Construction Performance Bonds

On my linkedIN group (Contracts Questions and Answers) an individual asked whether the principal can seek to recover any money in case of an on demand performance bond being cashed by the beneficiary? Can the payment be commensurate to the actual loss/damage? I thought I would post and expand upon my answer here.

A performance bond is a financial guarantee that performance will be completed and they are traditionally issued by banks or insurance companies. There are two types of performance bonds. Conditional bonds require the party to provide that the conditions have been satisfied for the issuer to make payment to the beneficiary of the bond. An “on-demand” performance bond does not need to prove that the bonded company was in breach.

There are several factors that will determine whether you could seek to recover monies. The first factor is the actual language that you use to establish an "On-demand performance bond". If you used language to the effect that the on-demand performance bond covers the actual and reasonable damages the other party sustained, up to the amount of the bond, the other party would only be allowed to collect their actual damages, and you could pursue an amount over that amount.

The second factor will be whether the jurisdiction allows or doesn't allow penalties. If there was no limiting statement, and the law allowed penalties, the beneficiary could collect the full amount of the bond even if that exceeded the actual damages. If the jurisdiction didn't allow penalties, their demand against the bond should be based upon their actual damages. If their demand exceeded their actual damages, you could seek to recover excess amounts, claiming that there demand for monies in excess of their damages constituted a penalty that would not be allowed by law.

It's always best to make the intent clear. For example if you contracted in a location that allowed penalties and you only wanted the proceeds of the bond to cover actual damages whether if you used either type of a bond you would want to make it clear that proceeds from the bond can only be used to pay actual damages sustained for breach of the committed performance. Further, if you have a limitation of liability provision that limited the types of damages that could be recovered you would want to make it clear that those same limitations apply any claims made under the performance bonds.