009 - Performance of Efficiency Guarantees

Introduction
Surety companies are occasionally asked to bond contracts that require the end product to perform to a specified technical standard - referred to as "efficiency guarantees" or "performance guarantees". The Surety Association of Canada urges owners and design professionals against requiring a bond to guarantee performance to a technical or output standard, particularly when new and unproven technologies are employed. Such obligations go beyond the realm of surety companies' expertise and will be unavailable to the vast majority of otherwise qualified contractors or suppliers.

Background
Surety companies possess underwriting expertise in evaluating risks associated with construction projects. This underwriting process involves assessing the contractor's overall operations in terms of prior track record and history, financial strength, and profit trend analysis as well as organizational capability which, if favourable, enables them to pre-qualify and guarantee these contractors to public and private owners.

However, there are occasions where the technical and/or long-term nature of a contract may go beyond the normal scope of a straightforward construction project. The contract may contain onerous terms and conditions stipulating that specific levels of output or certain technical standards be achieved and/or maintained over an extended period of time. This is often referred to as a "performance guarantee" or "efficiency guarantee". This form of guarantee is sometimes found in manufacturers' or suppliers' contracts, especially on energy-related projects.

Traditionally, this exposure was managed by the use of a finite risk product referred to as "efficacy insurance". However, due to the volatile and hazardous nature of this line of business, efficacy insurance policies are not widely available and tend to be prohibitively expensive. Consequently owners and risk managers seek alternative protection by incorporating efficiency or performance guarantees into contracts in an attempt to bring them under the coverage afforded by a performance bond. Often these are long-term in nature. The Surety Association of Canada strongly advises against this approach. As a rule, bonding companies are reluctant to provide efficiency guarantees of this nature, particularly when the contract specifies unique or unproven technologies.

The underwriting considerations for risk factors associated with guaranteeing high tech equipment, or computer software employing new and emerging technologies, are vastly different from those in the construction area and, for the most part, fall outside the surety industry’s realm of expertise. Sureties may not bond contracts containing performance or efficiency guarantees due to the difficulty in adequately evaluating the risk. Alternatively, a surety may require that the contract be modified to remove the efficiency guarantee component before providing a bond. As a result, owners requiring process guarantees may find that many competent and otherwise qualified bidders will be shut out as bonding will be unavailable to them.

On the claims side, a surety bond is neither designed nor priced to act as efficacy insurance. The challenge of establishing a default stemming from technical non-performance can be extremely complex and can lead to costly delays and protracted litigation to the frustration of all concerned.

Construction purchasers and design professionals are encouraged to contact the Surety Association of Canada should they require any assistance in the preparation of appropriate tender specifications.

This paper is intended to serve as a general guideline to assist members and other readers in responding to the issues discussed. Nothing contained herein should be construed as legal advice and readers are cautioned to consult with legal counsel for such advice.

Third Edition
December 2009