complications when making a claim on a performance bond:

Use standard bond forms: According to the Surety Association of Canada, parties incur in higher risks and complications when making a claim if they use non-standard bond forms [22].

Inform the bonding/surety company of any changes in the contract: Throughout the duration of the contract, owners should keep the bonding (insurance) company fully informed of any changes to the contract terms.[23] Bonding companies may not be ultimately obliged to provide guarantee to a contract if the terms of the contract change without its consent.[24] Some common changes include—but are not limited to: overpaying a contractor, over-certifying the value of the work, changing the scope of the work so that there is change in the value and/or duration of the work. Also, completion of work that had been left incomplete by a defaulted contractor will generally be seen as a change of the contract if done without the agreement of the surety company.[25]

Comply with the obligations in the contract: In general, a bonded contract requires Owners to have paid in a timely manner. It is important to comply with all the obligations in the contract. Compliance with the contract is often a condition for the successful advancement of a claim on the performance bond.[26]

Inform the surety/insurer of any potential default: The Surety Association of Canada recommends that an Owner contact the surety company as soon as a performance issue arises that may lead to a default of the contractor.[27] By taking this proactive step, surety companies can provide assistance and try to formalize solutions between Owners and contractors.[28]

Review the contract to determine whether the contractor is in default: For a claim to succeed the contractor must be in default of the contract. The contract will likely include provisions specifying when a contractor is considered to be in default of the contract. Before bringing a claim, Owners should confirm that the contractor is in default as contemplated by the contract.[29] For example, typically, a contractor denying performance of an specific activity because it is not in the scope of the contract is not a valid default of the contract.[30]

Review the contract and give proper default notice: If the contractor defaults, the Owner should review its contract and determine what, if any, obligations must be met prior to submitting a claim to the surety company. For example, contracts often require that the Owner provide a contractor with a notice of default.[31] It is common for contracts to require Owners to provide the contractor with an agreed upon period of time to remedy the situation.[32] Also, Owners should confirm whether the contract requires the notice of default to be prepared and/or delivered in specific manner.

Give notice of a claim to the surety company: In general, performance bond contracts include a specific clause stipulating that in order to bring a claim, the Owner must give prior notice of the claim to the surety. Typically, Owners are barred from bringing a claim if they do not comply with this notification requirement. Owners should also make sure to comply with any form and/or delivery requirements when preparing the notice for the surety.[33]

Send all documentation when submitting a claim: In order to speed up the process, the Surety Association of Canada recommends that when submitting a claim Owners include copies of the following documents: “signed bond, signed contract, all approved and submitted contract schedules, all approved and pending change orders or contract amendment requests, all contractor invoices and payment certificates or approvals, a summary of all payments made including the date of each payment, correspondence, meeting minutes and other documents relating to the default.”[34]

Mitigate costs arising from the contract: The Owner must mitigate any damages that may result from a delay between submitting a claim and the resumption of the work under the terms of the contract. It is recommended that the surety be fully informed of all opportunities and actions to mitigate costs.[35]

Obtain a “Memorandum of Agreement” when negotiating with the surety and the contractor: If during the claim process the parties enter into an agreement to resolve the situation, all parties including the surety company should execute a “Memorandum of Agreement.” [36]

Obtain written notification from the surety company: If the surety denies liability, ask for the denial in writing as a notification. The notification should state the surety’s position and reasons for that position. The notification should be signed and dated.[37] This documentation will assist if the case ever has to be litigated.

Be attentive to the limitation period: If litigation is ever required, seek legal advice to assist in determining the applicable limitation period within which the Owner can bring a claim to the courts.[38] Limitation periods are generally two years from the date of the event that gave rise to the legal claim. However, the facts of each case may implicate different limitation periods.

Typically, if the claim for enforcement of a performance bond succeeds, it is the surety company’s responsibility to determine how to resolve the situation.[39] In general surety companies have four main options, as noted above. They may try to remedy the situation by assisting the contractor and negotiating with the Owner to have the contractor complete the work. A second option is for the surety company itself to complete the remainder of the project. Alternatively, the surety company may arrange for another contractor to take over the project and finish the work. Lastly, the surety company may opt to payout. In this case the surety company generally pays either the excess cost to complete the work or the amount of the performance bond—whatever is the least expensive.[40]

This blog was prepared by Paula Lombardi and the staff at Siskinds LLP. The CIF does not provide legal advice in any form.  Municipalities and/or other users of the information provided by the CIF, its affiliates, partners and assigns do so specifically at their own risk. This information is not a substitute for qualified legal advice and the CIF, its affiliates, partners and assigns accept no responsibility for loss or damage, howsoever incurred, by the use of this information. You acknowledge that in using the CIF information neither CIF, nor any of its agents, partners, affiliates, directors, employees, assigns and associates may be held liable, responsible or accountable for any type of damage, litigation or other legal action that may arise directly or indirectly.


[1] Surety Association of Canada, “Contract Surety Bonds”, and “Performance Bonds
[2] Surety Association of Canada, “Making a Claim under a Performance Bond
[3] M Ogilvie, Bank and Customer Law in Canada, 2ed (Toronto: Irwin Law Inc, 2013) at 428.
[4] Poyner Spruill LLP, “A brief look at common loan credit enhancements” (2 October 2015), Lexology USA
[5] Ibid.
[6] Ibid.
[7] Ibid. Please note that I made an inference for the content of this footnote.
[8] Angelika-Whitewear Ltd v Bank of Nova Scotia, [1987] 1 SCR 59 at 70. Please note that Angelika is a case in which the Supreme Court of Canada (“SCC”) rule that in case of fraud the Principle of Autonomy Documentary Credits may vary slightly. However, my point in citing this case is to show that the SCC does recognize the Principle in Canadian Law.
[9] Ibid.
[10] Surety Association of Canada, “Performance Bonds
[11] Vic Lance, “A Look at Payment and Performance Bonds” (7 November 2011), the NEWS; “What Do Construction Bonds Cost?” (11 February 2016), Surety Bond – Construction & Commercial
[12] Vic Lance, supra note 2.
[13] Canada, Treasury Board, “Contracting Policy”, (Ottawa: Treasury Board, 2019)
[14]Verifying a Surety Bond” (26 February 2020), MG Surety Bonds
[15] AM Best-Canada
[16] AM Best, “About
[17] MG Surety Bonds, supra note 5.
[18] A performance bond is also known as a contract bond, is a surety bond issued by an insurance company or a bank to guarantee the satisfactory completion of a project by a contractor.
[19] Surety Association of Canada, “Performance Bonds
[20] John McCamus, The Law of Contracts (Toronto: Irwin Law Inc, 2005) at 601.
[21] See for instance Frederick Transport Ltd v Gaco Systems Ltd, 1987 CarswellOnt 2427 at paras 22-26. In this case Frederick Transport Limited sued Gaco Systems Ltd for balance owing on carriage (para 1). Gaco filed a counterclaim for damages due to late delivery (para 1). Gaco argued that the late delivery caused it to pay liquidated damages to A.E.S. in another contract (para 2). In Frederick the court understood that the delay in question was due to force majeure (para 22). The Court then determined that there was no legitimate counterclaim (para 22). One of the reasons was that the contract between A.E.S. and Gaco had a force majeure clause, which had language exempting either party from liability for loss or damage to the other party (para 22).
[22] Surety Association of Canada, Performance Bonds Work for You, at 3 [Surety Association of Canada, Performance Bonds Work for You].
[23] Ibid at 4.
[24] Manulife Bank of Canada v Conlin, [1996] 3 SCR 415 at paras 2-3.
[25] Surety Association of Canada, Performance Bonds Work for You, supra note 4 at 4.
[26] Surety Association of Canada, “Making a Claim under a Performance Bond
[27] Surety Association of Canada, Performance Bonds, supra note 1.
[28] Ibid.
[29] Surety Association of Canada, Making a Claim under a Performance Bond, supra note 8.
[30] Ibid.
[31] Surety Association of Canada, Performance Bonds Work for You, supra note 4 at 4.
[32] Ibid.
[33] Lindsey von Bloedau & Krista Johanson, “Don’t make these 5 mistakes about performance bonds” (20 February 2018), On-Site Canada’s Construction Magazine
[34] Surety Association of Canada, Performance Bonds Work for You, supra note 4 at 7.
[35] Ibid at 6.
[36] Canada, Public Services and Procurement Canada, “Dealing with Surety Companies on Construction Contracts”, (Ottawa: Public Services and Procurement Canada, 6 November 2019)
[37] Ibid.
[38] Ibid.
[39] Surety Association of Canada, Making a Claim under a Performance Bond, supra note 8.
[40] Ibid.

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