The role of guarantees in contracting

By Peter Suremann

A guarantee could substantially improve a contractor’s working capital — or not at all. To answer this question, one needs to understand guarantees and insurance in some detail.

 Guarantees are not an insurance product but rather a credit product similar to loans, which need to be repaid. In South Africa, guarantees can be issued by insurance companies and banks (collectively termed financial institutions).

Retention guarantees

The general principle of insurance is that the contributions of the many (through payment of premiums to an insurance scheme) should cover the losses of the few. Actuaries employed by the insurers ensure that premiums are set at levels such that the insurance losses and insurance-related expenses do not exceed the total premium income of the insurer. When you claim on an insurance product, your premium might increase after you claim or you might lose a no-claims bonus, or in the worst case, the insurer might not offer you future cover if you have a very high claims history. However, the insurer does not have the right to recover the full amount of the insurance claim from you — unless there was a fraudulent claim. Your ongoing contributions to the insurance scheme provides the insurer enough ‘comfort’ to continue to provide the insurance cover for you. In the event that you stop paying your premiums, your cover may be suspended or cancelled in terms of the policy wording.

Guarantees are different. If there is a claim on a contractor’s guarantee, the financial institution that issued the guarantee (the ‘guarantor’) will have the right to recover the full amount from the contractor. The contractor therefore needs to provide the guarantor with enough comfort and security so that a full recovery can be made by a guarantor, should there be a claim on a guarantee. The amount of security will depend on the risk profile of the industry, the contractor, and the specific contract.

Banks are generally conservative and demand higher levels of security, often requiring up to 100% of the value of a guarantee in cash and/or other forms of security. Insurers generally require a lot less tangible security than a bank and might often only rely on what is referred to as paper securities, such as suretyships and company indemnities. In comparison to a bank, a guarantee issued by an insurer can therefore free up a contractor’s working capital substantially.

Retention monies are typically withheld by an employer to protect it from any defects that occur under the maintenance period of the contract. This money will be used when the contractor does not return to site to repair the defects. Some employers are willing to pay out the retention monies in exchange for a retention money guarantee. To issue such a guarantee, a bank may require the full amount of the cash as security for the guarantee, therefore tying up the working capital, rather than releasing it for the contractor to use in their business. In comparison, an insurance-based guarantor might only need a portion of the cash, if any, which is far more beneficial for the contractor.

Demand guarantees

A demand guarantee is a contract in which the guarantor promises to pay the beneficiary a certain sum of money upon the beneficiary’s first demand alleging a certain event. The event — usually insolvency or breach of contract by a contractor — does not need to be proven by the beneficiary (the contractor’s employer). Upon receipt of a compliant demand from the beneficiary, the guarantor is obliged to pay, irrespective if there is a dispute relating to the contract between the employer and the contractor.

Despite standard forms of contract being used, such as FIDIC, NEC, JBCC, or GCC, each employer may have its own specific contract requirements for guarantees and insurances. Generally, the more onerous and complex a contract is, and the more risk-averse an employer is, the more likely that an employer will specify the need for a demand guarantee in the tender requirements.

On top of the onerous nature of demand guarantees, they may also prohibit a guarantor from informing the contractor that there has been a claim on such a guarantee. For a contractor whose demand guarantee has been called up, the phrase ‘pay now, argue later’ plays true. When there are contractual disputes, demand guarantees can be used as a strong-arm tactic to force a favourable outcome for an employer. This could sometimes be grossly unfair towards a contractor. The only defence that a contractor could raise against such a demand, is a proven fraud.

In contrast, a conditional guarantee or a suretyship creates an obligation on the guarantor to answer for any failure of the contractor. Due to the accessory nature of the suretyship, the guarantor’s obligations closely correspond to the contractor’s obligations. The guarantor may therefore become liable to complete the construction works, deliver material, or repay a cash advance. In similar vein, the guarantor can use the same defences under the construction contract as that of the contractor. This implies that a guarantor could step into the shoes of a contractor to resolve a contractual dispute first to determine whether there is indeed a valid claim against a guarantee or not. Conditional guarantees or suretyships are therefore much fairer towards a contractor.

The advice to contractors is to clearly understand the guarantee requirements at tender stage or at commercial negotiation stage of a contract and to avoid onerous demand guarantees if possible. Guarantees are legal contracts and if a contractor has any doubts, they should seek advice from their legal counsel or guarantor.

Current appetite for this business

Each industry goes through economic cycles. The civil engineering industry in South Africa is currently in a slump. This is clear from the latest Bureau of Economic Research’s Civil Confidence Index of 18, which level was last seen in the early 2000s. The press is also full of stories about the embattled contracting sector as well as weak output of new projects, particularly from the government.

Liquidity is severely constrained in the current conditions, from the top all the way down. Employers exploit the buyer’s market and pressurise contractors with longer payment terms or keener prices. Employers often hide behind contractual disputes as an excuse to pay late, or not at all. This puts pressure on contractors’ liquidity, resulting in contractors paying their subcontractors and suppliers late, with some of the latter being forced to approach the courts for a favourable outcome. This could be time-consuming and expensive and put further pressure on profitability.

The worse the cycle, the more guarantee claims one can expect due to the higher incidences of contractors’ failure. The appetite to do guarantee business in the current environment is therefore a lot lower than it would normally be. Guarantors generally become more conservative, resulting in higher premiums, additional security requirements, and reduced guarantee facilities. The best advice to contractors in the current circumstances is to keep their guarantors very well informed about the state of their businesses. 

 

Peter Suremann spent the first 12 years of his professional career as a civil engineer with the South African National Roads Agency SOC Limited (SANRAL), where he specialised in traffic and transportation engineering projects to improve road safety and traffic capacity. He gained vast experience in the management, maintenance, and upgrading of road networks.

During this time, he completed an MBA before making a career change into the financial services industry, where he has been for the past 12 years. He is currently an underwriting manager in the Construction Guarantee business of Lombard Insurance Company. Suremann holds a B Eng degree in Civil Engineering, a B Eng (Hons) in Traffic and Transportation Engineering, and an MBA. He is registered as a professional engineer with the Engineering Council of South Africa (ECSA) and is a member of the South African Institution of Civil Engineering (SAICE).

 

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