Perfecting design strategies for performance bond mechanism

By Wang Jihong and Li Xiaodan, Zhong Lun Law Firm
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Performance bond mechanism design is an important part of the government drafting of public-private partnership (PPP) project tender documents. To ensure that investors and project companies perform according to what has been agreed, lawyers of the consulting organizations and governments often design interlocking performance bond mechanisms rigorously to protect the interests of government, such as bid bonds, investor performance bonds, construction period performance bonds, operation period performance bonds, or even guarantee transfers.

However, if these guarantees are poorly designed or too rigid, then a performance bond mechanism that seems to protect the interests of government may in fact bind it, not only increasing the burden on investors, but also not being helpful for the effective progress of the project.

WANG JIHONG Partner Zhong Lun Law Firm
WANG JIHONG
Partner
Zhong Lun Law Firm

In a PPP project the authors handled recently, the government proposed the following performance bond requirements in the tender documents: first, the investor (or, in case of a consortium, the principal entity) would need to submit a RMB200 million (US$30 million) bid bond during the bid (in the form of a bank guarantee), which would be refunded within five days of the execution of the investment agreement; second, the investor would submit a RMB500 million investor performance bond within 30 days of receiving the notice that it had won the bid, and before entering into the investment agreement, and the performance bond would be refunded within 30 days of completion and acceptance of the project; third, the project company would submit a performance bond for the construction period of RMB1 billion within 30 days of registration and completion of project approval, and before entering into the project co-operation agreement, and the performance bond would be refunded within 30 days of the date of completion and acceptance of the project; finally, the project company would submit a performance bond for the fee-charging period of RMB1 billion before the commencement of the period, and the performance bond would be refunded within 30 days once the 12-month-long charging period has reached its end.

FORM OF GUARANTEE

In most projects, the government will require bank guarantees for performance bonds. The advantage is that, if investors or project companies default, the government will be able to request that the bank deduct corresponding liquidated damages without requiring any proof; also, the funds of investors or project companies would not be left unused.

However, in many PPP projects that the authors have encountered, governments still insisted that performance bonds be submitted in cash. In a large project the authors handled, the government requested that, commencing from the year following issuance of the final acceptance certificate, before February 1 of each year the project company would pay 5% of the operating income of the prior year as an operation period performance bond until the cumulative amount reached RMB1.8 billion. This large amount would be refunded to the project company 12 months after expiry of the licensed operation period.

LI XIAODAN Associate Zhong Lun Law Firm
LI XIAODAN
Associate
Zhong Lun Law Firm

In fact, the Regulations on Implementing the Government Procurement Law and Administrative Measures on Government Procurement of PPP Projects have clearly specified that “social capital shall pay the performance bond in the form of cheque, draft, promissory note or letter of guarantee issued by financial institutions or guarantee institutions, etc., (other than in cash)”. Thus, given the large investment in PPP projects and their long performance period, the authors recommend that demand guarantees be adopted as securities for PPP projects as much as possible, to avoid using a large amount of cash for performance bonds, which would effectively protect the interests of the government without increasing additional burdens on private investors.

THE GUARANTOR

Given the investment capacity, design capability, construction capability, professional operating experience and many other requirements of PPP projects, the government always allows investors to bid as a consortium. Under the current legal framework, consortium members are jointly and severally liable to the government. In some tender documents, the government requests that the principal entity of the consortium submit a letter of guarantee for the consortium. This requirement may create the following problems for investors:

First, the members of the consortium may misunderstand that only the principal entity is obligated to submit a performance bond, and that other members have no obligations or liabilities to provide bid security; if the leader submits the guarantee, liability arising from the default by any members of the consortium would first be borne by the leader.

Second, if other members are unable or unwilling to submit counter-guarantees to the principal entity, it will become very difficult for the principal entity to request other members to bear corresponding responsibility. As for the government, whether the guarantee is submitted by the principal entity as a whole or individually by each member, as long as the amount of the guarantee meets the requirements of the tender documents, then the government may, upon default of the consortium, pursue any letter of guarantee based on joint and several liability. The interests of the government are fully protected by doing this, and the government would not suffer any loss.

VALIDITY TERM

As discussed above, the investor performance bond and construction period performance bond for project companies required by the government would be refunded within 30 days of completion and acceptance of the project. If the tenderer requires private investors to present a construction period performance bond, the period for the investor performance bond would end before the construction period performance bond begins, and the investor performance bond would be refunded in batches as project funds are paid in instalments. It is not necessary to maintain two performance bonds during the construction period, as it increases the financial burden on investors.

In summary, when designing PPP project security mechanisms, the tenderer should as much as possible allow project participants to submit performance bonds as well as avoid overlapping guarantee periods, which will promote successful completion of the project.

Wang Jihong is a senior partner and Li Xiaodan is an associate at Zhong Lun Law Firm

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