May 15, 2023
Security is a key feature of construction contracts and a common way for principals to manage risk.
Security can take different forms however all have the same goal: provide the principal (or the upstream party) with protection in the event the contractor fails to fulfil its obligations under the contract.
The taking of, use of, and return of security can be controversial when there is a disagreement, therefore it is important for both parties to a contract to understand the nature and purpose of security – one of the most common forms in large infrastructure projects being bank guarantees (which is the focal point of this article series).
This article series will first consider the general concept of security having specific consideration to bank guarantees, and then in subsequent weeks will explore a principal’s entitlement to (and/or prevention of) calling on that bank guarantee.
What Is Security & Why Is It Important?
‘Security’ is financial assurance. Specifically, it is typically money given ‘upstream’ to the principal, which the principal has access to (and can make a claim on) in the event the contractor fails to perform under the contract. In some cases, security may also be provided ‘downstream’ by the principal or head contractor typically if their ability to satisfy its obligations to make payment is in question (albeit less common).
Security is important to both parties as it acts as a risk allocation device to protect each parties’ interests; the principal wants to ensure that security can be immediately and unconditionally accessed, while the Contractor wants to ensure it cannot.
While it is often the common expectation that security will be ‘as good as cash’, it is dependent on the drafting of the bank guarantee and the relevant construction contract and is often heavily negotiated.
Types of Security
Security comes in numerous forms each with different financial, commercial and legal considerations to be taken into account depending on the size and scope of the contract.
Although not all explored in this article series, the most common forms of security are:
- Retention moneys or cash;
- Unconditional undertakings – bank guarantees and insurance bonds;
- Parent company guarantee; and
- Letters of comfort (less common).
How much security do I give and when do I get it back?
In Queensland, if the contract is with a principal or special purpose vehicle, no more than 5% of the contract sum can be held as security unless certain preconditions are met (section 67K QBCC Act).
With respect to the return of that security, the principal’s entitlement to security will be reduced by a percentage stated in the contract which is generally:
- 50% of the amount held (2.5% of contract sum) at practical completion (unless there is a right of recourse); and
- the remaining 50% (remaining 2.5% of contract sum) at the issue of the final certificate.
It is important to remember that security requirements should be considered in the individual circumstances of each project, taking into account value, risk, complexity and timelines.
Once security has been provided under a contract, the next step is for the parties to understand when the right to move against security arises – next week we will explore this having particular regard to bank guarantees.
Bank guarantees as security – what is it?
A bank guarantee involves three parties – the bank, its customer (the contractor), and the third party who has the benefit of the bank guarantee (the principal). Bank guarantees are a promise from the bank to pay a specified sum of money to the principal when a particular event occurs (e.g., a demand for payment).
An example of a bank guarantee promise to pay is as follows:
“In consideration of [the Principal] agreeing at the request of [the contractor] and [the bank] to accept this guarantee in connection with [contract description], [the bank] unconditionally undertakes to pay on demand an amount or amounts not exceeding the amount of [amount]”.
This means that the bank will have the risk of having to make payment under that guarantee. Typically, the principal will want the bank guarantee to be unconditional and payable on demand. This is so the principal does not need to prove to the bank that the contractor has defaulted or there is a right to claim under the contract. While this can be common, there are circumstances where the bank guarantee is governed by additional clauses which will impact the principal’s ability to call on the bank guarantee. Therefore, it is important to carefully check the drafting of both the bank guarantee and the security clause within the contract.
Further, contractors should be aware that a bank guarantee may impact upon their existing security arrangements, funding agreements and overall asset portfolio and whilst treated as cash, the contractor’s borrowing ability can be reduced for the period that the bank guarantee is in place.
Lamont Project and Construction Lawyers
Each form of security has varying levels of support to a construction project, legal and commercial consequences and costs which may slight impact its operation and effectiveness. Therefore, wherever possible it is important that the most appropriate security for use is considered on a project-by-project basis.
We have the industry knowledge and experience to assist both contractors and principals in all major infrastructure projects. If you have any questions regarding security in construction contracts, please contact Lamont Project and Construction Lawyers.
The content of this article is for information purposes only; it does not discuss every important topic or matter of law, and it is not to be relied upon as legal advice. Specialist advice should be sought regarding your specific circumstances.
Contact: Peter Lamont or Stephanie Purser
Email: [email protected] or [email protected]
Phone: (07) 3248 8500
Address: Suite 1, Level 1, 349 Coronation Drive, Milton Qld 4064
Postal Address: PO Box 1133, Milton Qld 4064