These days, it takes nerve to enter into ordinary commercial relations. But luckily for all you cowards out there, what you lack in courage you can make up for in paperwork
The importance of financial security should never be underestimated, but in the current financial crisis it is more important than ever. But what types of security are available?
For the employer
Contracts can provide for an employer’s security by including, for example, obligations for the contractor to maintain the current net worth of its company as at the date of the contract and to provide cash flow details on request, as well as giving confirmation of its ability to finance the completion of the contract.
Where the contractor has limited assets and is part of a wider group, a parent company guarantee may be requested. This provides additional reassurance in relation to any defects that may arise, as it is usually not limited to a percentage of the contract sum and will be available for a longer duration than a bond. However, a parent company guarantee will be worthless unless the parent company has assets, so the financial stability of the group will need to be investigated.
The contractor may be required to procure a performance bond from a bank or insurance company in favour of the employer, which will usually be for 10% of the contract sum. Bonds are commonly required by employers to provide security in the event of the contractor’s insolvency. The bank or insurance company will charge the contractor for the provision of the bond. However, employers should be aware that in reality they will bear the cost of the bond as it is likely to be included within the contractor’s tender sum.
Usually the contract will provide for the right of the employer to keep a retention fund. This provides security to the employer in the event that it has valid claims against the contractor for defective works or materials that are not rectified during the defects liability period.
A retention bond is appealing for the contractor because the retention is not deducted from its payment; instead it provides a bond to guarantee the retention.
A key security document, which is often required by an employer’s funder, is a collateral warranty containing step-in rights. The purpose of these rights is to allow the funder to step into the shoes of the employer if it defaults under the terms of its facility agreement or if the employer fails to pay the contractor. A funder warranty also provides a performance warranty in the event that the contractor fails to carry out its work in accordance with the contract.
An employer is also likely to procure, for its own benefit, collateral warranties from any subcontractors with design responsibility and any consultants on design-and-build projects which may have been novated from the employer to the contractor. A funder may also require warranties from design subcontractors and consultants, whether retained by or novated to the contractor.
Security for contractor
As well as employers ensuring they are themselves secure, it is advisable for contractors to seek security from their employer.
Letters of credit, often issued by a bank, are similar to on-demand bonds. The letter will set out that if certain events occur the bank will make a payment to the contractor; for example, where the employer has failed to pay the contractor. Alternatively, the letter may be used to make milestone payments. This means that the contractor can be confident that the employer has the backing of a bank to the extent set out in the letter.
Where there is some doubt as to the financial viability of the employer, the contractor may ask for a payment bond so that it is protected in respect of the work it has already carried out but has yet to be paid for.
The use of project bank accounts certainly provides security to subcontractors that payment will pass down the chain. Additionally, prompt payment should save the costs associated with poor payment practices.
The types of security available to all parties can reduce their risk in a project. However, it is important that you carry out proper investigations into the parties offering security and that you closely scrutinise the wording of security documentation to ensure it offers the security you think it does.
Alex Smith is an associate at HBJ Gateley Wareing