Public Money and Management

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Transparency in the Procurement of Public Works

Xiaomei Deng , Qian Tian , Shizhao Ding & Bob Boase

To cite this article: Xiaomei Deng , Qian Tian , Shizhao Ding & Bob Boase (2003) Transparency
in the Procurement of Public Works, Public Money and Management, 23:3, 155-162, DOI:
10.1111/1467-9302.00363

To link to this article: https://doi.org/10.1111/1467-9302.00363

Published online: 15 Mar 2010.

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 155

Transparency in the Procurement

of Public Works
Xiaomei Deng, Qian Tian, Shizhao Ding and Bob Boase
The construction contract bonding system is used worldwide to protect the owner
of a project against the risk of non-performance by the contractor. There is a close
relationship between the construction contract bonding system and transparency
in public works, which policy-makers and officials need to be more aware of.
There are mainly three systems in use, which the authors have analysed in depth.
Each of the three models has a different influence on transparency in public
works: the ‘high penalty conditional model’ is considered the most functional
model in improving transparency, the ‘low penalty unconditional model’ does not
contribute very much to improving transparency, while the ‘substitute contractor
model’ can lead to greater opportunities for corruption on the contractor’s side.
The contract bonding system is used worldwide contractor’s side. Xiaomei Deng is in
in construction projects, many of which are the Integrity
sponsored by public authorities. The system is The Three Models Research Institute,
based on a contractual relationship between Under the construction contract bonding School of Public
three parties: an organization (such as a bank, system, ‘suretyship’ exists (according to the Policy and
an insurance company etc.) acts as surety against legal definition) within three parties: Management,
losses by the project owner due to non- Tsinghua University.
performance by the contractor. Based on an Suretyship is the relation which exists where one
investigation into construction contract bonding person has undertaken an obligation and another Qian Tian is Deputy
systems worldwide, the authors have person is also under an obligation or other duty Dean of the School of
categorized bonding systems into three models: to the obligee, who is entitled to but one Public Policy and
performance, and as between the two who are Management,
•The high penalty conditional model, which is the bound, one rather than the other should perform Tsinghua University.
typical practice in the USA. (Hunt, 1990).
•The low penalty unconditional model, which is Shizhao Ding is in
used in the UK and is the most popular Other than the obligee, the two persons, or the Research
model in the international market. parties, mentioned above are the principal and Institute of Project
•The substitute contractor model, which used to the organization providing the surety. Basically, Administration and
be the practice in Japan and Korea, although the surety agrees to answer for the obligation of Management, Tongji
these two countries now largely converted to the principal to the obligee up to a limited University.
something akin to the US model. amount—the ‘penalty’—if the principal fails to
perform during the valid period of the bond. Bob Boase is
It is generally accepted that the construction After the surety has performed the obligation, Resident Advisor,
contract bond is a useful way for a project it has the right to seek indemnity from the UNDP China.
owner to transfer the credit risk of a contractor. principal. Historically, the term ‘surety’ used
In addition, there is a close relationship between to mean anyone who was able to provide comfort
the construction contract bonding system and or a guarantee to the obligee, and a surety bond
transparency in public works, which policy- provided by a single individual is still sometimes
makers and officials need to be more aware of. used (Coleman, 1999). Over the past century,
Each of the three models has a different specialization in suretyship has become the
influence on transparency: the high penalty norm. Corporate sureties have emerged and
conditional model is the most functional model surety bonds have become a major aspect of
in terms of improving transparency; the low insurance business.
penalty unconditional model contributes very Banks are another important provider of
little; while the substitute contractor model not suretyship in the form of a bank guarantee
only has nothing to do with transparency, but (suretyship and guarantee are almost the same
can actually aggravate corruption on the thing, referring to the assumption of liability

© CIPFA, 2003 PUBLIC MONEY & MANAGEMENT JULY 2003

156
for the obligations of another in law). In this
article, the term ‘surety’ is used to mean the
guarantor, whether it is an individual surety, a
corporate surety, or a bank; the word ‘bond’
refers to either surety bond or bank guarantee.
It is a profitable business to write surety
bonds if there are few defaults on the principals,
because the surety can collect its premium (or
commission in banking terms) for every bond
it writes. Incautious underwriting, on the other
hand, may result in a big loss and can erase the
profit earned in previous transactions or even
cause bankruptcy. From the principal’s point
of view, suretyship can enhance the discipline
to perform obligations duly and properly,
because the surety bond can be called at any
time by the obligee after there is a default; the
principal then risks its long-run relationship
with the surety, in addition to the claims from
the obligee.
In construction works, surety bonds are
mainly used to guarantee a contractor’s
performance. As a result, the contractor is
usually the principal and the owner is the
obligee. Lenders can also be listed as the dual
obligee in addition to the owner.
There are significant differences in the
construction contract bonding system used in
different parts of the world. The authors have
analysed these along five dimensions:
1. What is the source of demand for the products of
surety bonds? Is there a mandatory surety bonding
system in public works? For example, the
mandatory system is applied to public works
in the USA and Japan, but not in most other
Figure 1. Types of bond.
•Bid bond—provides financial assurance that the bid has been submitted in
good faith and that the contractor intends to enter into the contract at the
price bid and provide the required performance and payment bonds.
•Performance bond—guarantees to the obligee (the owner, or possibly a prime
contractor, and the lender in the event of a dual obligee bond) that the
surety will be liable up to the penal obligation of the bond for the cost of
completing the work in the event that the contractor defaults.
•Payment bond—guarantees that the contractor will pay certain labourers,
material suppliers, and subcontractors associated with the project. The
payment bond is a kind of mandatory contract bond in the US. An
insolvency protection bond is generally used in the UK to protect
subcontractors and suppliers against loss due to the insolvency of the
contractor.
•Advance payment bond (also called as prepayment guarantee/bond)—this
secures the repayment of any sum or sums advanced by the beneficiary
(obligee) to the principal.
•Maintenance bond—secures contractual obligations relating to the maintenance
of works or goods after completion.
•Retention bond—secures the payment of sums paid or released to the principal
by the beneficiary before the contracted date for payment.
PUBLIC MONEY & MANAGEMENT JULY 2003
countries.
2. Are the bonds conditional (on-default) or
unconditional (on-demand)? This is a very
important concept when discussing
suretyship. Generally, a surety bond is a
specialized contract, in which the surety’s
liability is limited to the terms of the bond.
With a conditional bond, the surety will not
respond to a claim until the obligee submits
sufficient proof to demonstrate that there is
a default and how much the loss is attributable
to a default by the contractor. A conditional
bond is therefore also called an ‘on-default’
bond. What constitutes a default is based on
the original contract between the obligee
and the principal, where the requirement of
the obligee (the owner) has been (or should
have been) clearly expressed. With an
unconditional bond (on-demand bond or
first demand bond), however, the surety
waives its right of plea as obligor. A typical
wording in an unconditional bond is: ‘We
hereby undertake to pay the said amount or
part thereof on your first demand without
warning and without any restriction or
condition and notwithstanding any
objections’ (Dong, 1995, p. 104). The surety
can be generous mainly because it has
collected enough collateral or deposit from
the principal. At any rate, it has to be sure
that indemnity can be on hand immediately
after it honours the claim. Obviously, with
an unconditional bond, the principal is at
risk of an unfair call from the obligee, and
reports of this occurring are sometimes
heard, especially in the Middle East (Tiong,
1992). The main advantage from the obligee’s-
position with this kind of bond is that it is
easy to call and makes them feel more
comfortable. In practice, surety bonds vary
according to the wording. Many bonds are
not strictly conditional but, rather,
somewhere in between, and some are even
close to unconditional bonds. The
International Chamber has created a flexible
term referred to as ‘demand guarantee’ to
cover all the possibilities (ICC, 1992).
3. Who are the major providers of the bonds? Banks,
specialized corporate sureties or others? In the
USA, corporate sureties do most of the
bonding business, but in Europe and many
other places, banks are the major provider.
In Japan, there used to be a very special
system in which another contractor, mainly
the second lowest bidder, would act as the
surety, by guaranteeing that it would
complete the work if the lowest bidder failed
to perform the contract.
© CIPFA, 2003

4. How much is the penalty? Is it high or relatively
low? The penalty is always laid down in a
bond, so that the surety can control the risk
to which it is exposed. It is almost always a
figure based on some percentage of the
contract price. In federal works undertaken
for the US government, 100% of the contract
price is the mandatory penalty, both in
performance bonds and payment bonds.
However, in most other places, a 5–15%
performance bond is the most common.
5. What are the major types of surety bonds used
in the market? There are different types of
construction contract bonds to cover
different types of non-performance risks
(see figure 1).
Comparing the different construction
contract bonding systems worldwide across
these dimensions, the authors found that the
penalty acts as a controlling dimension in
shaping the features of the system (Deng, 2003,
pp. 41–44). With a high penalty requirement,
to keep their products as cheap as possible and
the business profitable, sureties tend to do
their underwriting based on the contract
performance capability of the principal, and
only the risk under a conditional bond is
acceptable for the surety. By contrast, with a
low penalty requirement, whether a conditional
bond or unconditional bond, sureties tend to
do the underwriting based on the possibility of
obtaining indemnity from the principal
immediately; this is typically the basis on which
banks issue unconditional bonds. Therefore,
for a construction contract bonding system,
only the high penalty conditional model or the
low penalty unconditional model can offer
equilibrium status.
Almost all the different construction
contract bonding systems can be categorized
into these two models, except the substitute
contractor model, which refers to the very
special traditional systems in Japan and Korea.
Comparing the three models across the five
dimensions shows that these models not only
differ in the first four dimensions, but also in
the fifth. The high penalty conditional model
uses only three types of bonds, in which the bid
bond covers the liability of the contractor to the
owner during the contract award phase, and a
performance bond covers the liability of the
contractor to the owner during contract
performance. In the low penalty unconditional
model, however, regarding the liability of the
contractor during the contract award phase,
bid bonds are sometimes exempted. Regarding
the liability for performing the contract, a
© CIPFA, 2003
157
greater variety of types of bonds is used. This
fact may suggest that low penalty performance
bonds by themselves cannot provide enough
protection for the owner. By such means, the
total liability of the contractor to the owner is
divided into many specific liabilities, each
covered by a different type of bonds. The
substitute contractor model also divides the
liability of the contractor, but in a different
way: the liability for completion is covered by
the substitute contractor, while the liability for
monetary compensation is covered by a separate
bond.
To divide the performance liability of a
contractor into pieces may reduce the risk
exposure of a surety on any one bond, and may
improve the availability of bonds; but it may
also sacrifice some of the functions that a single
high penalty bond can provide. This has
implications for transparency, as discussed
Figure 2. Types of corruption.
‘Contracts involve a purchaser and a seller. Each has many ways of corrupting
the procurement process, and at any stage. Before contracts are awarded, the
purchaser can tailor specifications to favour particular suppliers, restrict
information about contracting opportunities, claim urgency as an excuse to
award to a single contractor without competition, breach the confidentiality of
suppliers’ offers, disqualify potential suppliers through improper
prequalification, and take bribes.
At the same time, suppliers can collude to fix bid prices, promote
discriminatory technical standards, interfere improperly in the work of
evaluators, and offer bribes.
Bidder competition can be further restricted by establishing improper or
unnecessary prequalification requirements and then allowing only selected
firms to bid…
The final opportunity to distort the outcome of competitive bidding is at
the bid evaluation and comparison stage…
The most serious and costly forms of corruption may take place after the
contract has been awarded, during the performance phase. It is then that the
purchaser of the goods or services may:
•Fail to enforce quality standards, quantities or other performance standards
of the contract.
•Divert delivered goods for resale or for private use.
•Demand other private benefits (trips, school tuition fees for children, gifts).
An unscrupulous contractor or supplier may:
•Falsify qualities or standards certificates.
•Over- or under-invoice.
•Pay bribes to contract supervisors.
If the sellers have paid bribes or have offered unrealistically low bid prices in
order to win the contract, their opportunities to recover these costs arise during
contract performance…Unscrupulous suppliers may substitute lower quality
products than were originally required or offered in their bid. They may falsify
the quantities of goods or services delivered when they submit claims for
payment, and pay more bribes to contract supervisors to induce them to
overlook discrepancies. In addition to accepting bribes and failing to enforce
quality and performance standards, buyers may divert delivered goods and
services for their private use or for resale’ (Pope, 2000, pp. 207–210).
PUBLIC MONEY & MANAGEMENT JULY 2003
158
further below.
A payment bond deals with the liabilities of
the contractor to its subcontractors and
suppliers. It is unique and no comparable
types of bond are used in other places. Since
the focus of this article is on the contractor and
the owner, further analysis of payment bonds
is not pursued here.
Pitfalls for Transparency in the
Procurement of Public Works
What hampers transparency in public works?
The efficient and effective procurement of
major works is a highly complex aspect of
public procurement and provides an almost
irresistible lure for corruption. Transparency
International (TI) has carried out a
comprehensive study of corruption in public
procurement in its TI Source Book (see figure 2).
As a summary, three types of corruption should
be given special attention in public contracts:
•Collusion that involves an insider (employee
or consultant working for the owner) and an
outsider (a bidder in the contract award
phase, or a contractor in the contract
performance phase). Collusion may occur
during both the contract award and the
contract performance phase.
•Collusion that involves only the outsiders.
This type is usually described as ‘bid rigging’
and happens mostly during the contract
award phase.
•Cheating behaviour, involving the contractor
only, who may provide false information or
indulge in jerry-building during contract
performance.
Collusion between Insider and Outsider
Competitive bidding is regarded as an
important measure to achieve fair and efficient
procurement. However, TI observed that
collusion and kick-backs can occur even in
projects that comply with international
competitive bidding and tendering procedures
(Pope, 2000, p. 210). How is this possible?
Simply to choose the lowest bidder is not always
wise, because low price may also mean low
quality. However, it is not easy to distinguish
the most competitive bid from a group of
bidders who all declare that they will do the
best job. Some degree of judgement, based on
relevant expertise, is inevitably needed in order
to make the final decision. In such situations,
however, transparency is subject to challenge.
Some unscrupulous bidders, who might not be
the most competitive and who would not
normally be awarded the contract in an open
PUBLIC MONEY & MANAGEMENT JULY 2003
and fair competition, will try to influence the
result by bribing those who have some influence
over the final decision. In some contexts,
corruption is so pervasive that even the most
competitive contractor is obliged to pay bribes,
so as to make sure it will not be excluded from
the competition. The cost of bribes is, of course,
redeemed by raising the contract price, which
eventually becomes a charge on the public
purse. To protect the value of public money,
transparency in bidding and tendering should
be given special attention, and the key here is
who and how to choose the lowest responsive
bidder.
In all bidding and tendering systems, the
award of a contract is determined by: performance
capability investigation and bidding price comparison.
Price is easy to compare and the lowest bidder
is ostensibly easy to find. If the procedure is
open and fair, there is little opportunity to
influence the process.
However, the winner must be chosen from
the bidders who are capable of performing the
contract, i.e. the responsive bidders. This is
decided by a more complex evaluation of the
contractors, including their technological and
financial capacities, completed works records,
further development potential, etc. Obviously,
the owner cannot risk hiring an incompetent
contractor who may just waste public money.
There are many ways to achieve this, in the UK,
Germany and Japan, for example,
prequalification is carried out to exclude
inadequately qualified bidders at the start
(referred to hereafter as the ‘UK style’). In
France, comprehensive evaluations are
performed by judges at the evaluation stage
(the ‘French style’). As the TI Source Book reveals,
neither the UK style nor the French style are
immune from corruption. For a corrupt owner
who wishes to favour the contractor who pays
a bribe, he or she can either exclude all the real
rivals (while including some token competition)
under the pretence of prequalification; or can
manoeuvre the result through the use of
collusive judges. For an unscrupulous
contractor, he or she can influence the result
simply by paying bribes to some of the judges.
US practice allows another possible way to
exclude certain bidders. In the US, the task of
prequalification work is done by an
independent corporate surety before it writes
the bid bond for the contractor. Is this
important? What is the difference from the UK
style or the French style? Let us go back to what
kind of prequalification we need. Certainly it
must be processed with great scrutiny by a
responsible person who cares about the
© CIPFA, 2003

qualifications of the contractor as much as the
ultimate owner of the project—the public, or
the tax-payers. One way to ensure this would
be to place him or her at the same risk as that of
the real owner if an unqualified contractor
were to be allowed past the prequalification
stage. This is what happens in the US when
prequalification is carried out by a surety, who
submits a bond to undertake the liability jointly
with the contractor.
How much risk does the surety assume in
the US? Under a typical high penalty
conditional surety bonding system, if a surety
agrees to stand behind a bidder, it must be
ready to expose itself to a risk of 100% of the
contract price, which is a mandatory
requirement of the Miller Act (100%
performance bond and 100% payment bond).
For a low penalty bond, such as 10% of the
contract price, it is easy for the surety to collect
collateral from the principal so as to pose no
risk, which is the practice of many banks when
they issue on-demand guarantees. However,
no individual contractor can afford to provide
collateral as high as 100% of the contract price.
If a surety wants to write a high penalty bond,
it must be prepared to accept part or even most
of the risk. Sureties in the US describe this as
good risk. Only good risks can make sure the
profits of a corporate surety, while bad risks
may correspondingly cause big losses.
Therefore, careful and professional
prequalification procedures, based on the so-
called ‘4C’ standard, are required in the
underwriting process to enable sureties to
identify the good risks. (‘4C’ stands for
character, capacity, capital, and continuity, all
of which are important for the contractor to be
successful.)
Will the surety be subject to bribery? No
situation can be immune from corruption if
there is an opportunity and an attractive benefit
to be had. However, the risk of corruption of
the surety is much lower than corruption of the
owner of the public works (either directly or
among the judges). This is because, in most
cases, the nominal owner, whether an official
or the judges in a competitive bidding exercise,
does not have sufficient clout nor sufficient
resources to recover all the losses arising from
failure on the part of the contractor. It is also
very difficult to make a claim against the officials
or the judges on account of a bad decision in
selecting a contractor, unless there is clear
evidence to prove that they executed their
duties in bad faith. On the other hand, the
surety has to pay up to 100% of the contract
price if it performed a bad prequalification, no
© CIPFA, 2003
159
matter how well it conducted the underwriting
function. Even though a surety has the right to
be indemnified against a failed contractor, in
practice it is difficult to collect sufficient
indemnity in most cases, simply because the
contractor is probably in a very weak financial
condition (otherwise it would not have given
up on the job).
The Surety Association of America (SAA)
and the National Association of Surety Bond
Producers (NASBP) cite the following reasons
why contractor prequalification by government
employees is not suitable:
•Every contractor is unique and every construction
project is different. Thus, it is impossible to use
purely objective standards in making sound
contractor prequalification decisions. A
subjective decision made by government
employees is difficult for the government to
defend if it is challenged by a disappointed
applicant. When the private surety industry
is used as the prequalifier of the contractor
applicant, this problem is eliminated for
the government.
•Contractors that are rejected by a government official
have no place to go in search of a different result
except to court. Lawsuits are expensive and time-
consuming. Of course, if the suit succeeds, the
government is now forced to use a contractor it
wanted to avoid. When a contractor is turned
down by a surety, the contractor may seek a
different result from a competitor.
•When a government prequalifier makes a mistake in
judgment, the tax-payer pays for the loss, not the
government official who made the bad decision.
When the surety makes a mistake in
judgment, it pays. This forces the surety to
make prudent prequalification decisions,
thus the government and the tax-payers are
protected.
•Whenever government officials are responsible
for deciding which private contractors will be
allowed to perform public contracts, it is virtually
impossible to prevent contractors from using
political influence to obtain a favourable
prequalification decision. When private
sector sureties are used, the potential for
such corrupt activity is practically
eliminated.
•Contractors may be reluctant to divulge business
information to a government prequalifier who
is, in effect, a representative of the potential
owner of the construction project. With private
sector sureties, contractors are submitting
their applications and business
information to a third party, the surety,
and not the party they will be contracting.
PUBLIC MONEY & MANAGEMENT JULY 2003
160
US practice demonstrates that prequalification
by private sureties works well. With support
through the high penalty conditional surety
bonding system, the contract awarding process
in the US is simplified so as to concentrate on
comparing prices from responsive bidders, who
have also submitted their mandatory bid bonds.
Under US practice, bids are normally opened
with all the bidders or their representatives
present, and the lowest bidder is announced as
the winner immediately. There is almost no
opportunity for corruption. Sometimes the
judges may challenge whether the lowest bidder
is capable of undertaking the job and may then
decide to award the contract to the second
lowest bidder. However, they have to give a
clear explanation and cogent evidence to
support their opinion, which will be kept on
record and could be challenged by the lowest
bidder through the courts.
In contrast to the high penalty conditional
system, the low penalty model appears
somewhat less dependable. A 5–10%
performance bond, such as is used in France,
Germany and the UK, can act as an incentive
on the contractor to behave correctly and
comply with the contract, but not necessarily
on the surety. In practice, it is not hard for the
surety to reduce its risk almost to nothing by
collecting enough collateral. As a result, no
incentive can be generated on the surety to
exclude incapable bidders according to the 4C
standards. Although pressure on a contractor
alone could guarantee performance in good
faith, that does not necessarily equate to
successful performance. The contractor may
have over-rated itself and bid the job beyond its
actual capability. An outsider is more likely to
make an objective judgment on such matters.
Thus, if there is no dependable judgment by a
third party, a qualification evaluation process
by the owner (or by judges invited by the
owner) has to be performed, no matter whether
there is a surety bonding system or not.
The different attitude towards bid bonds is
interesting. Bid bonds are not required from
contractors in order to bid for public works in
the UK, France or Germany, whereas they are
mandatory in the US. This fact may suggest
that the bid bond is not deemed as a useful
instrument in the low penalty unconditional
model. One can summarize the two approaches
to underwriting as follows. US practice favours
performance-based underwriting in which the
capability of the contractor is prudently
investigated, and this is the only feasible
approach in the high penalty conditional model.
It can also function as a very useful tool to
PUBLIC MONEY & MANAGEMENT JULY 2003
reduce the type of corruption that involves
collusion between insider and outsider in the
bidding and tendering of public works. The
alternative is indemnity-based underwriting,
in which the surety investigates the contractor’s
financial strength in order to feel confident
about collecting an indemnity in case of default,
and this is similar to the situation of approving
a loan by a bank It is always the practice in the
low penalty model.
Contract Bonding Models and Bid Rigging
Bid rigging refers to a situation when some or
all of the bidders collude with each other to
raise the bid price. As a result, the owner has to
pay more than necessary. One of the collusive
bidders wins the contract, while the others may
either share part of the benefit or move up the
queue for the next bidding exercise. The less
open the bidding procedure, the more
opportunity there is for bid rigging. Among
the three models of contract bonding, the
substitute contractor model is the most-
vulnerable to this abuse.
A substitute contractor’s completion bond
is unique in that the bond is provided by the
contractor’s competitor who has failed in the
bidding process. This arrangement might seem
reasonable in that failed bidders presumably
know the project well and have undertaken
some preparatory work when bidding;
moreover, all of them have been prequalified.
The substitute contractor has to continue the
work at the same price that the failed original
contractor agreed, and there is no premium. It
would appear that the public saves a lot of
money under such a system.
However, if the bidding is a really
competitive process, the cost for the substitute
contractor must be higher than the original
contractor who was the lowest bidder. The
substitute is almost doomed to lose some money,
if it has to take on the work, and it will be very
hard to recover any loss from the failed
contractor, who is probably in a very bad
financial state anyway. Therefore, the financial
problems of one contractor may be passed on
to other contractors via the bonding chain.
Unlike an independent surety, the substitute
contractor cannot avoid such risk by prudent
4C underwriting because the awarded
contractor would not leak its business secrets to
a competitor.
Statistics support this view. In Japan,
construction companies comprised 20–30% of
the total number of bankrupt companies whose
liability was higher than 10 million Yen in
every year from 1984 to 1997; in 1994, the
© CIPFA, 2003

bankruptcy ratio for construction companies
was 0.68%, which is higher than the ratio of
0.58% for all industries (Yoshitsugu, 1999, p.
99). Korea, the other country which uses
substitute contractor’s completion bonds, has
also reported that this system causes bankruptcy
with a few contractors infecting others one by
one, and eventually hampering the whole
industry.
In sum, the substitute contractor can get
nothing good from the bonding, and can even
lose money. So what motivates failed bidders to
act as substitute contractors? The only reason is
the hope for future business with the
government. They want the chance to bid for
public works in the future, and they need co-
operation from other contractors if they happen
to be the winner. The effect is that the substitute
contractor’s bonding system encourages
competitors to co-operate with each other
leading in turn to bid rigging. The bidders
submit their prices at a relatively high level,
except for the one who has been pre-selected
by the bidders themselves as the intended
winner for a particular contract. This bidder
submits the lowest price, although still much
higher than it need be. Now, everyone is happy:
the collusive contractors will get their profitable
jobs one by one from the government; the
government has followed the correct form for
a competitive bidding process, and maybe will
never know that it has paid more money than
necessary. The substitute contractor is at less
risk of walking into an uncompleted job, or
maybe even makes money if called on to take it
over, provided that the contract price was
generous enough in the first place.
Rose-Ackerman (1999, pp. 81–82) has
highlighted severe cartel problems in public
works procurement in Japan and Korea. In
1996, the substitute contractor bonding system
was abolished. Instead, a 10% monetary
guarantee was required, in the form of cash,
deposit, national bond or any other assets with
good liquidity. This is close to the low
unconditional penalty model. Alternatively, a
30% performance bond or performance
guarantee insurance is required, which is close
to the high penalty conditional model.
Ackerman cites a source which says that, for
national public works after 1996, bids were
20% lower than the estimated figure of the
Construction Ministry. Kusakari has also
reported an average saving of 15% –20%,
based on his investigation over three years
following the revised system in Japan
(Kusakari, 2001). Korea is also in the process
of abandoning the substitute contractor’s
© CIPFA, 2003
161
bonding system.
The Contract Execution Phase
Under the high penalty conditional model,
completed jobs will be added to the historical
record of the contractor. A good job will be a
‘plus’ in seeking to get bonded next time, while
a bad job may cause the surety to reject the
company in future. Jerry-builders can easily be
weeded out. Therefore, a mandatory surety
bonding system can make the contractor self-
disciplined, and provide less incentive to bribe
contract supervisors who might overlook the
use of inferior materials and lower quality
standards.
Low penalty bonds also enhance self-
discipline on the contractors, but there is less
impact on succeeding jobs, because there will
be no 4C underwriting process by the surety. It
is not hard to imagine that a bank would not
refuse to lend money to a company that is
consistently involved in bribes, as long as the
bank feels comfortable that the company has
enough resources to return the money. To
underwrite an unconditional bond is very
similar to approving a bank loan. However, a
surety would more likely decline to issue a high
penalty bond if it heard that the contractor
always completed its work by using inferior
materials and with lower quality than required
because of corrupt transactions with the owner’s
supervisor on site.
Furthermore, under the low penalty
unconditional model, an unconditional bond
places the contractor at more risk—an unfair
call may occur at any time and profits will be
eroded. A rational response towards this risk is
either to raise the bidding price, or to reduce
the cost of performance; but raising the bidding
price is to risk not winning the contract.
Therefore, to reduce the cost of performance is
more likely. In contrast, under a high penalty
conditional bond, the contractor need not fear
the risk of an unfair call. As a result, both its
bidding and performance can be more
transparent. Further study is still needed to
confirm this point.
Conclusion
The high penalty conditional model is the most
useful for improving transparency. Prudent
prequalification by some independent surety,
whose guarantee services are backed by its own
financial strength and credit, and who has to
assume some of the risks due to the high
penalty requirement, reduces corruption
opportunities to a minimum. With the
mandatory surety bonding system, a contractor,
PUBLIC MONEY & MANAGEMENT JULY 2003
162
for whom a close relationship with the surety is
important in order to bid for public works on
a regular basis, will be better disciplined in
performing the bonded contract and be less
likely to be a jerry-builder. Therefore,
corruption related to lower quality performance
is diminished as well.
The low penalty unconditional model has the
disadvantage that the surety is able to write the
bond based only on the liquidity of the
contractor, rather than on performance
capability. Thus, some benefits of the high
penalty bonding system are lost. Furthermore,
the risk of unfair call lays an extra burden on
the contractor, which can result in either a
higher contract price to cover the risk of unfair
call or an incentive for jerry-building and use
of bribes during the performance phase. Finally,
the discredited substitute contractor’s bonding model
encourages bidders to co-operate and causes
bid rigging. In conclusion, a well-designed
surety system reinforces transparency and
restricts the opportunities for corrupt
behaviour, while a poorly designed surety
system can actually foster corruption.
Acknowledgements
The authors thank Professor Angang Hu from
the School of Public Policy and Management,
Tsinghua University, and several anonymous
referees for their valuable comments on this
article. They also thank the National Natural
Science Foundation of China for support of
this work under Project 70203004.
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