Surety Bonds and Bank Guarantees In Construction – Explained
A surety bond is a guarantee from the surety in favour of the named beneficiary that the contractual obligation of the principal will be fulfilled. Effectively, surety bonds are agreements between three parties for the benefit of one of them: the beneficiary. There are numerous surety bond wordings to meet the needs of specific industries and the construction industry is one of the main purchasers of them.
Large Contractors may pay an annual premium in exchange for the bonding company’s financial strength to extend surety credit in the form of bonds. The bonding company will normally be an insurance company whose solvency are generally verified by private audit and governed by government regulations. In the event of a claim, the surety will investigate it and if it turns out to be a valid claim, the surety will pay it and then turn to the principal for reimbursement of the amount paid on the claim and any legal fees incurred.
The vital term in nearly all surety bonds is the penal sum. This is a specified amount of money which is the maximum amount that the surety will be required to pay in the event of the principal’s default. The surety will assess the risk involved in giving the surety bond based upon this maximum amount and calculate the premium accordingly.
Although a surety bond is normally issued by an insurance company a bond is not the same as an insurance policy as risk is not transferred from the principal to the surety. The latter has a legal right to seek reimbursement from the former, usually via a counter indemnity. However, like an insurance policy the bond does protect someone (the beneficiary) against an unwanted event, e.g. non-completion of a contract by guaranteeing that money will be available, thereby giving similar peace of mind.
A counter indemnity is a written agreement signed by the principal entitling a surety to reimbursement if it has to pay claims under any surety bonds it has issued. Such agreements maybe very complex and can vary with each surety. They range from standard documents to indemnities incorporating undertakings and financial covenants.
Surety bonds offer an alternative to bank guarantees with surety bonds offering a number of benefits to Contractors as they do not reduce the working capital of the Contractor or restrict its borrowing capability. They are ‘conditionally worded’, which gives the protection of the underlying contract conditions. Surety companies rely on a counter indemnity, whereas banks often and additionally require a charge over the principal’s assets. Banks usually issue guarantees, which are payable on first demand and independent of the contract conditions, which means that the Employer does not have to establish any breach of contract.
A Bank Guarantee on the other hand is an undertaking from a bank or similar financial institution to the beneficiary normally on demand. Again the guarantee specifies a maximum sum which the bank guarantees to pay to the beneficiary. Instead of a premium as in the case of a surety bond the bank normally requires financial security from the principle in an equal amount to the maximum guaranteed sum. Depending on the arrangement between the bank and principle the sum may be invested to earn interest or similar, but the capital will be tied up until the banks obligations under the bank guarantee have ceased.
In this Article we review and explain the various surety bonds and bank guarantees commonly employed within the Malaysian construction industry.
- Performance Bond/Guarantee (Employer – Contractor)
These guarantee that a project will be performed according to the terms and conditions of the Contract and provide a cash indemnity to the Employer in the event of a default by the Contractor that leads to the Employer suffering a loss. The bonds/Guarantees are usually effected for 10% of the Contract Price but could be more or less. The default is usually caused by the insolvency of the Contractor. MALCONLAW Article entitled Performance Bonds & Bank Guarantees discusses in greater detail the general requirements of performance guarantees and bonds and also explains the various variants of bank guarantees such as conditional and on-demand formats.
- Performance Bonds/Guarantees (Contractor – Sub-Contractor)
These guarantee that a Sub-Contract Works will be performed according to the terms and conditions of the Sub-Contract and provide a cash indemnity to the Contractor in the event of a default by the Sub-Contractor that leads to the Contractor suffering a loss. These bonds/Guarantees are usually effected for 10% of the Sub-Contract Price but could be more or less. The default is usually caused by the insolvency of the Sub-Contractor. MALCONLAW Article entitled Performance Bonds & Bank Guarantees discusses in greater detail the general requirements of performance guarantees and bonds and also explains the various variants of bank guarantees such as conditional and on-demand formats.
- Retention Bonds/Guarantees (Employer – Contractor)
These are issued in favour of the Employer that has agreed to waive its right to deduction of retention monies from sums paid to the Contractor for work carried out. The bond/Guarantee will be for the retention percentage, which usually ranges from 2.5% to 5% of the Contract Price.
- Retention Bonds/Guarantees (Contractor – Sub-Contractor)
These are issued in favour of the Contractor that has agreed to waive its right to deduction of retention monies from sums paid to the Sub-Contractor for work carried out. The bond/guarantee will be for the retention percentage, which usually ranges from 2.5% to 5% of the Sub-Contract Price.
- Advance Payment Bonds/Guarantees (Employer – Contractor)
These are appropriate where an Employer makes a payment to a Contractor in advance of construction. This advance might be made to purchase an expensive piece of machinery essential to the work being done. The bond/guarantee amount would be the sum of the advanced payment.
- Advance Payment Bonds/Guarantees (Contractor – Sub-Contractor)
These are appropriate where a Contractor makes a payment to a Sub-Contractor in advance of construction. This advance might be made to purchase an expensive piece of machinery essential to the work being done. The bond/guarantee amount would be the sum of the advanced payment.
- Maintenance Bonds/Guarantees (Employer – Contractor)
These are a form of performance bond/guarantee relating solely to the maintenance period. They provide a remedy for defective workmanship or faulty materials discovered after practical completion during the maintenance period. The bond/guarantee amount would be assessed according to the risk or could be equal to the retention sun held during the maintenance period named in the Contract for remedying defects.
This type of bond guarantees the performance of the Contract. It covers the obligations of the Contractor to carry out maintenance after the building is has reached practical completion. Maintenance bonds generally run for between one and two years after the structure has been completed depending upon the maintenance period stated in the Contract. These types of bonds are always issued before the construction begins in combination with the performance bonds.
- Maintenance Bonds/Guarantees (Contractor – Sub-Contractor)
These are a form of performance bond/guarantee relating solely to the maintenance period. They provide a remedy for defective workmanship or faulty materials discovered after practical completion during the maintenance period. The bond/guarantee amount would be assessed according to the risk or could be equal to the retention sun held during the maintenance period named in the Sub-Contract for remedying defects.
Generally maintenance bonds are offered by the bonding or insurance companies. This maintenance bonds are used as an alternative to retention and are to provide security to the Contractor for maintenance of a Sub-Contractors works required after the completion during the defects liability period.
This bond guarantees the performance of the Sub-Contract. It covers the obligations of the Sub-Contractor to carry out maintenance time after the building is completed. Maintenance bonds generally run for between one and two years after the structure has been completed depending upon the maintenance period stated in the Sub-Contract. These types of bonds are always issued before the construction begins in combination with the performance bonds.
- Bid Bonds/Guarantees (Employer – Contractor)
A bid bond/guarantee indicates to the Employer is that the Contractor is serious about bidding for a particular contract and considers himself capable of executing the project as specified in the invitation to tender documentation and the Contractors tender offer. A bid bond/guarantee is a guarantee to the Employer that the Contractor will stand by and honour their bid.
If the bid bond/guarantee obligations are not met by the Contractor who either withdraws of fails to enter into a contract following acceptance of his tendered amount then the sum provided for in the bond/guarantee will be paid to the Employer. Generally there are two options in respect of the content of a bid bond/guarantee. It can either have a penal sum stated which is normally a percentage of the tender amount of the Contractor or alternatively the bond/guarantee will specify that the amount will be equal to the additional costs incurred by the Employer in selecting and awarding the contract to another contractor. Usually this the difference in amount between the Contractors bid and the bid amount of the next lowest compliant bidder.
A bid bond/guarantee will reduce the risk bidders submitting a non-competitive or insincere. Bond-issuing companies generally perform comprehensive credit and financial reviews before agreeing to provide surety bid bonds and will cover their exposure by seeking counter indemnities. Obviously Bank guarantees would be secured against the assets of the Contractor.
- Bid Bonds/Guarantees (Contractor – Sub-Contractor)
A bid bond/guarantee provides a Contractor with confidence that a Subcontractor will honour their tender to the Contractor who may in-turn be using the Sub-Contractors tendered amount in his bid to the Employer. Thus it acts in a very similar way manner to how a bid/bond guarantee offers some protection to the Employer. This is extremely important where the subcontractor is bidding on a major item of work or equipment and the Contractor must ensure that the invitation to bid documentation is very clear and concise. The difference between the Contractors plight and that of the Employer is the difficulty in proving a loss in the event of default as there are many factors to be considered were the works have been split and tendered amongst numerous subcontractors and suppliers.
- Payment Guarantee (Contractor – Employer)
These guarantee that the bank or other financial institution as named will in the event of the Employer failing to pay amounts due to the Contractor in accordance with the Condition of Contract (not exceeding the maximum amount stated within the guarantee) Care needs to be taken in establishing the maximum amount stated within the guarantee as clearly a bank guarantee for the full amount is not feasible unless this instrument is used to actually pay the Contractor. The Contractor should forecast his cash-flow and attempt to cover his expected exposure risk based on the projected payment amounts he anticipated under the contract. Consideration should be made also that if case of Employer default the Contractor will have an expose also to the time required to make and receive payment against a demand on the guarantee.
When drafting and executing bonds and guarantees the parties should take legal advice and it is also relevant that depending upon the standing of the Employer, Contractor and indeed the general economic situation, financial institutions and instrument providers may impose different conditions in respect of guarantees and surety bonds and these will have to be considered together with their associated risks in agreeing the content and protection offered by the guarantees and bonds.