Guidance on Security for Construction Projects: Industry Discussion Paper – December 2018
10 POINT COMMITMENT
In December 2018 the Construction Leadership Group (CLG)1 issued an industry discussion paper entitled “Guidance on security for construction projects”.2
The Security Discussion Paper addresses specific issues raised in June 2018 by the CLG with a 10 point commitment to the construction sector known as the “NSW Government Action Plan”.3
COMMITMENT No. 5
Commitment 5 of the Action Plan addressed reducing the time and cost of bidding and included as one area to improve, clarity and consistency as follows:
“Standardise requirements for bonding, parent company guarantees and other forms of security across projects and agencies, based on a realistic assessment of financial and performance-related risks.”
The Action Plan acknowledges security should be addressed in the bidding phase so as to ensure that it does not delay the signing of contracts and progress of construction, which is of benefit to Contractors and the Principal alike.
Whilst the Discussion Paper sets out the best practice for choosing security for NSW State Government construction projects, it is also a thorough and informative analysis of security in general for any business in the construction industry.
Types of Security
Security is provided by a contractor for construction contracts in order to reduce a Principal’s risk of financial loss that may be suffered if the contractor defaults during construction and/or fails to fulfill its obligations.
The Security Discussion Paper sets out the proposed guidance on the following key types of security:
- Parent Company Guarantee (PCG);
- Unconditional Undertakings (i.e. bank guarantees and insurance bonds); and
- Cash retention.
No specific amounts have been set to allocate which type of security would be appropriate in terms of monetary value, however, various factors have been outlined in order to best choose the type of security for a given project.
Choice of Security
The proposed Guidance on Security specifically acknowledges that security should be bespoke to an individual project, balancing the appropriateness of the security against its effectiveness and cost.
The security package chosen should address the following issues:
- Duration – should cover the project and defects liability stage;
- Risk – should be appropriate to the risk and complexity of the project;
- Credit Rating – the security must have a satisfactory credit rating;
- Enforceability – Principal must be confident that the security is enforceable in the event that the contractor fails to fulfill its obligations. There should be no restrictions and/or conditions that prevent the security being called upon.
- Amount – the amount of security should align with the potential losses that may be incurred.
- Balancing capacity of contractor to provide security and extra cost to the project of doing so.
Parent Company Guarantee (PCG)
A PCG is a promise by a parent company to a contractor to guarantee the contractual obligations of its subsidiary company. The proposed Guidance re PCG’s notes the following factors in assessing whether this would be an appropriate security:
- PCG would have to have sufficient assets/balance sheet to provide sufficient financial protection which aligns with level of risk a Principal may suffer.
- PCG’s usually guarantee both financial responsibilities and performance of the contract. However if parent company does not hold relevant licences and is unable to undertake the completion of works in the event of a default, then it can only act as a financial guarantor.
- Need to assess credit quality of guarantor. This can be a problem where there is a complex company group structure and it is unclear as to where the group’s assets are held.
- Enforcing a guarantee with a foreign parent company can often be difficult and may need to be reviewed by Treasury to assess acceptability.
- A PCG must include an indemnity in respect of the contractor’s non performance of its obligations.
- If the Parent Company becomes insolvent the Principal will be an unsecured creditor.
- Assess whether there may be under-resourcing due to bidding on various projects simultaneously.
- Be aware of the ongoing nature of the parent company’s financial position as it may change during the course of a project due to delays and other factors.
- In case of a Joint Venture obtain guarantees from each parent company.
Unconditional undertakings – bank guarantees/insurance bonds
Unconditional undertakings are the requirement of a bank (in case of bank guarantees) or insurance company (in case of insurance bonds) to make a payment on demand. The following guidance is provided on the choice of this type of security:
- Unconditional undertakings should be “as good as cash” i.e. truly unconditional and payable on demand.
- It is not standard practice in Government to accept “conditional” undertakings.
- The undertakings are contractual in nature only and do not give any interest in property.
- Insurance bonds are perceived as having additional complexities and are relatively untested in terms of enforcement making them less desirable security.
- Bank Guarantees and Insurance bonds are a better choice of security where the contract is broken down into specific amounts for performance of specific events under the contract.
- Assessed based on credit worthiness of guarantor/issuer.
- This type of security can be adjusted across the life cycle of the project depending on risk profile at that time.
Cash retention refers to a system whereby the Principal retains an agreed percentage of cash from progress payments to the Contractor. The following guidance is noted by the CLG as to the choice of this type of security:
- Cash retention will be most effective if it is structured to align with the project’s timeline, risk, milestones and objectives.
- Cash retention is built up over the course of a project and so it may not be suitable where the critical risk occurs at the beginning of a project.
- It is recommended that cash retention is not applied in the first weeks of a project to allow contractor sufficient funds to mobilise.
- Cash retention alone is not sufficient security.
- It is noted in the discussion paper that in the UK after a government review there has been a push to end the use of cash retention due to impact on liquidity of contractors.
- Cash retention is more common for smaller projects or contractors who cannot obtain bank guarantees or insurance bonds.
Other key factors
The CLG recognises other key factors arising on a case by case scenario as follows:
- Seek additional security where significant variations increase contract value;
- Seek security over contractor’s manufacturing leases of equipment vital to timeliness of project (e.g. boring machines for tunnels)
- Obtain evidence that title in materials, transfers to Principal on payment for those materials as well as security for the cost of those materials.
- Ensure security covers any mobilisation payments.
- Costs of security are ultimately passed on to the principal when pricing a contract.
- Across the project timeline, risk and complexity will change, which will impact the value-for-money (VFM) outcome of security.
Options other than security
The discussion paper recognises that there are alternative mechanisms available to influence the contractor’s performance, including:
- liquidated damages;
- deductions/setting off/netting provisions;
- fixed and floating charges;
- default triggers and cure plan requirements; and
- personal guarantees from company directors (typically used for smaller projects and contractors and are usually limited to an agreed amount).
Calling on Security
Calling on security allows a Principal with immediate access to funds in the event of a Contractor’s breach or insolvency.
Whilst the proposed guidelines note that there should be limited restrictions on calling of security, some common conditions are:
- Principal has a claim or entitlement against the contractor;
- Contractor has a debt due and payable to the Principal;
- Principal gives notice of intention to make a call to contractor;
- Notice period before Principal can call on security.
When calling on security the Principal should consider the following factors:
- Injunctions – A contractor may seek to obtain an injunction from the courts restraining the call on security. The court’s will then assess entitlement of Principal to make a call under the terms of the construction contract.
- Financial distress – calling on security can lead to financial distress to contractor and also impact on completion of the project.
- Insolvency – where a liquidator is appointed the Principal may need to quantify its losses before calling on security.
- Interim not Final Rights – even though the Principal may have the right to call on security the contractor may be entitled to recover the funds where it is ultimately held that the contractor was not in default.
- Other options – it may be easier to use other options rather than calling on security to avoid the circumstances set out above.
This discussion paper was open for feedback and comments until 24 February 2019 but no further reports have been issued about the draft Guidance paper at this stage.
It is important that contractors are aware of these draft guidelines on security at the time of tendering on projects for the NSW Government. An understanding of your rights and responsibilities and the favourability of the proposed security are helpful in obtaining a successful outcome to the bidding and contract process.
David Glinatsis (Director, Kreisson) and Catherine Lucas (Solicitor).
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|1 NSW Government Agencies included in CLG are Infrastructure NSW, Transport for NSW, Roads & Maritime Services, Health Infrastructure, Schools Infrastructure NSW, Justice Infrastructure, Public Works Advisory , NSW Treasury, Department of Industry and Department of Premier and Cabinet.|