The properties and applications of a performance bond

By Blake Yang, Martin Hu & Partners
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In China, the concept of a performance bond is derived from the laws and regulations of bidding and governmental procurement. Its applications, however, have long been beyond that. They usually appear in any major cross-border commercial transactions contracts, and are particularly common in foreign trade, such as long-term supply contracts, general agency contracts, patent pool licensing contracts, and Sino-foreign co-operative project contracts. The privileged party (usually multinational companies with possession of products, technology, brand and other competitive edges) often tends to use the terms of a performance bond to ensure the successful fulfillment of contracts.

杨奕 Blake Yang 胡光律师事务所 律师 Associate Martin Hu & Partners
杨奕
Blake Yang
胡光律师事务所
律师
Associate
Martin Hu & Partners

The terms of a typical performance bond often require the paying party of a performance bond to make a large amount of payment to the other party after signing a contract to ensure its fulfillment by the payer. If the payer breaches the contract, the payee can forfeit all or part of the payment to cover any losses incurred and demand the payer to pay up to any amount forfeited. If the payer has not breached the contract, the bond can eventually be used to settle the contract price, or refunded after the contract is completed.

Performance bonds often become the centre of disputes between concerned parties of a contract. The payee often directly follows the agreement templates drafted by its overseas affiliated companies in order to comply with the policies of the payee’s group or headquarters. These templates usually include terms of a huge amount of payment as a strong penalty and do not pass the Chinese judiciary test.

On the other hand, the payer is often overwhelmed by eagerness to win the contract and therefore will often not question such terms. If forfeiture of bond occurs later on, the payer often makes various excuses to demand a refund.

Origin of the performance bond

The concept of a performance bond only appears legally in a few published documents such as the Bidding Law, the Regulation on the Implementation of the Bidding Law and the Government Procurement Law Implementation Regulations. Among these documents, a definition of the performance bond has not been found. However, article 60 of the Bidding Law still reveals the legal nature of a performance bond. On one hand, a performance bond acts as a guarantee; it requires the bidder to pay the tenderer an upfront payment as a guarantee to ensure the establishment/fulfillment of contract by the bidder. On the other hand, it acts as a breach penalty; if the bidder refuses to establish or fulfill the contract, the tenderer has the right to forfeit all the money of the performance bond, regardless of whether the tenderer has incurred any losses.

Money guarantee

The Supreme Court mentioned a similar concept, namely the “quality bond”, in article 21 of the Interpretations of Issues Concerning the Application of Law for the Trial of Disputes over Sales Contracts, which can be used as an important reference to analyze the legal nature of a performance bond. Quality bond is defined as a “money guarantee paid upfront by one party to the other party according to the agreement between the concerned parties”.

The Supreme Court has categorized the contractual guarantee system into two basic types – a “general guarantee” represented by the liability of a contractual breach, and a “special guarantee” represented by deposit and warranty. The Supreme Court made clear that money guarantee, based on the agreement of the concerned parties, including quality bond, falls under the category of special guarantee. Therefore, money guarantee is different from liquidated damages. Even though liquidated damages can be seen as a warranty to fulfill a contract, it does not require upfront payment before the breach occurs.

Based on the concept that deposit and money guarantees both fall under the category of special guarantee, the Supreme Court further pointed out that the two are different in these four areas: legal ground; guaranteed object; maximum limit; and legal effect. This demonstrates that money guarantee is not a subordinate concept under deposit, but an independent concept that possesses the same level of legal status as deposit. Its applications are, therefore, not bound by the regulations of deposit. The Supreme Court further noted that whether money guarantee is applicable, and how the terms are set, can be freely agreed upon by the parties in accordance with the principle of autonomy so long as it does not violate the mandatory provisions of the law. This is different from the way statutory guarantee (deposit, etc.) works.

Nature of a performance bond

Performance bond and quality bond are similar in the following ways: both require upfront payment; both act as a guarantee to ensure the fulfillment of a contract; both grant the payee the rights to forfeit the money in the case of a breach of contract; both entitle the payer to ask for a refund from the payee after the fulfillment of all liabilities. Performance bond meets all the characteristics of a money guarantee described by the Supreme Court. The only difference between a performance bond and a quality bond is that the latter concerns “quality” issues in the fulfillment of a contract, while the former concerns “performance” issues in the fulfillment of a contract. The two have an inclusive relationship with each other, and there is no material difference between them.

Based on the above analysis, the definition that the Supreme Court gives to the “atypical money guarantee” nature of a quality bond is also applicable to a performance bond. At the same time, the Supreme Court does not link up quality bond with the actual losses incurred, thus encouraging the concerned parties to draft their own terms of liabilities protection given that the mandatory provisions of the agreement are not violated. Such judicial attitude has offered the payee substantial legal grounds in the case of a forfeiture of performance bond.

After all, a performance bond is a money guarantee agreed between concerned parties and is different from liquidated damages or deposit. Its legal nature and its applications are based on its autonomy – whether a money guarantee is necessary or how it should be applied can be determined by the concerned parties according to the agreement without violating the mandatory provisions of the law.

Blake Yang is an associate of Martin Hu & Partners

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杨奕 Blake Yang

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