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Guarantee or Bond – which offers the best protection against insolvent or defaulting contractors?

Posted on 30th October, 2015

Two of the most common security instruments made available in the construction industry to employers/developers are performance bonds and parent company guarantees.  There advantages and disadvantages to each.

Bonds

This is usually provided by a bank, insurer or other financial institution who guarantees that it will pay the employer a specified sum (normally 10% of the building contract sum) for the losses incurred as a result of the contractor being in breach either by a failure to perform its obligations or as a result of insolvency. As with any insurance-backed instrument, bonds come at a cost. This cost is passed straight on to the employer through the contract sum.

Generally, performance bonds fall into two categories either on default or on demand. The latter, where payment is triggered simply by service of a written demand, is rarely used due to the very high cost. On default bonds require not only the service of a written demand on the bondsman, but also proof that the contractor is in default and that this has caused the employer loss. It can be difficult to obtain payment of the bond as b ondsmen generally prefer to litigate a bond claim before paying it.

Bonds usually expire at practical completion of the project or at the end of the rectification period. Longer periods are possible but increase costs.

It is also important to ensure that the bond is assignable so that if the building contract is assigned the bond follows it, and that variations to the building contract do not void or reduce the liability under the bond.

Parent Company Guarantees

A parent company guarantee is given by the contractor’s parent or other connected or group company.  Contractors’ corporate structures are often designed to protect the ultimate parent company by dividing their construction operations and therefore a guarantee is needed to underwrite the obligations of the subsidiary that enters into the building contract.

Parent company guarantees vary significantly but usually include the performance of the obligations of the contractor, including payment of any sums due to the employer.  The guarantor is liable to the employer in the same way and for the same period as the main contractor.  It, unlike a bond, is not usually capped or limited to a percentage of the contract sum and its term is longer, being the duration of the building contract (6 or 12 years).

It is important to investigate the financial strength of the parent guarantor and whether the guarantee is a contract of guarantee or a primary obligation. A contract of guarantee is a secondary obligation, only when the contractor does not perform/pay can the employer bring a claim against the guarantor. More preferable for the employer (but not the guarantor) is for the guarantee to be drafted as a primary obligation independent of the building contract. This allows the employer to claim directly against the guarantor without first having to pursue the contractor.

Which is Preferable: a bond or a parent company guarantee?

Both have their drawbacks.

A parent company guarantee covers a longer period and is usually supplied at no extra cost to the employer. However, if the contractor becomes insolvent the parent company may also be affected and the guarantee may become worthless.

A bond is for a shorter period, covers less and the employer may not get payment until after formal proceedings against the contractor.

It will depend on the project, and both may be required. The alternative is to rely on retention sums and liquidated damages.


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