Performance bonds in Brazilian public works

June 2018 | EXPERT BRIEFING | RISK MANAGEMENT

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The performance bond is a relatively new phenomenon in the Brazilian legal landscape, particularly when compared to the other types of insurance available, as well as to the other more traditional guarantees, like bank guarantees.

In its original wording, the Brazilian Bidding Law did not include the performance bond as one of the available securities for administrative contracts. It only provided for collateral in cash, government bonds or surety and bank guarantee. The Bidding Law was then amended by Law 8,883/94, which included the performance bond as another type of security that can be presented in administrative contracts.

The guarantee currently required in administrative contracts, which can be provided by a performance bond, should not exceed 5 percent of the value of the contract, except “for works, services and supplies in large projects that are technically highly complex and carry considerable financial risk”, in which case it may be increased to up to 10 percent of contract value. For contracts up to BRL 37.5m, the maximum guarantee required is of 5 percent of the contract value, and above this amount, it may reach 10 percent.

The performance bond is undoubtedly the type of guarantee most-often adopted by government contractors, as it is cheaper than a bank guarantee and does not impact on cash flow, as would occur with the “collateral in cash, government bonds or surety”, which, for that very reason, is rarely used.

However, in relation specifically to administrative contracts with the government, the performance bond has not been able to play its role satisfactorily.

The first and most obvious reason relates to the limit of the coverage, which is known to be incapable of dealing with the losses arising from a default.

The situation gets dramatic when one considers the number of unfinished projects which create sizeable loss to the public treasury. Although there are no conclusive figures, it is speculated that more than 20,000 federal, state and municipal works, of all sizes, have not been finished.

Another important point concerns the role of the insurer in public contracts. Part of the doctrine understands that the insurer could only compensate damages, rather than execute the work itself, for example, as under the Bidding Law, the insurer does not take part in the bid.

In addition to the high number of insurance claims and the inefficiency of performance bonds, the Bidding Law has been the object of much criticism in the 25 years since its enactment. Accordingly, since 1995, several bills for a new Bidding Law have been put before the Brazilian Congress.

Changes proposed by bill number 6,814/2017

After years of processing several bills, a special commission was created and efforts were concentrated on Bill number 559/2013, which is intended to repeal the current Bidding Law, the Law of Pre-Auction and the Differentiated Regime of Contracting. The bill, which has already been approved by the Senate, is awaiting review by the Chamber of Deputies, where it is identified by number 6,814/2017.

Guarantees are the subject of a dedicated chapter and two extensive articles (articles 89 and 90). The first big change is seen in article 89, paragraph two, which provides for the possibility of waiving the presentation of a guarantee for contracts with prompt delivery.

Next, one of the main and most eagerly-anticipated changes is provided by paragraphs three and four of the same article, which increases the limit of the guarantee, with special treatment for ‘major’ contracts.

Article 89, paragraph three, provides that the guarantee may be up to 20 percent of the initial value of the contract, “the percentage being justified by a cost-benefit analysis that considers the factors present in the contracting context”.

The main novelty is in the following paragraph, which deals with works of great magnitude: “In works and engineering services of great magnitude, a performance bond must be required with a recovery clause in the percentage of 30% (thirty percent) of the initial value of the contract, in which case the bid invitation may provide for the obligation of presenting additional insurance.”

In the case of major works, the performance bond becomes mandatory and the percentage is fixed at 30 percent with a recovery clause. Furthermore, there is a provision for “additional insurance”.

The definition of what a great magnitude work is provided in article 50 as being those with more than BRL 100m estimated value.

Another important and controversial change is found in article 89, paragraph seven: “In case of contracting of engineering works and services, the bid invitation may provide for the obligation of the insurer to subrogate itself in the contractor’s rights and obligations in case of breach of contract by the contractor, in which case: (i) the contractor cannot opt for the guarantee modalities provided for in items I and III of paragraph 1; (ii) in case the insurer does not conclude the contract, a fine equivalent to the full value of the guarantee will be imposed; (iii) the insurer shall sign the contract, including the additives, as intervening party, and may: a) have free access to the premises where the main contract is carried out; b) supervise the execution of the main contract and attest to the conformity of the services and materials employed in the execution of the agreed terms; c) perform technical and accounting audits; d) request clarification from the technical responsible for the work or the supply; (iv) the issuance of the statement of agreement on behalf of the insurer is authorised, if it is demonstrated its fiscal regularity; (v)the insurer may subcontract the conclusion of the contract, in whole or in part.”

The issue is controversial since the insurer, which did not participate in the bid, would become actually responsible for the administrative contract, under penalty of a fine based on the value of the guarantee.

In addition, if there is a default by the contractor due to indebtedness and the insurer becomes responsible for such debts, the chances of the limit of 30 percent of the contract being sufficient for the execution of the work is remote.

The role of the insurer as provided by bill number 6,814/2017 draws on North American inspiration and is quite different from the current reality. It would force insurance companies to restructure themselves in view of the possibility of being called to effectively execute the object of the contract, rather than simply guaranteeing it, becoming signatories to the contract (as an intervening party), with extensive supervisory powers.

Such risk and the mere obligation to inspection of the works would entail costs, which would need to be reflected in some way in the price of insurance, indirectly increasing public expenditure on the contracting of works.

Market expectation and conclusions

Bill 6,814/2017 brings deep changes to the role of the performance bond in Brazil.

Though the idea behind the suggested changes in the Bidding Law won strong support, the adoption of the North American model, with a guarantee equivalent to the value of the contract, also saw strong internal resistance, as the market would not be able to absorb a risk of this magnitude.

For that reason, it was established that the 30 percent figure would represent a more balanced approach, covering most of the unfinished works without generating too great a burden for the government and harmonising the emission capacity of companies that operate in the country.

The bill is now being debated in the Chamber of Deputies, and still being criticised by the sector, especially in relation to the indiscriminate subrogation of the insurer, the issue of supervision of works and the possibility of penalising the insurer based on the value of the guarantee if work is not resumed, which is unlike any other legal system.

While advances in the law are commendable, adjustments to the final text are still expected and, if made by the deputies, will cause the bill to return to the Senate for voting, postponing its possible entry into force.

Ilan Goldberg is a senior partner and João Sá and Paula Roberta Rodrigues are senior associates at Chalfin, Goldberg, Vainboim & Fichtner. Mr Goldberg can be contacted on +55 21 3970 7200 or by email: ilan@cgvf.com.br. Mr Sá can be contacted by email: joao.sapaula.rodrigues@cgvf.com.br. Ms Rodrigues can be contacted by email: paula.rodrigues@cgvf.com.br.

Ilan Goldberg and João Sá and Paula Roberta Rodrigues

Chalfin, Goldberg, Vainboim & Fichtner